The Power of Working Capital Loans for Small Businesses

Stef: 0:10

Welcome to the funded podcast, where we dive into the details of how businesses really start, grow and operate. We'll hear from experts that will guide us as we make smart small business decisions on finance, marketing, managing people and everything in between. I'm your host, stephanie, the CEO and founder of funded, where we're on a mission to redefine how the smallest businesses understand and access capital. Today, I'm chatting with Luis. He is the director of business advising services at the Axion Opportunity Fund, which we'll refer to as the Opportunity Fund or AOF throughout, and we are talking today about working capital loans. So, luis, thank you so much for being here, and the first thing on my mind, of course, is what even is a working capital loan? Because I actually don't know.

Luis: 1:02

I think that's kind of like the one of the big kind of like magical points in like lending and banking, right. So working capital can really just refer to like any kind of business related project that requires any kind of excess capital that you within the business may not currently have, right. So if your business is fairly cash strapped or if its capital is fairly like allocated or fairly strict right, a lot of individuals will approach getting a working capital loan in order to fund either business expansion, help assist with a larger like, for example, a catering order right, and they need to buy more materials than what they're used to or what they currently a lot for right, or any kind of expansion, any kind of new work, any kind of new project and, honestly, working capital. Essentially it's just working capital, right. It's working for your business, right Easiest way to define it, I guess.

Stef: 1:52

Okay, so the one example that resonated for me so I just want to make sure I got it right is a catering company. They have like a big event coming up but they have to order all the food and pay for it today. So they know they're going to get that money, but they're not going to get paid until, call it like, the day of the event or within 30 days. And having a working capital loan essentially allows them to make those food orders they need to make in order to have that event, because they might not have the money in the bank.

Luis: 2:21

It's exactly that. Honestly, it's a tool just to kind of help them float those operational costs right, those direct costs of getting that like materials, ingredients, whatever it may be right and really just carry you forward through that net 30, 60, 90, whatever it may be right Until you eventually get paid right.

Stef: 2:38

Yeah, cool. And so some examples of what a working capital loan is not for might be. I don't know. You just got a new lease on a space and you like have construction to do on it. Is that an example? Or like when should a small business owner be like do not get a working capital loan for? Fill in the blank.

Luis: 2:59

Yeah, yeah, and I think it's more like, usually, when you think more working capital, you're thinking more like short term projects, right. Oftentimes you're thinking of projects, usually, rule of thumb, under a year, right, so anything where you can expect to pay it back within, like, under a year or something like that, right? Or you're utilizing that working capital for a purpose that a maximum term length up to a year right, usually, if you're doing, like, anything relating to construction, right, or a build out or something that's going to be a little bit more lengthy or a little bit more direct, right, so it's not so kind of like working capital can be a little bit wishy-washy because you can utilize it however you'd like, right. So I'd say, excluding those purposes, yeah, working capital is just like I have a project, this is what I'm going to do. I expect a return within 30, 60, 90 days from now and I'm utilizing the capital during that time period, right, it's usually fairly short term, under a year, I'd say.

Stef: 3:49

Got it Okay. If I'm a small business owner that doesn't have a working capital loan but probably needs one, how am I probably funding these things today? Like, what are the alternatives before someone gets a working capital loan? Is it credit cards or Great question?

Luis: 4:05

So anything, you're usually using any kind of revolving credit mechanism or tool, right. So other things that I've seen a lot of my clients use instead of like a working capital loan, right, credit cards primarily like the easiest and more convenient tool that people use and the most frequent one that people will use. Honestly, I also see like lines of credit being another thing as well. And then there's like special products that are a little bit more direct use right. So, for example, people get like purchase order invoicing right or things like those tools that are fairly similar to working capital.

Stef: 4:39

It was like specialty finance groups.

Luis: 4:42

Exactly. They're fairly similar, but they're a little bit more like a niche more than anything else, but usually kind of like rule of thumb is yeah, it's fine to use credit cards. However, if you anticipate that you're not going to be able to pay off that balance off in its entirety, or like at least most of it within like a 30 day window, then you're usually best off using another tool, just because the interest rate on a credit card will just destroy your cash flow over time. Right, and you don't want that as a business owner. And that's really where working capital tools or like loan programs really exists to kind of like fill in that gap. It's very similar to a credit card, is for a short term project, but it's definitely more affordable than a credit card.

Stef: 5:16

Yeah, and people seem to default to credit cards because it's so flexible. It is a good tool, honestly, for starting small businesses, and you brought up a line of credit to which I think is an interesting alternative. One thing I've been so surprised about in working with small businesses is there seems to be almost an opinion that that's like a great first loan, and I'm always like, oh, that's so surprising to me, because it's usually higher interest rate. Businesses like seek them out over a term loan because of the flexibility of them, so that's super interesting. Okay, so those are alternatives. Niche products, which I also want to bring up. Sometimes people think of a niche lending product, the one that there's I can't think of the name right now, but there's one in like e-commerce, and they're looking at your actual Shopify books.

Luis: 6:08

They're looking at your numbers, yeah.

Stef: 6:10

Yeah, while they're super niche and so they seem like they're made for you, they're also higher interest than traditional loan options. It's something to consider. Okay, so working capital those are the alternatives someone might see. So then, why does someone go from those to a working capital loan?

Luis: 6:29

Yeah, no great question, and I think a lot of it just comes from an entrepreneur's experience. Over time, I've met so many individuals and I think it's like very common where I've worked with a lot of clients that are just like growing their business right, and honestly, I feel like a lot of business owners early on in their entrepreneurial journey will default to things that they're more familiar with Right. So, for example, I know what a credit card is. I use one for my personal day to day kind of thing, so I could use it for my business too, right, it's one of these things where it's like they may not know what a working capital product is, or they may not be familiar with what a working capital product is and what happens very commonly, especially for younger businesses that are like under five years old fairly younger businesses like usually they'll go to a like a traditional financial institution, right, a big bank or something like that, and they'll say, hey, I want to get some startup financing or I want to get just like financing in general, and they basically say, hey, your startup, we can't work with you just yet. So a lot of individuals as default. Well, what do I have available currently to myself as like a budding entrepreneur, and usually the answer is credit cards in the beginning.

Stef: 7:28

Which makes sense? Are there certain kind of businesses that working capital loans are for, or could it be any type of business? What do you see?

Luis: 7:37

Yeah, honestly, it could really be used by any type of business, to be honest with you. So very common uses for working capital products kind of like, as I mentioned earlier, it's if you're expecting to embark on a project that's going to require more capital than you currently have in your bank account. It could be for the launch of new product lines I see that very commonly as well or for even just purchasing low dollar or smaller types of equipment, machinery, things like that. People also use the working capital projects to kind of just get that first step into this new segment of business or a new type of product or a new sales relationship. And they say hey, you know what, I want to fulfill this as best as possible and I'm undertaking either a contract or some sort of agreement and I want to make sure that I have capital essentially to fulfill that demand.

Stef: 8:25

Okay, cool. What are some of the common requirements for a business to get a working capital loan?

Luis: 8:32

So it'll really depend on the financial institution that you're working with. However, I will say, just as a rule of thumb for any entrepreneur that is looking to get into a working capital product they do exist across the spectrum, for someone that is in the infancy within their business or someone that's a little bit more established. But usually a couple of things that you do want to have at hand just for any lender that you're working with, is, if you're more of an established business, you definitely want to have at least two years worth of your tax returns for the business. You want to have your most recent P&L as well, profit and loss statement, a balance sheet as well, and I would say, at the very minimum, 12 month financial projections, just demonstrating to the lender how that working capital loan product is going to help your business essentially grow throughout that period that you're using it. If you're fairly younger as well, or a younger business, it would be all of these things, as I mentioned earlier, minus the tax returns, because you probably wouldn't have those just yet. But alongside with that, you definitely also want to have a fairly established or fairly structured business plan, just demonstrating your skills, your experience within the industry and really kind of like what that business is all about making sure that it's profitable and, honestly, all of it is just really to measure the risk propensity for any application that a financial institution will end up looking at. So all of these things are primarily used to kind of show what your risk level is. Lending, especially anything working capital related, is primarily going to be based off of risk, and the easiest way to measure that is through cash flow. It's a cash flow lenders.

Stef: 10:04

Okay, how important is the business owner's personal credit score in obtaining a working capital loan?

Luis: 10:12

That is actually a really good question. I would say it's very important right. I don't know. I feel like there's just like myth out there that I've seen from so many entrepreneurs even in entrepreneurs that are like fairly early on in their business where they keep saying, hey, my personal credit shouldn't matter because I'm operating a business and it's a very common thing I hear it way too often.

Stef: 10:31

We wish it were true.

Luis: 10:32

I wish it were true, but that's definitely not the case, right? So personal credit is actually incredibly important, especially the younger you are as a business owner. So if your business is under five years, it's going to be incredibly important. And the reason I say that is like kind of like going back earlier. It's all about measuring your risk right, and while the business may not be as established and you're still in its early infancy, trying to build it up, though, any lender is going to be looking at your personal credit as a tool or as a measurement to kind of see exactly kind of like the rule thumb or likes what I've heard from other lenders being. It's like hey, I'm going to look at your personal credit because I want to know how you pay your own credit cards, how you pay on your car loan, your mortgage, are you late? Are you always on time? You know things like that right, because at least the methodology being is that that behavior you're going to carry it to your business as well, and that's really the methodology behind that. It's like, how you treat your credit is probably how you're going to teach your business credit moving forward as well. That's usually how they will evaluate that. And then, more importantly as well, is that a lot of lenders, especially nowadays I don't know any lender that that isn't this anymore but a lot of lenders will also issue a personal guarantee to any kind of instrument that they make right. So whether you're working with a CDFI or a nonprofit lender or you're working with, like, a big bank, a lot of these lenders now will say, like hey, I'm willing to give you this working capital product. However, I'm also attaching a personal guarantee with that essentially meaning that if your business can't pay it back, then you essentially are making a pledge to pay that back personally. So same thing personal credit is important just for that same reason as well.

Stef: 12:09

Again, it's like I wish it weren't true, like, in fact, I started funded trying to create a path where this weren't true and it just is the reality of the world we live in, especially in these changing times where interest rates are higher and people are talking about a recession for like, apparently, multiple years without a coming, that it's like such a bummer, but it is true, it is a reality for all people. It's not something because I think, as small business owners, we take it personally. We think, oh, they don't like me, there's something wrong with me and that's why they're happy. We need to have a personal guarantee. I've been in small business for 17 years now. I still sign personal guarantees all the time. It's a reality of business ownership. So one thing that I don't think is a reality, that some business owners think is a thing, is the idea of a business credit score. So I would love to hear from your guys's standpoint Do you use think of business credit scores in any way in your underwriting process?

Luis: 13:13

Honestly and that's kind of like I wouldn't even say misconception, but like, just like another reality as well, especially working in the nonprofit finance phase we don't really look at business credit, to be honest with you.

Stef: 13:23

Because they like almost don't exist.

Luis: 13:25

It almost doesn't exist. Exactly right.

Stef: 13:28

They're an imaginary thing that all the credit companies would love for us to create for them and make exist, but the truth is is they don't have enough data yet to be accurate, Correct. Yeah, it's exactly that.

Luis: 13:40

And even then, though a lot of lenders even like big box lenders or like traditional institutions they don't really report on your business credit unless you specifically like tell that underwriter or tell that closing officer that you're working was like, hey, can you also make sure to also reflect my payments on my business credit as well? Right, it's, it's a tool that it does exist and, honestly, like if I sometimes I have seen people's business credit as well and it demonstrate like a really trustworthy business where you know I'm knowing that they're paying all of their accounts and that's great, but typically for a lending decision it's not utilized that much. The biggest things are going to be like we're going to look at your personal credit, especially if you're a younger business, and then two and I think more importantly it's really your business financials that are going to like talk the loudest Honestly. Your tax returns, your PNLs, how you're growing things like that matter way more.

Stef: 14:28

That's interesting idea too is like small business owners should think about their ability to manage their PNLs as their business credit score, what that looks like, how it's reflected, how professional it is, if it's even done Like that. Is you showing a lender that you understand your business finances that I have such a pet peeve about this idea of a business credit score. I said tool out there like charging business owners, like $50 a month, or business credit score Business owners. You can self report that for free. You actually don't even need to pay for it. You could just go get it. So I feel like so annoyed with this concept. So thank you.

Luis: 15:10

Yeah, of course.

Stef: 15:11

Maybe one day it will exist and it will make the world better, but today it doesn't. So how should a business owner then evaluate the right kind of capital for their needs? Should they be thinking like, well, what kind of project is this? Is it short term, is it long term? Because I think one of the biggest challenges with all of these different products that are in the market now is we're already overwhelmed as small business owners, we're already new to all of this, and then it's like oh my gosh, how do I even know what I need?

Luis: 15:41

Yeah, no, that's a great question, honestly, and I feel like it's also one of the traditional gotcha questions that a lot of lenders will implement as well for small business owners. So, typically, kind of like the biggest thing that a small business can do, it's really just evaluating the project. Oftentimes, I meet a lot of business owners that are kind of like in that similar situation right, I know I want to do X, y and Z, but except, I don't know how to get to X, y and Z just yet. I want to start selling on Amazon, I want to start selling, or I want to start doing this other completely new pivot thing for my business, right, new line, whatever it may be, but they don't know exactly how to kind of like go through that process as far as, like, the planning aspects at least. So, honestly, I think that's really where advisors, business consultants, your SBDC coach that's local to you they could probably work with you right, could definitely help with a lot of these things, right? So one of the actually that I actually have a lot of my clients that I have worked with that are in that kind of like they're stuck there is I really just sit down with them and we just start talking about OK, that's like you want to do X, y and Z. What do we need to get there? What kind of equipment do we need? What kind of do we need more staffing? What kind of materials do you need? How much is it going to increase by? And it's really more of like a thought experiment to really just start thinking about all of the things that they need. We end up breaking that down into two lists. We end up saying what is the minimum that you need, just to start doing it, and in the other list we end up creating as well. It's like if you could have, you know like your dream come true, and this looks like how you dreamed it. What does that list look like? And they kind of like the optimal setup. And the reason that's very helpful is that at many times, like at many times, you won't be able to get your optimal dream from a lender, just depending on the risk or how much capital it's going to require to like launch that kind of initiative. But that doesn't mean that you can't do it. So whenever you're working with a lender, you definitely want to be yes, you want to have a budget in mind. As far as, like I need this to get started and this is kind of what I want. But at the same time, if a lender works with you and they say, oh, I'm sorry, I can't give you that much, but I can give you this much instead, if that still works for you and as long as that still meets your bare bones, like requirements, like yes, I can make it work, then that makes sense. But it's one of these things where you do need that ample preparation just to kind of ensure it's like, because if you were to take that low offer right or like a lower offer, and if it's below your minimum currently, then you're just taking out debt that's not going to help you out. So it has to be very thoughtful and a lot of it is just like sitting down often times with a pen and paper and I've done that with many clients Because what you don't want to do is you don't want to approach a lender and saying like I need money for X, right, just for the lender to kind of like sit in front of you and I've seen that happen with many lenders that I've worked with, where I see them like sit down with a client that just came in saying like tell me about your project, tell me what you want to do, tell me how much it's going to cost and tell me and I think where they get most individuals is really break that down for me. Tell me how you're going to use that $30,000 loan, and I want to break it down as much as possible Tell me how you're going to be using $2,000 for this, $1,000 for that, $5,000 for this right. And if that client or that individual that's seeking that loan can't provide that clarity or that certainness, saying like I've done my research, then oftentimes, usually, that lender will be like I'm going to flag this individual, they're not ready for capital yet and they usually get denied, which is not ideal.

Stef: 18:54

Right, yeah, it's like realizing that when you go asking, every part of you is being evaluated. To be mindful of that so interesting. One of the things I love about CDFIs which Opportunity Fund is a CDFI is that aspect of business coaching and advising that you do there, of having access to someone to help prepare you, help think through this. Just even like that, how you were talking about figuring out your minimum. It's like as a business owner, we get so in the weeds that having a friend to be working with, that's like, okay, let's figure out your minimum. It kind of pulls you out of the business and helps you create space for that. That's so cool. But you brought up a good point on how much you qualify for. So are there any like good rules of thumb or something that a small business owner can use to know, like how much they would qualify for if they were a person, they were applying for a working capital loan?

Luis: 19:48

Yeah, no, that's a great question. Honestly, I would encourage anyone that's listening to this as well is to look up for any kind of like business loan calculators. There's a ton on the internet that you can find right, and a lot of bigger banks. They have their own calculators as well. You can use whichever one, honestly, but I think like the most important thing as far as like just getting to know what your minimum is kind of like usually a rule of thumb that I see a lot of lenders just kind of like utilize, as far as like an easy way to gauge exactly how much you could potentially get. It's usually three months gross revenues. I mean, it's not going to be a perfect measurement, but it's kind of like at least you can ballpark it a little bit as far as like what you could get. But an even better figure that I tend to utilize and I feel like it's a little bit more conservative, however, I feel like it's a little bit more accurate is I was a lot of clients. It's like hey, go to your last bank, to your last tax return, go to the line that designates, I kind of like, what your net profit was for the end of the year and divide that by 12. So really what that means is, at the very minimum, that is, the minimum monthly payment that your business can make. Yes, like that's a very simplified way of doing that right, because there's still like addbacks and other things that you can add to increase that number. However, at the very minimum, if you're doing like 12k net profit right Last year, then if you divide that by 12, it's like at the very minimum. I know that my business has enough capacity for me to do like a thousand dollars in a monthly payment per month.

Stef: 21:08

Essentially, yeah, that's actually a really good way to think about it, because, as business owners, I think we really get scared about taking on a loan we can't afford, and so it's good to be conservative and be like, oh, I know I could afford this, or I knew I could last year.

Luis: 21:24

Exactly Because the one thing that you don't want to do is you don't want to get a loan that you can't afford, right? And I've seen so many businesses that have done that, and then they'll usually connect with our nonprofit either a few months later and saying I made a big mistake. Is there anything that you can do to help? Or what are the resources that are out there for me to either refinance it or just make it more digestible? Just because there are a lot of companies out there that are more than happy to lend you whatever money that you need, and they'll do it quickly and at a higher rate as well, right? So you also have to be very careful as far as what can your business currently stomach, just because there are a lot of predatory lenders out there that'll say, yeah, you want like 50k, sure, but you're going to pay that back in six months and you're going to have like a 20% interest rate, right? So it gets pretty crazy. So just to evaluate that, just because, at the end of the day, the worst thing that it'll do it'll destroy your cash flow and then you won't be able to do anything, which is not great, horrible and so stressful.

Stef: 22:23

So stressful, cool. Thank you for that. So main last question. Here you're at the Opportunity Fund. You guys do working capital loans. So I would just love to hear, like, what is the Opportunity Fund, what are you doing with working capital loans and who should apply? If they're listening to this, yeah, great question.

Luis: 22:44

So, AOF, we do have a working capital loan product. That product extends, I think, minimum it's like 5k all the way up to 250,000. As far as like minimum requirements, we do require that individuals at least have be at least one year in business. Really, what that means is that having at least one year worth of business tax returns filed with the IRS for the business, and then just same thing as I mentioned earlier, making sure that you have your P&L ready to present, making sure that you have your balance sheet as well up to date as well and in many cases, a business plan as well, just depending on where you're at with that business or if you're doing any major projects with that working capital loan product. Just so that we can understand a little bit more about what that looks like. But we do have quick turnaround times as well, which is a good thing, just because a lot of lenders typically a traditional cash flow lender will take about 30 days to kind of turn that thing around and then we can do that in about seven days to like 14 days, which is kind of nice. But yeah, I would say that covers kind of like at least our working capital product.

Stef: 23:41

Awesome. Well, thank you so much for being on the show today I learned so much I always do in these shows and for everyone listening. Thanks for tuning into the funded podcast. I hope this episode was informative and helpful for your business journey. Don't forget to subscribe and also follow funded on social for more great content. If you're looking for help funding, visit the funded website. We connect you to lenders, like the opportunity fund. We help you evaluate which ones right for you. So we have great content there and until next show, I look forward to hearing you all again soon.