Financing Options: Working Capital Financing

We are coming to the end of the Financing Options series. This is the final post in the series. Today we are going to talk about working capital financing.

For those of you not steeped in finance and accounting matters, I suggest you go back and read the Balance Sheet post before reading on. Working Capital Financing relies on a company's balance sheet to support the loan so understanding how a balance sheet works is important to understanding working capital financing.

As a company grows, it starts to consume a lot of cash in the day to day operations of the business that has nothing to do with its profits or losses. This type of cash consumption is called working capital. In accounting terms, working capital is equal to current assets minus current liabilities. In layman's terms, working capital is what your customers owe you plus any inventory you have built up minus what you owe your suppliers and employees. Working capital also includes any cash you have in the bank.

One of the many awesome things about a software business is that it rarely has any inventory. But for the purposes of this post, we need to think about a business that has inventory because inventory buildup is a big reason that companies consume working capital.

Let's think about a company that makes iPad stands like this one (I have it, it's awesome). Let's say it costs $25 to manufacture one iPad stand. Let's say you have orders for 10,000 of them at a wholesale price of $40. So you need to  come up with $250,000 to produce the inventory to meet the demand. Then you ship the iPad stands to Amazon or some other retailer. And then you wait 60 to 90 days to get paid the $400,000 by that retailer.

On paper, your business looks great. You have revenues of $400,000 and costs of $250,000. You have profits of $150,000. But you cash situation is horrible. You are out $250,000 and you are going to wait 60 to 90 days to get the $400,000 from retail. And you've got another order but this time it is for 20,000 units. You need to come up with $500,000 to meet demand.

This is known as a working capital issue. The business is making plenty of money on paper but can't manage its cash needs. And the faster it grows, the worse it gets.

This is exactly the situation working capital financing was designed to deal with. Banks and finance companies will loan companies, particularly profitable companies, the money they need to purchase inventory and wait to get paid by their customers. Banks will rely on the purchase orders on hand and the actual value of the inventory that the company has in stock to backup the loan. They will also take into account the money the company owes its suppliers and employees in determining exactly how much capital to loan the company.

Most working capital financing has built in cushions. Banks will not loan 100 cents on the dollar of working capital. They might loan 75% or 50%. But as working capital grows, they will increase the size of the loans they make. These are all short term loans because the inventory eventually gets sold and the customers eventually pay. A typical way these loans are structured are lines of credit and revolvers meaning that as the money comes back into the business, the loans get repaid, but the total amount available under the loan stays the same so the company can just borrow it back when it needs the money again.

For companies that are particularly shaky, there is a technique known as "factoring" where the bank actually takes the amounts of money due from the customers as collateral and gets paid directly by the customers and then remits the extra amounts to the company. The bank essentially becomes the accounts recievable department of the company. Back in the dark days in the aftermath of the crash of the internet bubble, I got a bank to do this for one of our portfolio companies and it was the only way we got through a major financial crisis.

Even a software based business can build up a lot of working capital. It ususally results from the company having to pay its obligations much faster than its customers are paying the company. If you have customers that pay in 90 days and you are growing revenues quickly, then you can find yourself in a major cash squeeze. Working capital financing is a great way to manage that kind of cash squeeze.

#MBA Mondays

Comments (Archived):

  1. Rob Ganjon

    Great series Fred. Have you ever done an MBA Monday post on managing cash flow? Today’s post would be a great lead in to that. I’m thinking more about operating cash flow than financing cash flow. Just a thought.

    1. fredwilson

      i did this post early on in MBA Mondays…

  2. andyswan

    Angel investors would be wise to look for opportunities like this.  Anytime you can get equity (plus preference!) out of a company for something that a bank would accept a note for….you’re probably going to win**Flipside is why I don’t really like peer-to-peer lending.  “Anytime you are getting paid less interest on an no collateral loan than the bank is willing to accept……”

    1. Carl J. Mistlebauer

      Andy, you would think this would be the smartest investment, but the reality is, at least from my experience, is that most angel investors want risk more than they want return….

      1. andyswan

        That’s why they look soooooo good losing

        1. Carl J. Mistlebauer

          Kind of like two folks I know that own golf courses; neither one will ever make a profit, but boy these guys are popular in the community!  Popularity is WAY too expensive for my tastes…..

          1. Guest

            Two people who are quite close to me have owned golf courses. Your assessment of the situation, both good and bad, seem about spot on to me Carl.

  3. baba12

    Interesting, I gather Mr.Wilson has not known of the nefarious activities around working capital loans.There are small bushiness’s  that need working capital loans on a daily basis like hot dog vendors. There are few places that these vendors can go to secure working capital loans i.e. banks will not lend because there is not enough collateral to cover the loan.Enter guys with baseball clubs in their car trunk. Yes it is true, I have seen it myself. The loans are generally day loans, you borrow $100 and return $107 in the evening.When you look at startups like kickstarter or etsy, I wonder if they have provisions to offer working capital loans to provide the artists and entrepreneurs that float needed to sustain their business.

    1. fredwilson

      Etsy has thought about it bit nothing more yet

      1. jeff trudeaux

        Let’s see… Etsy’s office is in Brooklyn.  Guys with baseball bats willing to make day loans are in Brooklyn…  match made in heaven?

        1. fredwilson

          etsy’s thinking hasn’t gotten that far 🙂

          1. baba12

            But an easy fit, goombahs in tech….

        2. ShanaC

          if they are handmade baseball bats, sure!

    2. andyswan

      This and running laundry is how my grandpa made it through college in the early 30’s.  Great stories.

  4. Eric Anest

    I frequently tell people that you can go bankrupt while making money. This post is a great explanation of how that happens and one way to deal with it. Thanks.

    1. Carl J. Mistlebauer

      I spent 25 years in a company where we acquired profitable firms that were struggling with cash flow issues; Most of them ended up costing us absolutely nothing to acquire.In just about every case they could have factored their receivables and avoided us altogether.  But, there is a flip side to factoring/working capital that is negative, and that is the fact that by having the cash cushion, lots of companies then lose their “edge” they then compete differently than they did when they were hungry.Now for the first time in my life I get to say, “…oh, I am out of business because sales doubled in six months….”  its fun watching all the CPA’s and finance people pour over your financials trying to disprove that statement.  But then again, I live in a part of the world where they still grumble about the internet and B2C sales as they have no concept of exactly how powerful one little ad on the web can be let alone a whole website and marketing program.Even in the whelm of B2B I found that a website actually generated more new business than doing trade shows and hiring new sales reps.      

      1. ShanaC

        well, how do you create balance in your hunger?

        1. Carl J. Mistlebauer

          Shana,My knowledge is anecdotal…First off, never have a CEO who comes from a sales background; when they have a little cushion they will go nuts “buying” sales and then find themselves in the same situation they were before they had the cushion.  Second, always have someone in upper management who annoy’s the hell out of you!  This will keep everyone competitive and focussed; there is good competition and bad competition, and good competition is the type that makes everyone better and in any team based situation, and all companies are team based, you have to have good competition amongst the team members.  You got to have one person who is willing to be contrary….Bad Competition is what creates things like Enron….Too many times people get into business and think of competition like it is sports; you win a game and you play game to game but what they fail to realize is that business is more about competing with ones self, its about constant improvement of ones self and ones organization.  I have contacts on Linkedin who are executives with major apparel firms and all of them follow the same competitors on Linkedin.  They are just trying to keep up with their competition not be successful.

          1. Dave W Baldwin

            Well put!

  5. Carl J. Mistlebauer

    Act one time factoring ones receivables was also a great way to “outsource” ones receivables:  There were various factors that also provided credit approval on purchase orders and thus one could factor an invoice non recourse (with credit approval) and then recourse (without credit approval).  When it takes six to eight weeks to produce a good and you have a business mix where you are producing goods for inventory and producing goods specifically for a customer you have to factor; in the case of t shirts, from the time you purchase cotton to the day a retailer such as Walmart pays you it most likely will be 24 weeks!  Then if you produce a good that inventory is maintained on you could have a customer base of 10,000 retailers and trying to keep up with all of those credit wise is next to impossible.Sadly, factoring once was a smart business decision, but nowadays, even the big names in factoring, such as CIT, have become shady operations.

    1. greggdourgarian

      Not so, Carl.  There are still a lot of good factors out there providing full-service funding.

      1. Carl J. Mistlebauer

        Greg,Yes, and there used to be banks that would loan businesses money!  In fact for 25 years I had a line of credit with my bank, never really used it but it was there.  Then in 2008 they pulled my line and when I went back to re establish the line they wanted 100% collateral as security, and not my business’ receivables or inventory but my personal home.  I have over 200 retail customers who have been customers for a decade or so, and over half of them had their revolving credit lines pulled.  I know 15 companies here locally, who have been in business for decades and a couple are household names, all of which are financially secure, but they need working capital to grow and they are finding it impossible to acquire the capital.I am sure that there are great factors out there, and I would appreciate it if you would email your list so that I can add them to mine, my email is [email protected]  My focus for factoring is credit decisions and AR management as I get 15 to 20 new retailers a month and it would benefit my business to be able to offer them terms….

        1. greggdourgarian

          tx Carl…by the way that’s a fun-reading blog you keep…

  6. Tim

    Great post Fred.If I may be so bold to make a suggestion for your blog (forgive me if there’s a reason you avoid doing it or it’s already been asked): can your linked articles open up in a new window?This would partcularly enhance the reading experience because you link to highly relevant items that I then go on to review, but in doing so often lose my place on the blog and have to navigate back. Just a small suggestion on an otherwise superb blog.

    1. fredwilson

      i’d love everyone’s opinion on thisi choose not to open a new tab on a link because i got the feedback early on that readers found that annoyingi’m curious what everyone thinks about this

      1. Anthony Ortenzi

        With a tiny link at the bottom of the page, you could give folks the option by dropping a cookie to alter the behavior…

        1. fredwilson

          i will consult Nathan on this. it could be an excellent suggestion

          1. Peter Beddows

            Also remember that every user/reader of any comment that has a link in it also has the built-in browser option of using mouse Right-Click on the link => Open In New Tab (or new window) choice to control where and how to view content attached to any embedded link. Using this strategy to open a view in another tab or window thus keeps their place undisturbed in the originating article thread; you simply then return to the original tab and pick up where you left off.I do this all the time here except that I often “accumulate” new tabs for later reading of the related content unless that content will impact any response I may choose to add in reply to the originating comment.In other words, there is actually no need to make any changes to the blog configuration to change the way link details can be opened since this is already a function freely available in the hands of the viewer.Oy! Sometimes my engineering instincts make my explanations way too complex! Anyone want to know the time – I can build you a clock! 🙂

      2. RichardF

        I think that’s old view in web design.  Services like Twitter open links in a new tab/window I much prefer it.  I don’t want to be navigated away.

      3. baba12

        I look at the link’s, many I won’t bother clicking on. On the ones I do click, I prefer them being in the same window, so I can go back to the previous page/state.I like to read what I am reading fully and making a mental note of the links I want to followup on and then go there when I am done. That way I seem to have a fair idea of what is being discussed/written about.But maybe new kids on the block like multiple windows open and they can manage to read bits and pieces from everywhere and that works for them.

      4. Ravi U

        Oh god no, please don’t ever do that. Every browser in the world has a built-in method of letting readers open a link in a new tab (cmd-click, right-click and hit open in new tab, etc.), but there’s almost no option for the opposite.Forcing all links to open in new tabs is disrespectful of readers’ time and preferences.

      5. Tim

        I had a feeling you had already looked into this, but just thought I’d suggest all the same. There will certainly be a variety of opinions.For me it’s just great to tab back to the original window so I can follow the original thread. If you click through multiple options at each stage it’s not so easy to return back.Happy either way, just thought I’d propose it. Thanks Fred.

      6. ShanaC

        Here is an open poll about the matter:…I figure this is way more efficient than in the comments.  If people use it – I’ll hand over the data next week.

      7. Neil Kusens

        110% agree.   Just clicked away from the post, and put my name on the wait list for the PadPivot, and had to find my way back.  (looks like a cool product btw – thanks for turning us on to it).Anyways – new windows are the only way to go on trusted sites like yours!



  7. Pramod Dikshith

    There could be other ways Working Capital Financing could happen. I was involved in a due diligence project for a client of ours who were exploring entering the market either organically or inorganically..One area which is not explored is dynamic discounting.It’s very similar to supply chain financing, however there are two fundamental differences. It’s the buyer who initiates this process as against supply chain finance which is seller initiated. The discount terms vary. In case of dynamic discounting, discount is continuous over time..It is basically a sliding scale unlike SCF which is more discrete. As the buyer has an incentive to pay early in the form of discounts for early payments, the supplier has better cash flow and does not encounter a situation where he is squeezed of cash..

  8. Trevor McLeod

    Great post Fred.  I learned a lot.  I imagine that some of your readers may be in this situation and want to pursue working capital financing as an option for their business.  Maybe you could include a follow-on post that discusses the steps one should take to get this type of financing from a bank or other institution.  For example, what should you be prepared for if you talk to a bank about this option?  What are common mistakes that entrepreneurs make?Just a thought.  Thanks for writing.

  9. EmilSt

    That’s why is great when you have business model with negative working capital needs. Customers are paying you before you pay to your suppliers. Even better when there are no inventories. That’s the case with Groupon and similar sites. The problem with Groupon is that they are already borrowing to much from that money for expansion abroad. As soon as they see some downward trend in sales they will be in real trouble. I also doubt their IPO.

  10. Amund Tveit

    > One of the many awesome things about a software business is that it rarely > has any inventoryOne can perhaps view every line of code that is submitted but not used (i.e. deployed or sold) as inventory (that grows pretty quickly unless continuous deployment is in place)?

  11. Neil Kusens

    I grew an e-commerce startup from $0 to $30 mil in revenues in a few years using working capital loans among other financing tools – and came across every time of success and failure you can experience with these loans.Some words of caution for the community here:1)  It might go without saying to most of you — but just in case — most of the time, the borrowing company will need to have some serious personal guarantors to back up these types of loans.  Just looking at your purchaser orders (even if its from someone as well known as Amazon) won’t typically get you a working capital loan unless you are a very established company or are willing to pay ghastly interest rates!  Typically, most companies that need this type of loan aren’t established, so all the main principals of the business will need to have excellent credit scores in order to secure these loans.  And of course, if something bad happens, and you can’t make those repayments – you are personally on the hook.2) When thinking about these types of loans, make sure you take every possible headache into consideration.   In my naive days, I thought the formula was as simple as I was taught in business school (and summarized here by Fred).   But there are all kinds of headaches involved here — especially on the A/R side.   Some examples:    – if you are a young business and have a thousand pre-orders direct to consumers (not one big PO to Amazon in this example) – you are likely to be subjected to holds from your merchant processor in releasing your funds – without any notice in some cases.  These holds can last 6-12 months.  Depending on how good your personal credit is (again, your on the hook here with merchant processors too) and how itchy the merchant processing bank is, they might hold back 10% of all credit card funds in a reserve, or in some cases, much much more.  Bottom line:  it might take longer to get your funds than you think – and you better plan for this contingency!  – on the other hand, if you have one big PO from someone like Amazon, you might have other headaches.  Not only might they slow pay you at 90 days, but they know how much power they wield as the primary retailer for a small up-and-coming business, and often times will demand better pricing terms after the PO is already placed and product was shipped.  I’ve seen it happen plenty of times!   (Also, they will often time demand you take back product if it hasn’t sold-through – ready your contract with them very carefully!)I’ve got all kinds of other lovely war stories I could spend days typing about.  In the end, these types of loans can go very wrong – so tread carefully!

    1. fredwilson

      love the real world experience commentthanks for sharing

    2. sigmaalgebra

      “you are likely to be subjected to holds from your merchant processor in releasing your funds – without any notice in some cases”Can you explain more fully about this?

      1. Neil Kusens

        Sure.  In nearly all merchant processing applications/contracts you, the merchant, are giving the processing bank the unilateral ability to withhold funds from you for an extended period of time.   The processors don’t have to give much of a reason – although a single bad day of chargebacks, or fraud orders can definitely trigger it.  (I’ll explain my personal situation in more detail below for reference).Many consumers and definitely many EBAY sellers have probably experienced this in a very small way with PayPal not allowing you to take out funds from your account.  Try getting PayPal on the phone to ask them to release your funds — it’s impossible.   Well, in the big e-com world, the big boys do the same thing.   In our case, we were processing nearly $100,000 of credit card transactions a day.  As I alluded to in my initial comment, all the principals in our business had to sign personal guarantees and have our credit ran in order to open our merchant processing account.   Over the years, we built a trust with our processor, GE Capital, which allowed us to continue processing high dollar amounts without a large reserve, or so we thought.When one of the three partners in our business wanted to be bought out, he called the processor to have his personal guarantee removed.  This one phone call triggered a daisy chain of hell.  Although our account was in excellent standing w/ GE, by him removing one of the three guarantees (note: his personal credit was the best amongst the three), they unilaterally imposed a 100% reserve for one week of funds processed (without our knowledge) to ultimately hold back 500k+.   We had NO notice, and had NO say in the matter.  We had lawyers, bankers, creditors involved to get our funds released.  While we ultimately got them to release a few bucks, the majority was withheld for a year, and caused us to borrow even more money at super high interest rates to keep operations afloat, and ultimately destroyed our margins.I came to learn our situation was not unique.  Go ahead and google ‘merchant processor withholding payments” and you’ll get a small taste of this.Also – this is just one example with this one processor.  Over the course of our existence, we worked with several other processors that imposed crazy reserves for no other reason than we were an ‘internet’ company at a time when the processors were horrified with ‘card not present’ situations.

        1. Carl J. Mistlebauer

          Neil,I started reading Fred’s blog a couple of months ago and it didn’t take me long to realize that he is a different breed and in a positive way!  There is a reason bankers and finance folks DON’T blog and its because its hard to type on a keyboard when you are so slimy!  :)The reality is that our economic system actually penalizes success, which your case is an example of.  We had a hold put on our account by our credit card company the third month after we started B2C sales; up to that time all of our credit card processing were retailers.  They claimed it was because of the “no card present” situation but the reality was that none of our transactions were ever face to face.  What changed was the totals and the number of charges.  They froze us and held a month of charges for 7 months over 25% of our monthly charges.  Even though we never had one complaint, one chargeback, or one fraudulent change.Of course, being who I am, I asked them if they were going to pay me interest for the loan!  

        2. sigmaalgebra

          Many thanks.The situation can be worse than I would have guessed.”In nearly all merchant processing applications/contracts you, the merchant, are giving the processing bank the unilateral ability to withhold funds from you for an extended period of time.”WOW! I hadn’t even a clue. They want my wife’s wedding rings, all my software, title to my house and car, title to any gold crowns on my teeth, and my first three children, too? Of course they want my remaining half case of decent Chianti and the one Corton I’ve been saving!The ‘Golden Rule’: He who has the gold makes the rules. Or “cash is king”.You are talking about funds being held up for ballpark a year. This could get to be darned serious and, indeed, have some serious tax implications and even out’a business implications.So, as I move my startup to going live and getting revenue, I will do all I can to accumulate CASH.For the taxes, I will want to revisit the idea of each year, as revenue arrives, taking offsetting positions in some volatile portfolio, at the end of December, closing out enough of the losing position to make my earnings for the year near zero, and on January 1 closing out the rest of both positions. So, move pre-tax earnings from one year to the next as a cushion in case needed. Then if I take a big loss the next year, I will get to cover the loss with pre-tax money in effect carried over from the previous year.That is, if pay taxes each year, and/or estimated taxes each quarter, then can be paying taxes on ‘earnings’ that really are not ‘in hand’ yet, might not be for a year, and may never be. So, that money is not really ‘earnings’ yet. I mean, if the money was ‘earnings’, then I’d have access to it? Right? If I ain’t actually got it, then mostly to me it ain’t ‘earnings’ yet.There is fairly recent IRS regulation forbidding simple versions of such ‘offsetting positions’, but I doubt that the regulation covers all possible cases of ‘volatile’ portfolios, e.g., ones that are not ‘arbitrages’ or ‘deterministically offsetting’. ‘Probabilistically offsetting’, in simple terms, ‘volatile instruments’ in a ‘market neutral’ portfolio, is sufficient.So, write a little software to say how to take the current ‘state’ of the business and apply a ‘control’ to the portfolio. So, it would be a case of applied stochastic optimal control (the field of my Ph.D. dissertation).Without getting out a book on Accounting 101, it looks like for a startup cash accounting instead of accrual accounting would be better because (1) it’s simpler (don’t have to think about money that has not moved in or out of the checkbook yet) and (2) with the long delays in getting paid accrual accounting could have me paying taxes on revenue I won’t see for months and well into the next tax year (which could be a huge bummer). E.g., I might owe taxes on $1 million I haven’t seen yet which would be one effective way to lose sleep, get distracted from the real work, and even go out of business.”IRS: Yes, the good news is my business had pre-tax earnings of $2 million this year. Your 35% is, yes, $750,000. Congratulations. The bad news is, the business is broke, with a total of just $1000 in the checkbook. Why? The business checkbook has yet to see any of the $2 million. Sorry ’bout that.” I doubt that the IRS would like this. They might do things like take the $1000, etc. and, really, just put me out of business.Sounds like the ‘merchant processor’ would make me “an offer I couldn’t refuse”: Make me a ‘working capital loan’ at only 22% APR with my receivables, they have already received and are holding, as my ‘collateral’. So, they get interest on my money they are holding and, then, another 22% APR as they loan me the money instead of giving it to me. Hmm …. They wouldn’t actually think of anything like that, would they? Hmm ….Am I going wrong here somewhere?I’m reminded again of some of the Mother Goose wisdom about discipline, the Little Red Hen, saving for rainy days, putting away nuts for the winter, and building a house of bricks instead of wood or straw.I’ve been a Big Ten MBA program prof: There’s more ‘density’ that’s serious about actual business here at The material here, in total, maybe in part, could be the difference between success and failure of my business.When the comments in this thread die down, I will capture the text, save it, index it, and, of course, back it up. Especially for your post, this thread’s a ‘keeper’.All my ‘business idea’, ‘business model’, original applied math, software, etc. all necessary, but not sufficient, will come to zip, zilch, zero if I don’t make a successful business out of it. The ‘success’ has to mean big bucks in cash or near-cash, and that has to be getting PAID, not having to accept offers I can’t refuse, and not having the IRS shut me down for what I ‘owe’ them on money I haven’t seen yet.Actually, in my business, my ‘working capital’ needs should be about the least, as a fraction of revenue, of any business. E.g., I don’t have to pay for cotton to make T-shirts that I have to sell and get revenue on six months later.Still, that I might not get revenue from my customers for ballpark a year would be from an irritation to something somewhat serious, if only for, say, accrual accounting showing earnings of $2 million some year where by the time I have to write a check to the IRS I haven’t yet seen even the tax fraction of that $2 million yet.Thanks, I needed that.

    3. Carl J. Mistlebauer

      Most factors are going to only allow you to draw against 80% of your receivables; which in turn acts as a 20% cushion.  Yes, credit card companies can and do hold 10%, on average, and sometimes more, especially if you are an “overnight” success.  As far as major retailers go, they not only demand better pricing after the goods ship, but they have all sorts of chargebacks and fees that they can impose and that will add up long after they have sold the last of the items on the original PO.  I always tell start ups in apparel to be thankful to get 80% of the value of a PO with a major retailer and be thankful; that is 80% after they have beaten you up on the initial price.That is why you have to discount your cash on your cash flow by roughly 25%.  So many people base their projections on sales and assume 100% in 30 days; you get a much better picture of operations using 75% of sales to available cash at 90 days.  Yes, and nowadays even factors and banks regardless of the business will demand personal guarantees on top of everything else…….and everyone wonders what is wrong with our economy!   

      1. Neil Kusens

        Amen!  Lesson learned for me — don’t be greedy with equity and if you are in a position to do so, raise cash for rainy days from good people like Fred and USV.  We thought we could do it on our own using cash flow and other types of working capital financing, and it leaves way too much power in the hands of banks and financing firms to ruin your business.

      2. Guest

        @tao69:disqus great stuff you and @neilkusens:disqus are sharing today. 

      3. greggdourgarian

        Carl, we almost always factor at a higher rate than the 80% you mention.You must be thinking of the dark ages when factoring was a money-only thing.  That doesn’t make sense any more because a factor that provides a complete platform of software and services can supercharge client growth and keep better track of their investments.

        1. Carl J. Mistlebauer

          Greg,You provide funding services to temp companies, which is a specialty within the the factoring world, as are companies that factor truck company manifests.Most truck lines and temp agencies bill their clients at Net-7 or Net-10 days while most manufacturers have to bill at Net-30 to Net-90.With the factors such as GE Capital, CIT, Suntrust, and Wells Fargo they now do not credit approval orders for under $750 and thus any invoice for under that amount is bought on recourse and immediately chargedback in 30 days.  There are smaller factors that will “credit approve” orders under $750 but the catch is that they charge a 1% fee for every 30 day period past the due date that an invoice is not paid.That right there should tell you that the factors motivation is not to get paid, and thus not to make collection calls.  All of them now automatically chargeback any amount disputed after payment.  Today, if you do business with a major retailer, such as Walmart they will dictate to the manufacturer which factor they will do business with.The reality is that back in the early 90’s and before factors were a way to outsource ones credit decision and AR functions but that is not the case today.  Most major factors nowadays will not take an account unless you can document annual receivables of a minimum of $5 million dollars.  The smaller factors, some of which are associated with the majors, only allow credit reviews of 20 customers a month then charge another fee.  Or there idea of credit approval involves insurance.  The reality is most factors now have fees for services that can equal more than the fees charged by credit cards processing services.  Thus more manufacturers are opting to take credit cards for an initial order, carrying their best customers in house, and using factors only for their business with the majors.  Which basically has created the “dark ages” that you refer to.Yes, I know factors that will allow for a 90% rate but the reality is the higher the rate recourse and chargeback. 

        2. Carl J. Mistlebauer

          Greg,In 1990 I used a factor, Barclays, which ended up being bought out by CIT a few years later because of their software, which was awesome.  Back then to supply credit decisions and AR management/collections there was a fee of 2%.  The reality was that up until you hit 50 million in sales you would be hard pressed to provide that service yourself.But that was back in the days when everyone was on Net 30.  By the late 90’s the situation had dramatically changed.  For example, I had 7 million in invoices factored for Walmart, and Walmart paid the factor, but not my invoices but they took a chargeback of 1.5 million on the invoices they owed me, which in effect was a loan to Walmart from my factor reserve balance….for six weeks.They basically allowed Walmart to take money from my factor account and apply it as payment to other Walmart suppliers who used the same factor.I realized that factors were costing me an additional 5% a year in deductions and chargebacks that I did not have with the accounts we carried in house.  Thus, by moving receivables in house I ended up saving over 7% annually. Call me cynical, but for a vast majority of start ups factoring is not an option, because the fees, the chargebacks and the abuse of terms are costs that have to be added to the cost of borrowing.  Then when you add to the mix that GE Capital and CIT decided to get into subprime mortgage financing, something they have no experience at, the recipe for disaster was sprung.For 20 years I had a partnership with CIT, and I mean that as a true partnership; we worked together and if I knew something about a new customer they took me at my word and in turn I trusted them.  Sadly, we have taken the concept of entreprenuership and turned it to mean one person against the world, whereas before one could have partnerships….I actually considered the President of the bank I have used for 25 years and my account executive at CIT to be personal friends, but not any longer.  Like I always said, “I did not go into business to burn anyone” and I still make sure that everyone gets paid before I do.  To this day I do not take a salary until the end of the year and I have paid all payables, rewarded my employees with a bonus, and left a little on the plate for Uncle Sam, then I pay myself.Now, I am starting to realize that it might be time for an attitude adjustment.

          1. greggdourgarian

            Great insight Carl.  Thanks.

    4. PhilipSugar

      Great, great, great comment.

    5. Phanio

      Goes to show that you really need to work on building a solid business model that includes different size of customers and not just try to rely on outside financing to manage your business.To overcome retailer asking for better terms after shipping, set up early pay discounts with the original agreement.

      1. Eric E.

        Great post.Have you heard of The Receivables Exchange? It’s an online marketplace forworking capital that lets businesses sell their receivables in a real-timeauction. It offers a number of advantages to bank financing and factoring –not least of which is that it doesn’t require personal guarantees, all-assetliens or long-term contracts.Unlike traditional factoring arrangements, The Receivables Exchange merely facilitatesthe sale of receivables through a dynamic marketplace. The business – once approved– chooses which receivables to sell, and sets the maximum discount fee andminimum advance amount. Buyers (accredited institutional investors) bid basedon the quality of the receivable, as well as the Seller’s transaction history.Competition among buyers lowers the cost for Sellers, with businesses gettingrates as low as 0.5%, and 1.5% on average. The Receivables Exchange was founded in 2008 and has beensteadily growing since. The company won the Wall Street Journal’s innovationaward for e-commerce last year.

  12. Pete Griffiths

    Great stuff fred.  Many thanks for this ongoing series.

  13. Curt

    You can also use insurance companies. The insurance company buys your Account Receivable and collection risk, giving you the cash up front to pay for production. Not too many people know of this trick, comes in very handy in the right situation.

  14. Modify Watches

    We’re a year-old startup designing interchangeable watches. We’re transitioning to our version 2.0 product right now and, well, are entering a working capital crunch. If we’re going the bank route, do you have any advice between obtaining a Line-of-Credit versus an outright loan? And similarly, if we’re going to borrow from friends/family in this environment, what’s a “fair” interest rate for a short-term loan.Great post (and great comments so far as well!)

    1. Carl J. Mistlebauer

      Line of credit is better…but you have to check interest rates.”fair” interest for friends and family?  If you pay them back then anything would be fair…if you don’t then 1000% interest isn’t even fair….

  15. Parveen Kaler

    >> One of the many awesome things about a software business is that it rarely has any inventory. It depends on how you track customer acquisition cost and lifetime value of a customer.  For a SaaS company, you can think of a user that has contributed less revenue than acquisition cost as inventory.

    1. PhilipSugar

      If you have value you invest more in “inventory” i.e. upfront development cost, than you ever would in actual inventory.

  16. Peter Beddows

    “Working Capital Financing” very well explained in your blog post Fred (another opportunity to add to a Skillshare class? ) and further well qualified with anecdotal experiences in the comment threadI’ve seen all three methods (Credit Card, Factoring and Revolving Line of Credit) used in various situations with varying degrees of success and challenge.The best option, IMHO, if you can secure it, is the Revolving Line of Credit but don’t look to any big bank for that. Explore the smaller commercial banks and banks know for their favorable treatment of startup ventures such as Silicon Valley Bank. Even the Carlyle Group have been known to make such funds available though that may now be a thing of their past.

  17. greggdourgarian

    Fred, factoring is not just for the ‘shaky’.  We factor some 35 high-growth temporary staffing companies, providing them software, career sites, marketing, and payroll processing to fuel growth.Our clients are winning because they focus on sales and recruitment instead of all the bookkeeping and cash flow worries that keep their competitors at bay. 

  18. Phanio

    Nice post. Many growing companies who can’t manage their working capital grow themselves broke. Imagine building success with your business model only to have to shut your doors due to lack of capital.Know that any form of working capital financing should be short-term. If you are using outside capital to build inventory or complete jobs for an extended time, you have more issues with your business than just poor working capital management.Other forms of working capital financing:Accounts receivable factoring – mentioned here,Purchase order financing for those companies with orders on hand but no capital to complete then – can usually get up to 100% to complete the jobs including labor costs,Business cash advances. If your company accepts credit cards are payments, you can factor future credit card revenue for needed working capital today.

  19. Guest

    Working capital finance really is a major issue. Here in the UK around £220Bn of invoices per year are financed through factoring or invoice finance – it’s by far the largest market in the world.I’ve recently joined @marketinvoice, which provides UK-based companies with access to an online marketplace where they can obtain cash advances on their invoices of up to 90% by auctioning them to a pool of global institutional investors. We are getting a lot of traction and interest from both companies and investors (buyers).

  20. Andy Sack

    Fred great post! You did a very good job explaining working capital. I would agree with you that working capital financing is a great way to mange the cash crunch you get when starting a company and keeping up with demand. ps. I love that ipad stand, I need to get one! 

  21. David Haber

    @tao69:disqus and @greggdourgarian:disqus I just wanted to thank you guys for your comments in this post – really, really helpful.I was just curious if either of you have had experience with online marketplaces for receivables factoring – like the Receivables Exchange.  Do you think businesses are able to command better terms bc of the increased competition?Thanks!

  22. doral homes

    Financing NeedsIt’s a fact of life; your company needs capital to conduct business. Of course the best way to obtain it is through sales. Sometimes, however, you need other, more immediate sources. Different sources may be appropriate for different stages of growth.