The Price of Money: which financing option is right for your company?
There are a variety of choices out there when it comes to financing your business
by Geoffrey Morgan
Whether you’ve built a better mousetrap or found a new market you want to sell it into, there’s one thing you need to turn your plan into reality: money. But finding the capital you need to grow your business is a challenge in our risk-averse, recession-scarred lending landscape. Thanks to record-low interest rates and a need to retrench their balance sheets, many major financial institutions aren’t as willing to sign off on your loan application as they used to be, while those that are may not extend you the credit you need.
The Canadian Bankers Association (CBA) says 88 per cent of small- and medium-sized enterprises that apply for business loans get approved. But more than a third of entrepreneurs surveyed by the Canadian Federation of Independent Businesses say obtaining financing is an obstacle to the growth of their companies. Taken together, those statistics suggest that the loans, which have an average size of $319,000, just aren’t big enough.
The good news is that you have options, and while there is no one-size-fits-all solution for financing a business, there’s likely one that’s a good fit for yours. Suit up.
Right now, interest rates in Canada are at historic lows, and borrowing money is attractive. Wes Priebe, senior vice-president and director with MNP Corporate Finance, helps companies shop for business loans and debt financing. Last year, his company helped 30 businesses obtain a total of $200 million in bank loans and debt financings and, with current low interest rates, he leads his clients to the lowest-cost financing option first.
The first option, Priebe says, tends to be an operating line of credit at the traditional lending groups like a big bank, regional bank or credit unions. Next is a loan from a government loan agency like the Business Development Bank of Canada or the Agriculture Financial Services Corp. which, despite its name, lends to both farm and commercial businesses at the provincial level. If those options don’t provide enough capital for Priebe’s clients, he’ll lead them to subordinated debt financing, asset-based financing and, finally, equity financing in order to raise the money they need.
The big six Canadian banks all have divisions that lend at each cost level, but they’re not the only option for entrepreneurs looking to raise money. The marketplace is full of niche lenders and specialized groups focused on one or two types of financing, such as subordinated debt or asset-based lending. Priebe says Wells Fargo Canada is one company focused on asset-based lending, which tends to cost more because it requires ongoing due diligence to ensure the health of the asset. That is especially the cases where the security is a store of inventory. “They’re relying on the fact that the inventory you’re reporting is there and the receivables you’re borrowing against are there,” Priebe says. “It’s the fees related to that facility that bring the cost of asset-based lending up.”
Glen Eastwood, a senior vice-president with Canadian Western Bank, says his bank’s loans are based on a percentage of a company’s accounts receivable. “We can typically go up to about 75 per cent of accounts receivable with 90 days or less,” he says. But the bank does have limitations. “If it’s beyond what the bank can do, we’ll point them in the direction of venture capital or other equity financing.”
And while most entrepreneurs don’t want to give up too much control of their company, equity-based financing is among the most common ways to finance the growth of a business. Last year, more than half of the deals MNP’s corporate finance division consulted on required equity financing, and $110 million of the $200 million the company helped raise was in equity-based deals.
In early October, an angel investor attending the Banff Venture Forum deconstructed each cost level in the world of equity financing. Not surprisingly, investors who can offer the most money also demand the most control.
Companies can access subordinated debt, or bridge financing, if they’ve lent money to other companies and are willing to subordinate the collection of that debt to the bank, though many banks prefer other financing options. Eastwood says his bank is interested in being a primary lender, or, as he puts it, in the “first-charge position,” on its loans. Other lending groups, however, specialize in subordinated debt financing.
Entrepreneurs need to make a choice between money and power as they grow their business, something Harvard Business School associate professor Noam Wasserman calls “the founder’s dilemma.” Successful company founders rarely become successful CEOs, he says, mainly because most founders give up control of their companies long before those companies are listed on the public markets. “By the time the ventures were three years old, 50 per cent of founders were no longer the CEO,” Wasserman writes in the Harvard Business Review, “and fewer than 25 per cent led their companies’ initial public offerings.”
The transition is rarely smooth, though. “Most [entrepreneurs] are shocked when investors insist that they relinquish control,” Wasserman writes, “and they’re pushed out of office in ways they don’t like and well before they want to abdicate.” While this loss of control might not be directly measurable in dollars and cents, it’s still the biggest cost associated with equity-based financing.
One of the avenues that venture capitalists use to assert control in exchange for capital is a company’s board of directors.
Most want a seat on the target company’s board, and many want to appoint enough board members to give them control over the company’s executive decisions. Exempt market consultant Craig Skauge describes this as the tension between finding investors and finding business partners. The exempt market, he says, offers an attractive alternative, as entrepreneurs can raise similar amounts of money – typically, between $10 and $15 million – without being tied to the will of a venture capitalist.
Skauge is the president of the Western Exempt Market Association and the founder of Exempt Experts Inc., a consulting firm that helps entrepreneurs raise money through the exempt market. In the exempt market, the amount of control an entrepreneur relinquishes to her shareholders is structured into the offering memorandum. In many instances, an offering memorandum gives shareholders the right to elect a company’s board of directors at the company’s annual general meeting.
However, Skauge says some deals arestructured so the shareholder receives a dividend instead of the right to vote at the AGM. “Typically what you see is unaudited financial statements and a shareholders report that goes out to investors,” Skauge says.
Financing options available to entrepreneurs
Bank loan and operating line of credit financing
- Banks and credit unions
- 3.00 per cent – Current prime business rate, Bank of Canada*
*Very few businesses will actually borrow at this rate, as it is the current base lending rate set by the Bank of Canada.
Government loan financing
- Business Development Bank of Canada, Agricultural Financial Services Corp.
- 5.06 per cent – Current one-year commercial loan rate
Subordinated debt financing
- Chartered banks, BDC and specialized lending groups, including First West Capital and Callidus Capital Corp.
- 12.00 per cent – BDC rate on sub-debt financing
- Chartered banks and specialized lending groups like Wells Fargo Canada
- Nine to 24 per cent – estimate from 7 Park Avenue Financial
- Angels, venture capitalists, the exempt market
- No interest. Equity lenders demand a stake in the company.