What Businesses Should Know About Debt Financing

The Obstacles Businesses Face

In today’s climate, where traditional asset-backed lenders are still relatively hesitant to service newly emerging businesses, options for financing seem limited.

Part of the issue is traditional lending solutions are not typically built to finance small and growing companies. As a result, it can be a nightmare to get approved or receive a meaningful amount of capital without a good credit history, long operating track record, or positive cash flow. Traditional solutions can also come with stipulations and drawbacks such as warrants, extra fees, zero flexibility, long underwriting processes, and, most importantly, no scalability. Instead, many businesses consider other debt financing options.

What is Debt Financing?

Debt financing is an umbrella term for ways to fund your business by borrowing money and agreeing to pay it back (with interest) at fixed payment terms. Many capital solutions fall under this description, so how can you make an informed decision on which is best for your business.

How Should You Assess Your Options?

To understand the most common debt financing options, you should consider these 5 key attributes about each:

1. What are they?
2. Their structure of financing.
3. The revenue streams considered during underwriting.
4. Typical underwriting approval time.
5. Typical payback timeframes.

Traditional Lines of Credit (LOC)

What is it?: A Traditional LOC offers capital against a business’s collateral base, which usually comprises physical assets such as accounts receivable (A/R) and inventory.

Financing Structure: Instead of a one-time cash advance, lenders provide a set credit limit you may borrow up to at your discretion (similar to a credit card, except that interest begins accruing immediately). Once you borrow up to that limit, you must pay at least a portion of it back, plus any interest, to free up capacity and borrow again. Your credit limit may increase with additional collateral, but the maximum amount to which your credit limit can grow is usually fixed at the time of underwriting.

Revenue Streams: This option considers only retail and wholesale channels, meaning eCommerce revenue streams are not accounted for and will not land a meaningful amount of cash.

Typical Approval Time: With an outdated underwriting process done by hand, being approved can normally take roughly 30 days.

Typical Payback Period: Anywhere from 6-12 months.

Merchant Cash Advance (MCA)

What is it?: On the other end of the scale are MCAs, which provide you with cash in exchange for a percentage of your future sales. MCAs began to appear as a solution for eCommerce businesses struggling to build up their inventory or spend on marketing.

Financing Structure: MCAs provide a single cash advance that typically must be paid back in full prior to borrowing additional funds. They are not lenders, meaning their advances are unsecured with no collateral involved. MCAs cannot charge an interest rate or quote their solution in terms of an APR. Instead, they charge a flat fee that may seem attractive but usually does not tell the whole story. In fact, even a 10-12% flat fee can result in a 20-50% implied APR, depending on the payback period involved.

Revenue Streams: MCAs will look only at your eCommerce revenue streams.

Typical Approval Time: The application process is straightforward, getting you cash with basically the click of a button. There is often no underwriting process to wait for, and it may be a relatively easy choice for those who already conduct business through platforms such as Shopify and Amazon.

With such a simple process, companies can find themselves borrowing from one MCA to quickly finance a production run or marketing campaign. However, because they sometimes cannot draw additional funds until the full advance is paid down, they will borrow from another MCA and so on to fulfill future working capital needs. These unsustainable practices land many businesses on a hamster wheel, stacking multiple providers and often overleveraging their business.

Typical Payback Period: Anywhere from 2-7 months, but can be as long as 12.

Invoice or Accounts Receivable (A/R) Factoring

What is it?: Another option is invoice (or A/R) factoring. It is a way for businesses to borrow capital against their A/R, or money owed by a company’s channel partners for goods that have been delivered but not yet paid for (in other words, invoices). Instead of holding on to several unpaid invoices, you can turn them into immediate cash to fulfill new POs or simply restock inventory.

Financing Structure: Lenders will typically purchase eligible A/R at rates of 70-90% of the gross amount but will collect 100% of the purchased A/R on the back end. As a result, this solution’s implied “flat fee” can range from 10-30%, but given that  payback periods can be as short as 30 days, APRs of this type of solution can range from 20-50%+.  

Revenue Streams: Lenders will provide funds only for eligible A/R, making it ideal for businesses with a Fortune 500 retailer (like Walmart and Target) or a large distributor (like UNFI and KeHE) already under their belt. But at the very least, you need a retail presence. As a result, it can be nearly impossible for eCommerce businesses to receive significant funds using invoice factoring.

Typical Approval Time: Between 15-30 days.

Typical Payback Period: Anywhere from 30-300 days, depending on how quickly your invoices get paid by your channel partners.

Inventory Financing

What is it?: Inventory financing is a way for businesses to borrow capital using their inventory assets as collateral.

Financing Business Structure: Lenders will provide capital in exchange for a lien on the borrower’s inventory (or some portion of it) to collateralize and secure the loan. In fact, these lenders will typically pay the borrower’s supply channel partners (such as manufacturers, co-packers, etc.) directly. The borrower will then pay the lender back as the borrower sells through its inventory over time. If the borrower fails to pay back the interest and fees in full, the lender can take action to seize the inventory and sell it themselves.

Revenue Streams: Technically any revenue channels through which the borrower plans to sell its inventory.

Typical Approval Time: Between 15-30 days, but can be longer depending on whether an inventory inspection is necessary.

Typical Payback Period: This can be anywhere from 90-300 days, depending on how much inventory you are financing, how quickly you plan to sell through that inventory, and which provider you are working with.

Venture Debt

What is it?: A type of debt financing offered to startup and high-growth businesses that have already raised Venture Capital (VC) equity funding. Typical providers include organizations that work adjacent to VC funds, such as private debt investors or banks.

Financing Structure: Venture Debt providers tailor their terms towards startups who want to maximize their cash runway and minimize interest burden. Depending on a few factors, lenders typically offer low interest rates in the mid to high single digits or the option to defer interest payments until later (called Paid in Kind or PIK interest). In exchange for these accommodations, they request warrants, which are similar to equity options. Although typically less dilutive than an equity raise, warrants can still substantially impact your equity ownership.

‍Covenants also play a central role in venture debt. They are a way for lenders to manage a company’s operational activities to maximize the lender’s probability of getting paid back. Depending on the type of covenant, they can require businesses to perform specific actions or meet certain benchmarks, as well as restrict activities such as taking out additional debt.

Breaching any agreed-upon terms is considered a “default” and can result in some serious action on the lender’s part. Usually, a business will have a set timeframe to remedy the default (sometimes in as little as 30 days) by paying off the debt in full or raising equity. If a solution is not reached, the company risks bankruptcy or losing the business entirely.

Revenue Streams: With Venture Debt, all revenue streams are considered.

Typical Approval Time: Can range between 30-90 days, depending on the intensity of the lender’s due diligence process.

Typical Payback Period: Anywhere from 12 to 60 months.

Ampla’s Modern Growth Line of Credit

What is it: Ampla provides a tech-enabled scalable growth line of credit to help consumer brands grow.

Financial Structure: Similarly to a traditional LOC, you are given a credit limit you can use as you need. The difference is Ampla works more as a sustainable, long-term partnership with a credit limit that will automatically increase as your revenue grows. With transparent APRs and no hidden fees, you won’t pay more than what you are quoted.

Revenue Streams: Ampla can underwrite on an omnichannel basis, including all of your revenue streams, to give you as much capital as possible. We make this process simple by connecting your accounting, banking, and commerce systems via our seamless integrations.

Typical Approval Time: With a quick, tech-driven underwriting process, our experts can chat to provide a quote within 48 hours.

Typical Payback Period: Ampla works on a long-term partnership structure, meaning there are no set payback periods.

Key Takeaway

Many know from experience that big banks are not the best option for funding a growing business. That being said, it is still essential to understand the ins and outs of some of the most common debt financing options. Knowing each option and the 5 key attributes that come with it will ultimately help you make a more informed decision for your business.