As a 10 year veteran of the working capital industry, one of the most common questions I hear is, “Why would I borrow money from you instead of getting a loan from a bank?” It’s a great question, but the answer is not so simple. It depends on your scenario and has several moving parts.
The purpose of this article is to look at why working capital is often not more expensive than a bank loan, or an SBA loan by extension. The best program for your scenario may surprise you!
The Key Concept
Without getting into all the differences between traditional bank loans and private working capital funding (such as banks’ long application times, their low approval rates, etc.), let’s focus on a general rule of thumb that is typically true: Bank loans have lower rates/fees than working capital funding from non-bank lenders. Yes, banks can be cheaper. But…(this is key)…meeting the requirements of the bank loan may cost you more money!
Here’s how. The main issue with the “bank vs alternative” comparison is that most owners of small and mid-sized businesses won’t qualify for a bank loan. Why? Profit is the most common answer. There are other reasons you may not qualify (insufficient credit, lack of collateral, simply not having 30-60 days to wait, etc.), but more often than not it’s a lack of profit that eliminates the bank loan option.
You need to show the bank a healthy profit for 2+ consecutive years on your business tax returns to even start the conversation. And not just any profit will suffice! That $50K in profit you claimed on that $2M+ gross revenue business is NOT going to work. Your profit needs to be a healthy percentage of your gross revenue. At a minimum, banks like to see 10-20% profit margin to qualify. The required range can be higher for certain industries.
In the example above, banks would like to see $300K in taxable profit on that $2M+ gross revenue business – a 15% net profit margin. That 15% profit margin tells the bank your business is healthy and it can afford to absorb the cost of their potential loan offering without adverse effects.
By comparison, private working capital lenders DO NOT put nearly as much weight on profitability as a traditional bank does. In fact, profitability rarely makes or breaks an approval with Formula Funding.
Getting Caught in a Catch-22
In the real world, most business owners deploy every strategy possible to reduce their tax liability and show as little profit as they can. This is especially true for new businesses that are still digging themselves out of the hole from launching their company. While maximizing your deductions is great for minimizing your tax bill, it spells disaster for qualifying for that low single digit interest rate bank loan you saw advertised on the bank’s billboard.
I know what you’re thinking…”I’m stuck either way! If I don’t show as many deductions on my taxes in order to satisfy the bank’s requirement I’ll end up paying Uncle Sam a TON more money in taxes! On the flip side, if maximize my deductions (like most business owners already do) I won’t owe Uncle Sam nearly as much come tax time…BUT…I won’t qualify for that low interest bank loan. That means I’ll end up paying higher interest rates to a non-bank lender for the working capital my business needs.” I’m here to tell you all of these things are correct.
So how should you determine which is best for your situation? For starters, businesses that deploy tax reducing strategies are welcomed at Formula Funding despite their relatively low bottom line profitability because we take into account the big picture, the entire business potential, not just what it shows on paper.
If you need working capital for your business but your business declares a loss or small profit on your tax returns, grab a calculator. Take a minute to calculate how much in taxes you would pay Uncle Sam to get to that 15% profit range. Don’t forget your state taxes! The average combined tax bracket for our customers is around 35%. Compare that number to what you pay in “normal” years. The difference is probably pretty scary!
If you’re like most of our customers, you’d pay 10s if not 100s of thousands of dollars more per year in taxes. That is the additional cost of satisfying a traditional bank to get an 8% interest rate bank loan!
Rethinking Your Approach
Since costs from that non-bank lender are more than 20%, you may have rejected the idea in the past. However, check the math. Let’s say your request is for a $50K working capital loan. The difference in cost between the 20% working capital funding over the 8% bank loan is $6,000/year. That may sound like a lot of money, but how does it compare to the $100K increase in taxes (each year) that would have to have been paid to qualify with a bank in the case above?
The comparison is usually pretty black and white for most of our business customers. Going through a non-bank lender like Formula Funding will cost you a lot less money in the long run despite it carrying a higher rate.
That’s right, sometimes more is less and less is more! You cannot just compare bank loan rates to working capital loans from non-bank lenders. It’s not just interest rate versus interest rate. You need to factor in what it takes to get that interest rate! Compare the numbers in your specific scenario and decide for yourself which program is best for you and your business.