This is a financing method where you actually sell your accounts receivable to a buyer such as a commercial finance company to raise capital. A "factor" buys accounts receivable, usually at a discount rate that ranges between one and 15 percent. The factor then becomes the creditor and assumes the task of collecting the receivables as well as doing what would've been your paperwork chores. Factoring can be performed on a non-notification basis. That means your customers aren't aware that their accounts have been sold.
There are pros and cons to factoring. Many financial experts believe you shouldn't attempt factoring unless you can't acquire the necessary capital from other sources. Our opinion is that factoring can be a very good financial tool to utilize. If you take into account the costs associated with maintaining accounts receivable such as bookkeeping, collections and credit verifications, and compare those expenses against the discount rate you'll be selling them for, sometimes it even pays to utilize this financing method. After all, even if the factor only takes on part of the paperwork chores involved in maintaining accounts receivable, your costs will shrink significantly. Most of the time, the factor will assume full responsibility for the paperwork.
In addition to reducing your internal costs, factoring also frees up money that would otherwise be tied to receivables. Especially for businesses that sell to other businesses or to government, there are often long delays in payment that this would offset. This money can be used to generate profit through other avenues of the company. Factoring can be a very useful tool for raising money and keeping cash flowing.
Customers are another source of bootstrap financing, and there are several different ways to take advantage of these valuable assets. One way to use your customers to obtain financing is by having them write you a letter of credit. For example, suppose you're starting a business manufacturing industrial bags. A large corporation has placed an order with your firm for a steady flow of cloth bags. The major supplier from which you will obtain the material the bags is located in India. In this scenario, you obtain a letter of credit from your customer when the order is placed, and the material for the bags is purchased using the letter of credit as security. You don't have to put up a penny to buy the material.
In your personal financial dealings, you may have had a builder, or someone else working for you, ask for money up-front in order to buy the materials for your job. That contractor used your money to get started on the job. You were actually helping to finance that business. This is how customers can act as a form of financing.
Another bootstrap financing source is real estate. There are several ways to take advantage of this source. The first is simply to lease your facility. This reduces startup costs because it costs less to lease a facility than it does to buy one. Also, when negotiating a lease, you may be able to arrange payments that correspond to seasonal peaks or growth patterns.
If you enter a business for which you will need to buy the facility, your initial cost will increase but the cost of the building can be financed over a long-term period of 15 to 30 years. Again, the loan on the facility can be structured to make optimum use of your planned growth or seasonal peaks. For instance, you can arrange a graduated-payment mortgage that initially has very small monthly payments with the cost increasing over the lifetime of the loan. The logic here is that you have low monthly payments, giving your business time to grow. Eventually, you can refinance the loan when time and interest rates permit.
Another advantage that the outright purchase of the facility will provide you is continuing appreciation of the property (hopefully) and the decrease of your principal amount to create a valuable asset called equity. You can borrow against this equity. Lenders will often loan up to 75 or 80 percent of the property's value once it's been appraised.
This applies to any private real estate you might own. If you have a desire to get into business and you need startup capital you can't get in any other way, you may have to borrow against the equity in your home or sell it altogether. If your home is appreciating in value, real estate is a good venue to choose. If it's depreciating, it won't be quite as attractive.
If you spend a lot of money on equipment, you may find yourself without enough working capital to keep your business going in its first months. Instead of paying out cash for your equipment, you can purchase it with a loan from manufacturers; that is, you pay for the equipment over a period of time. In this way, equipment suppliers are a source of bootstrap financing.
Two types of credit contracts are commonly used to finance equipment purchases:
1. The conditional sales contract, in which the purchaser does not receive title to the equipment until it is fully paid for.
2. The chattel-mortgage contract, in which the equipment becomes the property of the purchaser on delivery, but the seller holds a mortgage claim against it until the amount specified in the contract is paid.
By using your equipment suppliers to finance the purchase of equipment you need, you reduce the sum of money that you need upfront. There are also lenders who finance 60 to 80 percent of the equipment value. And then, of course, the balance represents the borrower's down payment on a new purchase. The loan is repaid in monthly installments, usually over one to five years, or the usable life of that piece of equipment.