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Difference Between A Line of Credit And Term Loan

July 20th, 2010 :: Gary Honig

As a business owner looking for help financing part of your business, it is important to understand the fundamental differences of a bank line of credit and a term loan. They are used specifically for different purposes. Applying for the wrong type of loan may cause problems later on as the business grows.

A line of credit (LOC) is usually considered a short term loan. The payments are interest only based on the outstanding funds in use. As you draw down on the line, using it to pay bills, interest is accrued monthly. The line is like an open checkbook for ‘use as needed’ purposes. The critical nature of the LOC is the necessary discipline to put funds from income back to pay down the line. There should be a constant flow of money coming from the line to pay bills and then replenished as customers pay for your goods or services. When applying for the LOC, the bank is typically looking for historical cash flow. What does the revenue look like? Is it steady or fluctuates wildly? The bank will take a conservative view of the existing accounts receivable to get a baseline. For the most part a bank will not be able to consider potential new business when considering a LOC credit limit.

A term loan is a fixed funding transaction. It is a onetime loan based on cash flow of the business plus certain collateral pledged against the loan. The loan should be used for a major expenditure rather than daily cash flow for the business. All the proceeds are available at the time of closing, not like a line where funds are circulating. The payments are interest and principal based on the amortized terms of the loan. For example; a $100,000 at 8% interest over a 5 year term. The bank will assume an ownership position on the collateral, meaning the collateral cannot be transferred or liquidated. The historical cash flow of the business is critical to securing a term loan. The lender needs to see that loan payments will not have an adverse affect on the business operations. Term loans are used to purchase real estate, equipment, for build-outs, or franchising.

There are situations where a LOC that has been used to the credit limit is converted into a term loan, so the business will have to make monthly payments to pay off the old line. The problem becomes the business no longer can gain access to additional funds while the loan is outstanding. Access to capital is the lifeblood of any company, and lack of capital will starve a growing business.

The IRS Is Not A Bank

April 9th, 2010 :: Gary Honig

The Internal Revenue Service is not a lender of last resort. By not paying taxes, you are ultimately borrowing from the Government, at extremely costly rates. The addition of compounding interest and penalties will make a bad situation much worse. Any unpaid taxes due will garner a daily interest rate, plus a monthly 5% penalty each month up to 5 months for a maximum of 25%.

For businesses, the most common tax payment problems come from not paying the payroll tax. Failure to pay 941 payroll taxes can easily put the entire business in jeopardy and have a drastic affect on the business owners’ assets. If the company is dissolved, the IRS will still require the owner to pay outstanding balances of payroll taxes.

The best advice for tax problems is to be pro-active at all times. Like most bad situations, ignoring it will not make it go away. If there are not enough funds to pay taxes on a timely basis, there is a strong indication the business is improperly capitalized. This can cascade into difficulties that may be hard to get out of, which could create lasting negative obligations.

As far as the IRS is concerned, first they will send a letter for a balance due. Upon not hearing anything from the taxpayer they might send a few more. When the bureaucracy figures out no one  is heeding the message, they will assign a case worker. This means your account has moved down a notch.  At this point either a payment plan is negotiated or a Notice of Federal Tax Lien is filed. Avoiding a tax lien is highly recommended. Once a payment plan is in place, it is imperative that payments are made on a timely basis. With good cooperation a payment plan can be in place without having a formal tax lien.

The latest news is that the IRS is now checking that Federal contractors are in compliance. Meaning, they conduct a review of certifications of non-delinquency in taxes for any companies bidding for Federal contracts. This could potentially kill an active solicitation bid if there are outstanding taxes due.

In some cases a factoring company can actually assist in situations where there is a delinquency. But once a lien has been levied against a company it will require written subordination from the IRS in order for any commercial finance company to even consider funding. . When a payment schedule is in place, the factor may send advances from invoices directly to the IRS. This insures that payments are being made in a timely fashion per the IRS agreement.

Fortunately tax problems can be remedied, but they can’t be ignored.

Interest Free Loans!

April 2nd, 2010 :: Gary Honig

Sounds great doesn’t it? Well that is exactly what businesses do everyday when they offer credit terms to their customers. Sure it’s considered normal to allow a customer thirty days to get their bookkeeping in order to pay the bills. But many large companies take advantage of credit terms and take 60 – 90 days to pay an invoice. That becomes 3 months of interest free money. Your money. You are essentially helping to grow their company using your resources, time, material and energy.

This problem is compounded by many small businesses who fail to recognize the critical nature of extending credit to customers who would otherwise not qualify. Being in business and offering credit to customers is just like being a bank. A bank lends money to borrowers based on strict guidelines. Small businesses offer credit terms on little or no guidelines at all. When it comes time to go to a commercial lender and attempt to borrow capital, the creditworthiness of customers is definitely taken into consideration. One large sale that ends up not paying, which could have been avoided with proper credit management, may potentially wipe out a years worth of profit.

How to avoid selling to poor credit customers;

  1. Use a credit rating agency like Dunn & Bradstreet or Experian
  2. Know how to read these reports
  3. Be conservative when offering a credit limit based on the report
  4. Ask for financial statements – Balance sheet, Income statement
  5. Ask for credit references, and follow up on them
  6. Let the customer know the faster they pay the quicker they can order more
  7. Keep an eye on payment history before allowing more credit
  8. Stay on top of collections, develop a routine

Proper Use Of Collateral

March 26th, 2010 :: Gary Honig

Business owners who are operating revenue driven companies often turn to outside sources of capital when looking to grow faster. Either a company can sell shares (and shared ownership) to raise capital or they can borrow against collateral. Collateral usually means some sort of tangible asset such as equipment or receivables.

When using collateral for borrowing, it can be costly to not recognize the ramifications of pledging certain assets. This means, once collateral has been borrowed against in the form of a loan, the loan must be paid off in order for the same collateral to be used again. All lenders can quickly ascertain whether a loan exists and what collateral has been assigned. Asset based lending companies require a first security position on the collateral they are financing. Pre-existing loans or credit activities that have been issued a secured position on collateral make additional funding impossible.

Generally the problem stems from a line of credit, which was used up over an extended period of time. Ideally, a line of credit from a bank should be properly managed and treated like a revolving loan. Money should be taken from the line, but regularly paid back to pay down the line. Having the discipline to borrow and pay back on a line of credit will keep the financial condition of the company sound. This means certain expenditures must wait until profit or other investment is available.

What finally happens with the mis-management of a line of credit is – the line has reached the maximum credit limit. In today’s lending environment, the bank will be unwilling to extend further credit and probably will change the structure of the outstanding amount into a “term loan.” This means the total amount is due on a monthly installment payment plan, leaving the company with their collateral spoken for and no ability to raise additional capital through alternative sources.

So the critical lessons here are, knowing when the company assets are being used as collateral and don’t get caught in a dead end where there is no access to badly needed working capital.

Contractor vs Employee – Getting Scrutiny

March 5th, 2010 :: Gary Honig

You may not have noticed in the news, but the issue of “independent contractors” is becoming a hot item. This is where a company will forego making payroll tax payments and just hope the individual will pay their own way.

Make no mistake, one way or the other, tax on hourly wages must get paid. Either the company deducts them from a paycheck and makes monthly 941 payroll tax payments or the individual needs to make self employment tax payments. The IRS has determined there are three criteria for consideration when deciding whether an individual is an employee or independent contractor.

  1. Behavioral – Does the individual decide where to be, when to be there and what to do when performing their duties?
  2. Financial – Is the individual completely responsible for tracking their finances, negotiating their rate, paying for their own expenses?
  3. Type of Relationship – Does the individual conduct all aspects of their part of the business relationship with regards to contracts, starting, leaving, paying taxes?

If the answers to all of the above is Yes, without any reservations, the individual may be considered an independent contractor. But any shades of gray will pull toward requiring the company to pay the payroll taxes. One rule of thumb would be, when looking at the operating financial statement for the business, the cost of payroll should be one of the bigger, if not the largest cost of doing business.

The reason this is timely has to do with the loss of revenues to both Federal and State budgets. In an effort to recoup shortfalls, agencies are taking a hard look at companies that try to avoid making their necessary tax payments. And here is the kicker, if a company is found to have avoided paying payroll taxes and is levied with past due amounts plus penalties and interest – that liability follows the company owner until it’s paid. Liquidating the company will not resolve unpaid payroll taxes.

Will An ARC Loan Help Your Business?

January 11th, 2010 :: Gary Honig

The stimulus plan created for small businesses the America’s Recovery Capital or ARC loan program. With $255 million of funds, it is geared to help businesses who have an existing loan with their loan payments.

1. The business seeking an ARC loan must have outstanding business debt.

The ARC loan program was designed to help “viable” as defined, small businesses who are suffering “immediate financial hardship” also defined. In order to be considered viable, the business must show that at least one of the last two years the company was profitable. It further requires that the outstanding loan(s) from a credit institution may not have any payments more than 60 days past due.

2. The ARC loan is not for start ups or change of ownership scenarios

The requirement of immediate financial hardship would need to be fully documented for these kinds of financial conditions; trouble making personnel payroll, slowdown of sales, bank refuses additional credit on loans, trouble paying debts etc. Evidence of these conditions must be shown in excruciating detail. So it is necessary that the borrower has very good accounting in place in order to run the necessary financial reports.

3. An ARC loan can be made up to $35,000

The Small Business Administration (SBA) is running the ARC program and an SBA preferred Lender, a bank, will be making the actual loan. A borrower needs to find a bank that is offering the ARC loan program. The bank will be looking for the SBA (US Government) to guarantee 100% of the loan. Proceeds of the loan can only be used to make payments on existing loans, like; secured or unsecured lines of credit, business related credit card debt, capital leases, and term debt.

4. This is an interest free loan, guaranteed by the SBA

The loan may be dispersed in up to 6 payments that go directly to paying off loans. After the last disbursement, there are no payments by the borrower due on this loan for 12 months. After the 12 months, the balance of the loan is amortized over 5 years (60 months) for full repayment of the principal. Again, there is no interest due on this loan, but any older existing loans must still have regular payments.

5. Will the bank require additional collateral for the loan?

This requirement is based on the individual SBA 7a Lender. Some will only require a signature from the business owner who is personally guarantying the loan. But in this case the personal credit of the owner will be scrutinized. Because the size of the loan is small enough and the SBA is guarantying 100% of the risk, if the business owner still has fair credit there is a chance no additional collateral will be required.

6. How do I apply?

Find a local bank who is participating in the ARC loan program. There will be a multipage comprehensive loan application. With the application a loan package including 2 years of tax returns, both personal and for the business, historical financial accounting, documentation for the existing loans, 2 years of Performa financial projections to show the business can make the necessary loan payments. The entire loan application will be packaged by the Lender and submitted to the SBA for approval. Once approved, a loan closing will occur and the disbursements commence. Many businesses are finding the application process so onerous they are turning to business consultants and SCORE volunteers for assistance, which is highly recommended. Do not be taken in by individuals who claim to guarantee approval if you pay them an up front fee.

Bottom Line

So in the end, if you have a business that has been around for a few years, and you have meticulous accounting records, and you have a loan with a bank in which you are struggling to make loan payments – the ARC loan is designed to provide interest free funds where for the first year you do not have to make any payments in order to help stimulate your business. For additional details contact the SBA.

What Is Invoice Factoring and Why Is It Important In Today’s Economy?

December 14th, 2009 :: Gary Honig

In today’s credit restricted economy it is critical for business owners to be aware of all the various forms of financing that are available. Too often these days, banks are self absorbed in protecting their internal balance sheet, rather than taking on risk in the form of loans to small businesses. Even in the best of times emerging growth companies need to rely on alternative forms of financing to insure their success.

Factoring companies have been around for ages, and still in everyday life most people have no idea what they do. Simply put, “factoring” is a form of commercial financing or debt financing which has collateral as the basis for borrowing money. In this case, an invoice or obligation to pay by an account debtor is the collateral for borrowing.

Whenever a company provides a service or sells a product to a customer and offers terms of payment, the company is in essence “loaning” money to the customer until it gets paid. This act of making a loan to the customer is commonly known as the invoice. The factoring company makes arrangements to buy this invoice, pay the company immediately and waits for the customer to pay their invoice – back to the factor.

There are some principal benefits to this type of financing;

  1. Speed: Unlike most capital resources, the factoring relationship can be set up in days, and once set up, the funding of an invoice happens within 24-48 hrs.
  2. Financial: The funding decision is based on the financial quality of the customer, while the factoring client can be financially challenged or just getting started.
  3. Credit Limit: Generally as long as the client is invoicing a good creditworthy customer the factoring relationship can grow with the client, so there may not be any limits of access to capital.
  4. Discipline: One of the ways a company can get into trouble with a bank line of credit is lack of discipline – meaning not regularly paying down the line. With factoring each time the customer pays the invoice it retires the mini-loan.
  5. Equity: Factoring is considered an “off-balance sheet” form of financing which keeps any net term liability off the corporate balance sheet preserving the equity position in a positive manner.
  6. Set Up: The process of getting started requires minimal paperwork and no lengthy negotiations compared to banks and equity venture funding.
  7. Cost: The cost of factoring invoices is relative to the short term nature of the transaction – not lasting more than 90 days. So more than a bank but less than a V.C. Companies that have very thin profit margins are not best suited for this type of financing to grow their business.
  8. Growth: Having access to capital improves the financial condition of a growing company and ultimately leads them to conventional bank financing.

Here is a typical example of how factoring works and why it can be so important to a company that is on the verge of doubling in size. A company has been struggling to get a large contract for a long time. This has created stress on their finances, getting by until the big contract finally hits – and then it does, congratulations. Now a dozen new hires need to be quickly put in place. Two weeks later comes the first payroll, two more weeks and another payroll, but the invoice is submitted to the customer. With factoring, the next day, access to the capital tied up in the invoice is available to the company allowing them relief from the working capital crisis.

Typically there are three parts to a factoring transaction:

  1. Advance: The percentage of the total amount of the invoice that the company has access to when they are funded, which is around 80%.
  2. Reserve: The remaining percentage held back and released when the customer pays the invoice.
  3. Discount Fee: The fee associated with doing the transaction which gets deducted from the reserve. Based on how long it takes to receive payment of the invoice the fee can be 2 – 5% of the full value of the invoice.

Bear in mind that factoring companies tend to work operate differently, and specialize in particular industries, so it is important to see that you get a good match when seeking an optimum funding relationship.

Understanding Angel Funding vs Venture Captial

December 4th, 2009 :: Gary Honig

It should be noted there is a distinction to be made regarding equity investors. Knowing the difference between Angel investors and Venture Capital is critical to working with and marketing to them.

With Angel investors the first very important attribute should be – are they truly professional accredited investors. Only work with professional investors who properly know how to manage the transaction so that it does not encumber further investment down the road. Angel investors have various motives and drivers that will get them to become a partner in a company.

Unlike angels who work independently, Venture Capital Funds are managed by a team of people who answer to shareholders. The VC group goes out and raises a Fund themselves, targeting a specific mission. By the time a potential client is being considered, there is a council of voices that must be attended to and reasoned with. So the experience is much more institutional, with layers of process. Obviously smaller VC funds are more streamlined, but for the purposes of this discussion the difference between working with an Angel and a Venture Capitalist is generally individual versus group. A good FAQ about Venture Capitalists is on the NVCA web site.

Financing A Business: Using Equity vs. Debt

November 16th, 2009 :: Gary Honig

At various times in the life of a company there are going to be requirements for outside capital in order to grow the business. Choosing which type financing vehicle is best for your company is very important. Deciding whether to seek equity capital or debt financing is the first step. Usually companies trying to get equity capital are very early stage with little or no real assets, while companies on their way to a steady growth curve use debt financing.

The equity route

As the owner of a business idea, plan, or company – you hold ownership to a subjective value called equity. The equity of any type of property whether intellectual or physical is the value someone is willing to pay for it minus any liability attached to it. In business that could mean the value of an entity today measured in time and money invested versus the value in the future measured by comparable growth.

Once the owner and investor determine the “valuation” of the equity, the owner can then sell parts of the equity in order to raise capital. There are a variety of methods you can raise equity capital (Seed, Angel, Venture) and you should learn the pluses and minuses for each. An equity capitalist is interested in picking a company that shows great potential. They are expecting that there will be significant growth due to their involvement. That could mean that the company will grow tenfold within five years.

Debt Financing

Securing capital through debt financing does not entail “selling” your equity, but instead works by “borrowing” against collateral assets. Debt financing is only available to business owners who have something of value that the lender can instantly liquidate. The debt finance company is not interested in becoming a partner, instead they are in business to make money from their money, letting you use it for periods of time.

Like equity financing there are a variety of methods available to raise debt financing. Traditional banking will always be the least costly source for your financing, but remember bankers are not in business to take on risk. When they ask for three years of company tax returns it’s because they want to see a steady reliable set of profitable growth numbers. Borrowing from the bank relies on two variables, the collateral that secures the loan, and your ability to repay the loan. You might have enough collateral, but if your business is losing money, the bank can’t expect you to handle the added expense of loan payments.

Many early stage companies turn to private commercial financing which is better suited to deal with riskier issues. Factoring companies use the loans you make to customers (invoices for finished work) as the collateral for their funding. Here the emphasis will be the creditworthiness of your customers rather than the credit of your company. Equipment leasing companies will allow you to purchase new equipment and pay for it over time, usually three to five years.

Finally,

When seeking outside capital, whether equity or debt, remember that certain sources are familiar and like to work with particular industries. Take the time to look around and be sure that the source you are considering is well-aquatinted with your type of business.

7 Ways To Be More Attractive To Lenders

October 12th, 2009 :: Gary Honig

It’s always said that access to funds is the life blood of any company. Going out and securing outside financing to help grow a business is an important step in the life of an emerging organization. Keep in mind, the process of commercial borrowing is best done in preparation for needing the capital, rather than when the request is made in a dire situation. Here are some necessary tips to keep in mind when preparing to seek a loan.

    1. Bookkeeping – install accounting software so you can produce up to the moment financial reports including Balance Statement and Profit Loss Statement. These reports will give the Lender a snapshot of the current financial condition of the company. It also assures that you know enough about accounting to understand the internal cash flows.
    2. Customer Credit – show you have a process in place to check the credit of all your customers. Learn how to avoid issuing credit for more than they are qualified. Sales to customers are what business is all about. Knowing the difference between a solid customer and a bad credit is crucial to long term stability.
    3. Borrowing Amount – know how much capital the business requires to operate. Whatever the business does, whether provide a service or sell a product, you must be aware of the profit margin on these activities. You should have a solid business plan in place with budgets where you can determine the potential short fall and take precautions through financing.
    4. Purpose – your business plan needs to be able to show a purpose for using the capital. This must be very specific. The more details you can provide on where the loaned money will be employed, the better the Lender can determine the viability of your plan. By admitting potential problems and offering contingency suggestions, your business plan will have added dimension.
    5. Repayment – in the business plan, give a reasonable timeline for the repayment of the loan. Preparing cash flow performance will show the road map to ultimate success and profitability. Again, incorporating contingency budgets will help to mitigate potential risk.
    6. Team – make sure the owners, managers have strong bio’s and thorough knowledge of the industry. The Lender must have confidence that the operators of the business plan can perform based on their experience.
    7. Loan package – do your homework, and put all this together with your business plan into a binder so a lender can easily see who, what, where, how this company will deal with a loan. By being pro-active through the entire process you will become a more attractive prospective client to a Lender, and therefore will have some bargaining leverage with regards to the terms of the loan. It’s always a good idea to get involved with a professional to help you through the process.