Factoring, convertible loans, or venture debt: companies can choose between numerous alternative financing options. These alternative finance instruments complement traditional approaches, contributing to a diverse capital structure. What essentials do businesses need to grasp?
Whether a startup, a mid-sized company, or an enterprise: securing capital is paramount for investment and operational needs. Businesses often employ internal and external financing methods to meet their financial requirements.
Internal financing entails retaining company profits for reinvestment, while external funding sources vary widely. In the case of debt financing, the best-known source is probably the bank loan. Regarding equity, stock exchanges, venture capital, and private equity funds are used.
Beyond these conventional routes, recent years have seen the emergence of various alternative financing methods that are reshaping the financial landscape.
Forms of alternative financing
The modern financing landscape offers a diverse array of instruments for raising capital. Alternative finance instruments are available to companies of all sizes and in all industries. The choice allows for funding customized to the company's capital needs.
Below, we introduce distinct forms of alternative financing that companies can access.
Factoring
With factoring, a company sells its outstanding customer invoices to a factoring institution. In return, the company receives a part of the invoice amount instantly as capital. It is immediately liquid – and does not have to wait several weeks or months for the customers' money. This procedure is particularly beneficial with long-payment terms.
The factoring institute buys the outstanding receivables and approaches the customer to collect the entire invoice settled. It retains the difference as a fee.
Factoring has several benefits for companies:
- They receive capital directly instead of waiting for the payment of their receivables.
- The company's liquidity increases immediately.
- Companies are protected against payment defaults, as the factoring institute takes over the receivables management, including dunning and collection procedures.
Trade, healthcare, or manufacturing: Factoring is used in various industries today. In particular, it has established itself as an alternative form of financing for SMEs. In 2022, the revenue in the German factoring industry amounted to €372.9 billion. This corresponds to a growth of around 137% compared to 2012.
When does factoring come in handy?
When a company is growing, factoring comes in handy. Growing sales also mean that the total number of open customer invoices increases. In theory, companies that rely 100% on factoring have no outstanding receivables.
Leasing
Besides factoring, leasing is one of the most widespread alternative finance options.
With leasing, a company rents machines, vehicles, office equipment, or hardware from a leasing company or directly from the manufacturer for a certain period. A regular fee is payable, for example, monthly or quarterly. At the end of the leasing contract, the company can either buy the leasing object or return it.
In practice, there are various types of leasing:
Finance leasing with full amortization
The lease payment covers the acquisition costs, financing costs, and the profit of the leasing company.
Finance leasing with partial amortization
The leasing rate only partially covers the costs of the leasing company. At the end of the contract, the contract is either renewed or the company buys the leased objects.
Operate leasing
The company leases an object only for a short time to work with it. This operational leasing occurs, for example, during seasonal fluctuations in business.
Sales-and-lease-back
The company already owns the leasing asset. It then sells it to a leasing company. Afterwards, it can lease it back again. In this way, it can directly access the funds and remains liquid.
All-in leasing
Asset costs, maintenance, repair, and other expenses are covered.
Leasing has several advantages for companies:
- Leasing is balance sheet neutral and does not affect the equity ratio.
- The leasing rate remains constant over the entire period. That makes planning easy.
- The leasing rate is treated as an operating expense for tax purposes. This treatment reduces profits, which leads to lower taxes in the year of acquisition.
- The company secures liquidity as the leasing company finances the leasing asset.
Production, hardware, software, cars, and cloud applications drive the leasing business. In 2022, their volume was around €66 billion in Germany. They thus accounted for more than 90% of leased objects.
Crowdfunding
In crowdfunding, many individuals participate with small amounts in financing a company's project. In return, they receive a "Thank you", for example, in the form of the product produced. This product can be an item of clothing or a commodity.
An online platform collects the capital. This platform acts as an intermediary between the company and the donor.
A popular form of crowdfunding is equity-based crowdfunding. Here, the company receives mezzanine capital from investors, which stands between debt and equity and has characteristics of both. The investors contribute small to medium amounts, usually starting at 100 euros. In return, they receive their investment, including interest rates over a specific period.
In equity-based crowdfunding, companies use three financing instruments, depending on the contract:
- Participation certificate
- Silent Partnership
- Participatory loans
Convertible loans
With a convertible loan, companies receive a loan from investors. They can convert this loan into company shares at the next financing round. In addition, the company pays interest to the investors.
The convertible loan is unsecured and subordinated. It means that there is no security for the investors. They are treated as subordinates and must step back to all other investors.
Convertible loans for startups
Although convertible loans do not legally count as equity, banks classify them as equity-like, similar to a silent partnership. This handling increases the creditworthiness of companies. From an accounting perspective, a convertible loan is a hybrid of equity and debt. It classifies as a mezzanine capital.
Convertible loans are particularly interesting for startups with existing investors. The procedure is faster because the existing investors are already familiar with the business model. In addition, the administrative effort is low: a convertible loan does not require notarization.
Convertible loans are relevant between two funding rounds. The startup quickly receives debt capital (for example, because it has to bridge a critical phase), which converts into equity in the following official round.
For companies, a convertible loan has further advantages:
- Because the company valuation is not the focus, startups receive capital quickly and bridge the gap until their next funding round.
- A convertible loan is less expensive than a direct investment in the company.
- The lenders only receive information rights but no co-determination rights.
- Banks give companies a higher credit rating, as they treat convertible loans as equity.
Venture debt
Venture debt is a risk loan to primarily finance growth. It is comparable to a conventional bank loan and is issued by private and government providers. The risk loan ensures startups can invest in further growth and remain liquid between equity rounds.
Characteristics of venture debt:
- It provides debt capital for startups.
- Venture Debt always follows venture capital: It is usually raised shortly after or during an equity financing round.
- Companies use it to finance growth, for M&A, for marketing or sales activities, or to hire new employees.
- Venture lenders receive high-interest rates (8% to more than 20%) on the capital they provide, plus warrants, covenants, and other collateral.
- The company must repay the money in monthly installments over a specified time.
- Venture debt is suitable for startups that have already completed the seed phase. One prerequisite is, for example, sales, an established product, and a focus on growth.
Alternative debt financing
In recent years, several alternative financing models have been established. They describe non-dilutive, alternative debt funding for companies. In other words, companies do not sell their shares in return for equity funding, but finance themselves with debt and retain the company shares.
As described, fintechs are technology-driven and use data-driven approaches. They focus their risk analysis on specific metrics regarding financial ratios, recurring revenues, and unit economics. This way, capital requirements precisely align with the company's business plan.
What alternative debt financing instruments have in common is that they do not dilute the shares of existing shareholders or reduce their influence on the company. This type of alternative finance is also offered by re:cap.
The use cases of alternative debt funding are individual. Among other things, companies can use it to:
- create a cash buffer to postpone the next equity round to a more convenient time
The goal is to service the capital needs at an ideal time for the company. This precision – possible on a monthly or even daily basis – avoids overfunding, which impacts the cost of capital and capital efficiency.
Alternative debt financing offers several advantages:
- Companies secure the liquidity they need that fits their business plan
- No dilution of company shares
- Companies can agree on flexible repayment terms
- Financing does not include warrants
Revenue-based financing
Recurring revenue financing (RRF) and revenue-based financing (RBF) are instruments related to alternative debt funding. These instruments have been popular in the USA and Great Britain as alternatives to conventional financing for quite some time. However, more and more early-stage companies from the software and SaaS environment are also using this type of financing in Germany.
Revenue-based financing
With RBF, companies receive debt capital and guarantee investors a fixed percentage of their revenue over a certain period. If the revenue increases, the costs increase.
Recurring revenue financing
In RRF, companies also receive debt capital. The amount financed and the interest are based on the amount of recurring revenue and remain the same over the entire period. Thus, capital is provided to the company only up to a specific financing limit, which depends on the annual recurring revenues.
In both alternatives, the investors assess the company in advance. They review its financial performance. They analyze metrics and deduce how the business might develop in the future. Based on this, investors decide the funding amount and the interest rate.
The difference between alternative and traditional financing
Traditional corporate finance relies on well-known instruments like loans, credit, and subsidies, typically provided by established financial entities such as banks, equity and debt funds, or other financial institutions.
In contrast, there are alternative forms of finance, often provided by fintechs—digital financial service providers that revolutionize traditional offerings using technology and data. With their offer, fintechs stand apart from the conventional financial world.
Fintechs provide alternative funding
This approach enables fintechs to have a streamlined process when providing capital, usually without lengthy negotiations, bureaucracy, and administrative work. Particularly startups seeking to raise funding fast benefit, as traditional options often fall short. Why?
- Startups lack of tangible assets (machines, real estate, vehicle fleet),
- a (still) lacking orientation towards break-even, and
- a business model that might deviate from the conventional underwriting models of banks
Nevertheless, under specific circumstances, early-stage companies remain viable candidates for financing. By focusing on data and digitization, alternative finance providers can assess risk profiles and the future growth of startups. Usually, the underwriting models of banks are not able to do that. The business model of early-stage tech companies operates outside their frame.
A high degree of individualization helps fintechs here to make funding decisions. In this way, fintechs can determine a startup's capital needs precisely. However, alternative financing methods are not exclusive to startups; mid-sized companies also tap into its potential to support their operations.
Alternative business finance doesn't intend to replace its classic counterpart. It acts as a supplement to bank loans, venture capital, or other traditional financing instruments. The sweet spot lies in combining classic and alternative funding options.
In doing so, companies can diversify their capital stack and finance investments matching their needs. After all, not every type of financing is suitable for every investment need.
Companies should combine different funding options
Whether traditional or alternative financing, or a combination of both: companies today have a variety of instruments at their disposal.
The choice of financing method should align with a company's unique investment and business model, allowing for a tailored approach to capital acquisition. Ideally, companies combine classic and alternative financing options.
With finance options available no matter size or stage, each business can select the most suitable financial instruments to meet their specific needs.
