True Cost of Capital: Factoring vs Venture Capital
Businesses often have a misguided view on the pros and cons between factoring receivables and venture capital (or private equity). Many entrepreneurs today truly misunderstand how to compare the cost of equity vs debt. Indeed, this can be a daunting task, and often argued over, even by professionals having spent years in banking or private equity industries. Factoring: As misunderstood as any financing tool out there. One of the most common misconceptions about factoring is that it’s too expensive (or risky), while private equity is largely considered to be a safer way of expanding business and boosting shareholder value. Factoring companies, simply put, make money by charging a “discount fee” on each invoice that is factored. If you have a $1000 invoice that is factored, you would likely get an immediate advance of $800. When the invoice pays in 30 or 45 days, you would receive what is called the “reserve” (the remaining $200), less the Factor’s fee of say $2.50 (this would be the high end of the “fee” scale). This is roughly the same discount that many companies would pay if they offered “early payment terms” to a large customer. Factoring indeed can carry a heavy fee structure depending on the size and concentration (how many customers a business is invoicing) in the deal. However, fees can vary widely so entrepreneurs should weigh options carefully before choosing this option. Venture Capital: A fancy term for companies that provide capital at early stages to entrepreneurs in need of cash. Venture firms acquire substantial ownership stakes in companies, allowing these companies to expand using the capital these firms provide for their stake in the company. Many times, the entrepreneur is left with less than a 50% stake in the company and technically does not have the control they really want or need to be an entrepreneur. In other words, you are reduced to “employee” status again, which defeats the rationale that led them to wanting to be a business owner in the first place. Once an entrepreneur has given up more than 50% of his business he is no longer in control. There is a great article on this written by Forbes magazine earlier this year. You can access it here: Forbes Without getting “lost in the weeds” over the cost of Venture Capital vs factoring, just think of it this way. With factoring you are paying a fee for each invoice you factor. You can choose to move on to different financing (bank loan or line of credit) any time you want if you feel you are paying too much or are unhappy with what you are receiving in return for your cost of capital. With Venture Capital, you will now share your profits with your new owner (the Venture Firm), on a permanent ongoing basis. It is unlikely you can get rid of them if you are unhappy without an unbearably high cost (but they can certainly get rid of you). Of course, there are many other factors that an entrepreneur should weigh in deciding which type of capital to help with growth of the business. Certainly, these are two options worthy of investigation.
Mr. Cox is Managing Principal with Pendleton Capital Group, Inc. – a factoring and trade financing company headquartered in Houston, TX. PCG provides professional “best practices” Factoring and Trade Financing and other small business services. His office is in Houston, TX, and he can be reached for additional information or consultation at [email protected] or 713-808-9746. The company’s website can be accessed at Pendleton Capital Group.