We touch a lot on the subject of financing to fund your business in this blog. It is perhaps the most important aspect of running your business, and not being in the moment when making funding decisions can really get you in trouble.
As a typical small business, you are likely finding resistance at your bank you getting a line of credit sufficient to fund and grow your business. And that is just regular operating funds. What happens if some equipment breaks? Maybe your supplier will finance it, maybe they won’t. What about a big new order from your sales team? Can you fund the inventory or extra labor?
Today we are focusing on an industry that has mushroomed, literally over night. It is called the ‘alternate funding’ market. On the surface it will seem to tick all the boxes and appear to be a dream come true. Some of these companies can actually do same day funding and you can get money in your bank in less than 72 hours. These companies are growing so quickly that investment banks, like Goldman Sachs, have taken note and entered the market. Given the huge margins they create, it is no wonder that the sharks on Wall Street are jumping at launching there own funds.
The main players are OnDeck, Funding Circle, and Kabbage. In the case of OnDeck, the application and funding process could not be any easier. And, it can mostly be done online without even talking to anyone. What a difference from the commercial bank process of sitting across from a banker with a stack of financials, business plan, forecast, and other required documents, and then have to wait for a few weeks as some faceless, nameless underwriter sitting in a cubicle a thousand miles away makes a life changing decision for you.
Before you make the mistake of taking one of these loans, please read further. It could save you from making a mistake you will quickly regret and feel the effects a long time after.
So, let’s start with the obvious point here. The money is not cheap. In fact it is down-right burdensome from an interest perspective. Before you take that loan, think about it for a long time. Do you really need to pay up to 30% interest for your funding? Have you exhausted every other option? The rate you will pay will be dissolved from view quickly by these companies, as they will focus you on the re-payment amount, which will seem do-able. That is exactly what they want you to think. As you will soon discover, it is not easy to pay off the loan.
The next issue, is that the term of the loan is short. This is for a reason. You are more likely to default on a longer term loan, and the interest amount on a longer term would go from obscene to insane. So by boxing you into either a 6 month or 12 month term, it doesn’t seem that bad. Still not convinced this is a bad idea?
Next comes the killer part of the deal. You must re-pay the loan with daily payments, and they are auto-draft EFT payments pulled from your bank account. Every business day. Read that again…every business day.
So let’s put this in play. You take out say a $10,000 loan at 28% for 6 months. Let’s say you take that loan for inventory needs for upcoming orders and the real need is $10,000. Not a horrible strategy on paper, but let’s look at what actually happens. In this example your payment will be around $100 +/- every day. So on a Monday the funding takes place and $9,700 lands in your account. Why not $10,000? Well, there is an application fee deducted from the total. So, you are already short $300 for your inventory needs. Now, the clock starts ticking. Tuesday morning, $100 is pulled from your bank account, as it is on Wednesday, Thursday, and Friday. So no you are down to $9,300 in funds, and have to repay $12,800. Let’s say on Friday you purchase raw materials in the amount of $5,000, leaving you with $4,300 in the bank. They do not pull money on non-business days, so you will learn to look forward to the weekends. But the following week, another $500 is pulled leaving you with $3,800 with about $12,000 to repay. Seeing this, you quickly realize you better purchase more raw materials before you run out of money and buy another $3,000 of materials, leaving you $800. If you are like most small businesses, you extend terms to your customers, probably at net 30. So far, we are two weeks into this example and it is not likely you have received raw material, built your product, shipped it, and invoiced it. Week #3, another $500 is pulled, leaving you essentially with no way to buy more inventory. So for a loan of $12,800, you have bought just $8,000 of inventory. Week #4 comes along and guess what? All of the funding is exhausted in one month, and you now have to find a way to pay the loan payment…every day.
The reason you took out this loan is because you did not have the cash flow to fund your upcoming operations. Seemed like a good and easy idea. But you have taken the problem you were in and made it much worse. Now for the next several months, you are repaying thousands of dollars out of your cash flow. How does that make it a good idea? It does not. As we have said many many times, debt only makes sense if you are in control of the terms. A credit line makes sense because you always have the option to just pay the interest each month, once a month. The daily loans don’t give you an option. Have money in the bank? Pay every day. Don’t have money in the bank? Too bad, pay every day.
Want more insight into the devious plan by these companies? If you pay down half of the loan, they will allow you to roll over the remainder into a loan renewal. Of course they will incent you by cancelling the interest charges on the current loan. Actually they have to, or they will be charging you double the already insane rate. So now they have managed to extend you for another six month period. And on and on it goes. You will literally not be able to break this cycle and it will be a major burden on your business going forward.
In our opinion there is only one way to use this service. If you can turn around a revenue opportunity very quickly, say in two weeks, then it may be worth doing. In our example above, borrowing the $12,800 may make sense for you if it is to generate $20,000 over a two week period and you can pay off the loan in full. Other than that, we recommend you steer clear of these alternate financing methods. Drop us a line if you need help on this. Good luck.