Capital vs Financing

Many aspiring entrepreneurs are misled into pursuing a capital investment without taking into account financing, which is the key component that gives your company its ability to grow. Say you are in a product driven business and you are looking for a million dollars for your initial cost of goods, your selling expenses, and all of your general & administrative expenses (i.e. salaries, office space, telephones, utilities, etc). For arguments sake, let’s say your cost of goods allows you to make $500,000 dollars in product with a respectable thirty percent margin. Let’s take it a step further and say your pursuit of the investment was successful and you have your million dollars.

And just to put the icing on the cake, let’s further say that your product sells well and you make that thirty percent margin, translating into $150,000 profit on that first order. Sounds great! But wait a minute. What happens when your customers come back and now re-order $5,000,000 dollars in product because your sales were so good? Who’s going to come up with the money now to finance $5,000,000 in sales? You can’t go to back to your investors and quickly try to convince them into exposing themselves with further capital, because that simply wasn’t the deal. And a deal is a deal. Plus it will scare them away.

What you need is a financing entity to fulfill your orders because that’s what they do. They charge you an interest rate to finance your orders up front. Not inject capital, that’s for the other guys. However, financing purchase orders up front (purchase order financing) is a dangerous business because the financing entity doesn’t have a guarantee that the goods will be made properly, if you’ll ship late, etc. For this reason, they will charge you a very high interest rate that will eat away your margins. If, however, you had the money to manufacture the goods and simply needed interim cash before the customer pays, that is much easier and attainable through a factoring company, who is similar to a bank but specializing in these types of transactions.

This is called accounts receivable financing, which you can get at a very respectable interest rate, because you have taken the manufacturing risk away, and then it becomes their job to check the credit of the customer to decide whether or not they are worthy of a credit line for the order. But that’s a mute point because you don’t have the money to manufacture the goods (it will take a lot more than your $150,000 profit), so you are stuck in the mud. So now what? Without the financing in place, you will be unable to grow and the investment you secured will be useless if you don’t have the fuel to go forward. Think of it as the investors bought you your car, but you need fuel for it to move. Financing is the fuel that keeps your engine running, and the more fuel you have, the farther you can travel.

So how are you going to get purchase order financing at an interest rate that doesn’t swallow all your profits? Certainly not from a bank in this day and age. This is where forming strategic alliances come in which I will fully discuss in detail in my next article. To give you an idea what a strategic alliance is, it is where go to manufacturers in your industry who are already doing what you are doing and look for your financing there, because they can control risk by making the product in their own factories, so your interest will be much lower.

The best possible scenario however, and your most probable, will be that you kill two birds with one stone and get both the investment and financing all under one roof. Bottom line, they are doing what you are doing and they are succeeding so why wouldn’t they? Most of these companies have a built in turn-key model that makes it infinitely easier to create a successful business model. But don’t think you’re going to hold on to all your equity. Anyone that does, doesn’t understand that 20% of something is worth a heck of a lot more than 100% of nothing.

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