6 Sources of Bootstrap Financing
When you’re thinking about how to raise money, one of the first things you should consider is bootstrap financing–using your own money to get your business off the ground. This is one of the most popular forms of internal funding because it relies on your ability to utilize all your company’s resources to free additional capital to launch a venture, meet operational needs or expand your business.
Bootstrap financing is probably one of the best and most inexpensive routes an entrepreneur can explore when raising capital. It utilizes unused opportunities that can be found within your own company by simply managing your finances better. Bootstrap financing is a way to pull yourself up without the help of others. You are the one financing your growth by your current earnings and assets.
There are a number of advantages to using the various methods of bootstrap financing:
- Your business will be worth more because less money has been borrowed, and therefore, no equity positions had to be relinquished.
- You won’t have to pay the high interest on borrowed money.
- Coming from a stronger position (with less debt on hand), you look more desirable to external lenders and investors when the time does come to raise money through these routes.
- You can be creative in finding ways to raise profits, without having to look to external sources. It will give you the added confidence of business savvy.
The first source of business money we’ll discuss is trade credit. Normally, a supplier will extend you credit after you’re a regular customer for 30, 60 or 90 days, without charging interest. For example, suppose that a supplier ships something to you, and that bill is due in 30 days but you have trade credit or terms. Your terms might be net 60 days from the receipt of goods, in which case you would have 30 extra days to pay for the items.
However, when you’re first starting your business, suppliers aren’t going to give you trade credit. They’re going to want to make every order c.o.d (cash or check on delivery) or paid by credit card in advance until you’ve established that you can pay your bills on time. While this is a fairly normal practice, to raise money during the startup period you’re going to have to try and negotiate trade credit with suppliers. One of the things that will help you in these negotiations is a properly prepared financial plan.
When you visit your supplier to set up your order during your startup period, ask to speak directly to the owner of the business if it’s a small company. If it’s a larger business, ask to speak to the chief financial officer or any other person who approves credit. Introduce yourself. Show the officer the financial plan that you have prepared. Tell the owner or financial officer about your business, and explain that you need to get your first orders on credit in order to launch your venture.
The owner or financial officer may give you half the order on credit, with the balance due upon delivery. Of course, the trick here is to get your goods shipped to you, and sell them before you have to pay for them yourself. You could borrow the money to pay for your inventory, but you would have to pay interest on that money. So trade credit is one of the most important ways to reduce the amount of working capital you need. This is especially true in retail operations.
Despite the urge to use trade credit on a continual and consistent basis, you should consider it as a source of capital to meet relatively small, short-term needs. Do not look at it as a long-term solution. By doing so, you may find your business heavily committed to those suppliers who accept extended credit terms. As a result, the business may no longer have ready access to other, more competitive suppliers who might offer lower prices, a superior product or more reliable deliveries.
The Cost of Trade Credit
Depending on the terms available from your suppliers, the cost of trade credit can be quite high. For example, assume you make a purchase from a supplier who decides to extend credit to you. The terms the supplier offers you are two-percent cash discount with 10 days and a net date of 30 days. Essentially, the suppliers is saying that if you pay within 10 days, the purchase price will be discounted by two percent. On the other hand, by forfeiting the two-percent discount, you are able to use your money for 20 more days. On an annualized basis, this is actually costing you 36 percent of the total cost of the items you are purchasing from this supplier! (360 ( 20 days = 18 times per year without discount; 18 ( 2 percent discount = 36 percent discount missed.)
Cash discounts aren’t the only factor you have to consider in the equation. There are also late-payment or delinquency penalties should you extend payment beyond the agreed-upon terms. These can usually run between one to two percent on a monthly basis. If you miss your net payment date for an entire year, that can cost you as much as 12 to 24 percent in penalty interest.
Effective use of trade credit requires intelligent planning to avoid unnecessary costs through forfeiture of cash discounts or the incurring of delinquency penalties. But every business should take full advantage of trade that is available without additional cost in order to reduce its need for capital from other sources.
This is a financing method where you actually sell your accounts receivable to a buyer such as a commercial finance company to raise capital. A “factor” buys accounts receivable, usually at a discount rate that ranges between one and 15 percent. The factor then becomes the creditor and assumes the task of collecting the receivables as well as doing what would’ve been your paperwork chores. Factoring can be performed on a non-notification basis. That means your customers aren’t aware that their accounts have been sold.
There are pros and cons to factoring. Many financial experts believe you shouldn’t attempt factoring unless you can’t acquire the necessary capital from other sources. Our opinion is that factoring can be a very good financial tool to utilize. If you take into account the costs associated with maintaining accounts receivable such as bookkeeping, collections and credit verifications, and compare those expenses against the discount rate you’ll be selling them for, sometimes it even pays to utilize this financing method. After all, even if the factor only takes on part of the paperwork chores involved in maintaining accounts receivable, your costs will shrink significantly. Most of the time, the factor will assume full responsibility for the paperwork.
In addition to reducing your internal costs, factoring also frees up money that would otherwise be tied to receivables. Especially for businesses that sell to other businesses or to government, there are often long delays in payment that this would offset. This money can be used to generate profit through other avenues of the company. Factoring can be a very useful tool for raising money and keeping cash flowing.
Customers are another source of bootstrap financing, and there are several different ways to take advantage of these valuable assets. One way to use your customers to obtain financing is by having them write you a letter of credit. For example, suppose you’re starting a business manufacturing industrial bags. A large corporation has placed an order with your firm for a steady flow of cloth bags. The major supplier from which you will obtain the material the bags is located in India. In this scenario, you obtain a letter of credit from your customer when the order is placed, and the material for the bags is purchased using the letter of credit as security. You don’t have to put up a penny to buy the material.
In your personal financial dealings, you may have had a builder, or someone else working for you, ask for money up-front in order to buy the materials for your job. That contractor used your money to get started on the job. You were actually helping to finance that business. This is how customers can act as a form of financing.
Another bootstrap financing source is real estate. There are several ways to take advantage of this source. The first is simply to lease your facility. This reduces startup costs because it costs less to lease a facility than it does to buy one. Also, when negotiating a lease, you may be able to arrange payments that correspond to seasonal peaks or growth patterns.
If you enter a business for which you will need to buy the facility, your initial cost will increase but the cost of the building can be financed over a long-term period of 15 to 30 years. Again, the loan on the facility can be structured to make optimum use of your planned growth or seasonal peaks. For instance, you can arrange a graduated-payment mortgage that initially has very small monthly payments with the cost increasing over the lifetime of the loan. The logic here is that you have low monthly payments, giving your business time to grow. Eventually, you can refinance the loan when time and interest rates permit.
Another advantage that the outright purchase of the facility will provide you is continuing appreciation of the property (hopefully) and the decrease of your principal amount to create a valuable asset called equity. You can borrow against this equity. Lenders will often loan up to 75 or 80 percent of the property’s value once it’s been appraised.
This applies to any private real estate you might own. If you have a desire to get into business and you need startup capital you can’t get in any other way, you may have to borrow against the equity in your home or sell it altogether. If your home is appreciating in value, real estate is a good venue to choose. If it’s depreciating, it won’t be quite as attractive.
If you spend a lot of money on equipment, you may find yourself without enough working capital to keep your business going in its first months. Instead of paying out cash for your equipment, you can purchase it with a loan from manufacturers; that is, you pay for the equipment over a period of time. In this way, equipment suppliers are a source of bootstrap financing.
Two types of credit contracts are commonly used to finance equipment purchases:
1. The conditional sales contract, in which the purchaser does not receive title to the equipment until it is fully paid for.
2. The chattel-mortgage contract, in which the equipment becomes the property of the purchaser on delivery, but the seller holds a mortgage claim against it until the amount specified in the contract is paid.
By using your equipment suppliers to finance the purchase of equipment you need, you reduce the sum of money that you need upfront. There are also lenders who finance 60 to 80 percent of the equipment value. And then, of course, the balance represents the borrower’s down payment on a new purchase. The loan is repaid in monthly installments, usually over one to five years, or the usable life of that piece of equipment.
Another thing for you to consider is to lease instead of purchasing. Generally, if you are able to shop around and get the best kind of leasing arrangement when you’re starting up a new business, it’s much better to lease. It’s better, for example, to lease a photocopier, rather than pay $3,000 for it; or lease your automobile or van to avoid paying out $8,000 or more.
Leasing has been around for a long time. It’s common for businesses to lease real property for retail facility, office space, production plant, farmland, etc. There are advantages for both the small-business owner using the property or equipment (the lessee) and the owner of that property or equipment (the lessor.) The lessor enjoys tax benefits and may gain from capital appreciation on the property, as well as making a profit from the lease. The lessee benefits by making smaller payments, retains the ability to walk away from the equipment at the end of the lease term, and may be able to negotiate build-in maintenance provided by the lessor.
Still, there are many ways that a lease can be modified to increase your cash position. These modifications include:
- A down payment lower than 10 percent or no down payment at all.
- Maintenance costs that are built into the lease package, thereby reducing your working-capital expenses. If you needed employees or a repair person to do maintenance on purchased equipment, it would cost you more than if you had leased it.
- Assignment of all executory costs such as insurance, property taxes, etc. While this will initially increase your cash-flow, it will reduce the amount of taxable income the business generates.
- Extension of the lease term to cover the entire economic life of the property. Use of the property can be guaranteed for as long as you wish to use it.
- A purchase option, which can be added to the lease allowing you to buy the property after the lease period, has ended. A fixed purchase price can also be added to the option provisions.
- Lease payments that can be structured to accommodate seasonal variations in the business or tied to indexes that track interest to create an adjustable lease.
Avoid the Need for Financing
Bootstrap financing really begins and ends with your attention to good financial management so your company can generate the funds it needs. Be careful and aware when you buy. Make sure that you don’t go top dollar when you don’t have to, and that you aren’t in an overly expensive office or location, unless it’s really going to pay off in dollars and cents. If a new desk isn’t necessary for your business, and you have an opportunity to buy a used desk, then by all means do so.
Also, keep a close watch on operating expenses. If interest rates are high, it won’t take too many unpaid bills to wipe out your profits. At an 11- or 12-percent interest rate, carrying an unpaid $10,000 is costing you as much as $120 per month.
One way to foster a profitable cash flow for your firm is to start each production order off on the right track. Implement
this three-step payment plan
. Negotiate terms and conditions that require payments when you want them. Profitable cash flow will occur when you establish and execute timely cash-flow concepts into every order.
This article was excerpted from The Small Business Encyclopedia.