Financing an asset-light business

What type of companies tend to have few assets?

“Tech companies—particularly those that have not reached a certain level of maturity—often have few assets,” explains Dubé.

Some have offices, for example, but most do not. Their other assets are often intangible in that they cannot be seen or touched, such as patents or intellectual property. Because their value is more difficult to assess, they are less favoured by banks.

Here are some examples of companies with few assets to pledge as collateral:

• Software as a service (SaaS) companies providing access to software on a subscription basis.
• E-commerce companies, which often have inventory. These short-term assets are often less attractive to long-term lending institutions. That is because inventory is often financed on a short-term basis, using a line of credit, for example.
• Cleantech companies sometimes own equipment. However, in many cases, there may not be enough equity in the equipment when it comes to meeting the company’s financing needs.
• Companies in the media industry that typically have assets of lesser collateral value, such as filming equipment, in their early stages.

Why is securing a loan for a business with few assets more difficult?

A company with few assets cannot offer much in the way of collateral to secure a loan. The lending institution, therefore, takes on more risk by granting such a borrower a loan, as it will have difficulty recovering those funds should the business cease its operations.

Many start-ups in innovative sectors have few assets and a shorter track record. Their profits are often modest, as the funds are reinvested in the business. This makes obtaining institutional financing more difficult.

Why apply for financing?

Below are four of the main reasons why businesses with few assets apply for financing, according to Dubé.

1. Develop new technologies

Many companies have ideas for innovative projects such as developing new software or new technologies.

However, such projects may be difficult to finance using borrowed capital. There is a better chance that a company’s application will be accepted if it is already generating revenues and profits through its existing products or services.

2. Increase market share

Expanding into new markets may be an easier way to secure financing from lending institutions, says Dubé. This type of project can generate more revenues through a product or service with a proven track record in the market in which it was originally launched.

To that end, the company may want to invest in sales and marketing, for example.

3. Recruit

Lending institutions may also finance a recruitment project if it stands to generate additional revenues for the business.

4. Obtain certifications

Companies seeking to enter specific industries must obtain certifications. “Let’s consider the example of a company specializing in data hosting,” says Dubé. “To continue to grow, attract new customers and build confidence in the services provided, it will need to obtain certifications. To that end, it may apply for financing to cover the cost of cybersecurity consulting services, for example. Canadian companies collaborating with the military are also required to obtain certain certifications.”

What financing options are available to businesses with few assets?

Businesses with few assets to pledge as collateral often have limited access to financing. Here are three options that could benefit your business.

1. Cash flow financing

This type of financing is based on a company’s ability to generate positive cash flow in the future. In such cases, the lending institution determines that the company will make a profit at a specific point in time.

Since such loans do not involve pledging a particular asset as collateral, the terms and conditions differ greatly from those for a mortgage, for example. The interest rate is likely to be higher and the repayment period shorter. This implies a higher level of risk, which also leads to larger payouts. There is also a possibility that you will be asked to provide a personal guarantee, that is, a personal commitment to repay the loan should the business cease its operations.

This type of loan is usually short term, often less than seven years. However, there are a number of flexible, customized financing options available, such as subordinate financing, that can be adapted to meet a company’s needs in various situations.

2. Equity financing

This type of loan is a form of financing that involves obtaining funds in exchange for shares in a company.

Equity financing is widely used by businesses in the tech industry. Companies are not bound by set time limits and amounts to repay the funds raised, as is the case with loans, for example. It is often considered a form of patient capital in that it is a longer-term loan. It provides greater flexibility, making it possible to finish developing a product, for example. However, shareholders must give up shares in their company, which can be very costly and sometimes even lead to a loss of control.

Equity investors can offer advice and a network of contacts that could benefit the business. 

Below is a summary of the advantages and disadvantages of both types of loans:

Advantages of cash flow financing

• Business owners retain control and do not have to give up part of their equity stake in the company.
• Interest on a loan is tax deductible, which can reduce a company’s tax burden.
• Customizing repayment terms based on projected financial performance is sometimes possible, making it easier to anticipate cash requirements.

Disadvantages of cash flow financing

• The loan must be repaid under various terms and conditions, which may reduce cash flow should revenues fall or projected profitability drop.
• This type of loan requires a certain degree of cash flow stability. 
• Borrowing conditions are often more restrictive for businesses with few assets to pledge as collateral.

Advantages of equity financing

• Unlike with loans, there is no obligation to repay funds secured through equity.
• You may be able to benefit from greater strategic support.

Disadvantages of equity financing

• Your shares will be diluted. This may eventually lead to the loss of some control over your business and cost you much more than the interest on a loan when the business is sold.
• Raising capital using equity can be a long and costly process.

Combining both options

By combining the two financing options, you could benefit from the advantages of each and end up with an additional financial cushion.

For example, you could:

• use equity financing to fund research and development projects for new products
• use cash flow financing for market development and marketing

How do banks assess applications?

When financing applications are made, banks must ensure their investment is viable and secure, while considering the following questions.

Managerial quality

• Do you have any entrepreneurial experience?
• Have you been successful in the past?
• Do you have a strong management team in place?

Ability to secure financing

• You may have received contributions from friends and family, but have you ever been able to attract angel investors, venture capitalists or institutional private equity firms?
• If your company runs into financial difficulty, will you be able to raise equity capital or approach other financial institutions?

Debt service and cash flow

• Is your debt service ratio on track?
• Does your company generate enough cash flow to cover expenses and repay debts while growing at a healthy pace?

How to prepare a solid loan application

Your financing application will only be accepted if it is clear and specific. Here are a few tips to help you draft it:

1. Ask for help

Dubé urges companies to enlist the help of external specialists. “Business owners tend to know a lot about their products, but not necessarily about financing. Getting help to raise funds can be very beneficial,” he says. For example, you can contact external financial managers or accountants to assist you with your application and determine your actual needs.

Such experts can review your financial statements and make recommendations. Your financial documents must be well organized and detailed if you expect your application to be accepted.

“New and growing businesses often submit financial statements in the form of a notice to reader,” says Dubé. A notice to reader is a type of financial statement that provides limited assurance on the validity of the information included. “While it is possible to secure financing with a notice to reader, banks will generally limit the total amount of financing based on this type of financial statement, which could hinder a company’s potential growth.”

Dubé recommends carrying out review engagements as soon as a company has reached a certain level of maturity. Review engagements are financial statements prepared by chartered professional accountants (CPAs) containing information subject to more thorough scrutiny than required for a notice to reader. Banks are usually more inclined to grant more financing if their decision is based on a review engagement or an audit rather than a notice to reader.

You should also consider hiring a chief financial officer if possible.

2. Prepare reliable forecasts

Put together solid, realistic financial forecasts that reflect your project’s viability and profitability. “Financing a company that does not expect to be profitable in the medium term using borrowed capital is probably just a temporary fix. It’s important to finance the right project using the right financial product,” says Dubé. Forecasting is a good exercise, as it allows you to determine your actual needs and ensure that the company will be able to repay loans per the proposed terms and conditions.

If the business is still in the development phase and expects to incur losses in the process, he recommends having a contingency fund in place to cover debts and guarantee the company’s stability for a period of 18 to 24 months.

3. Demonstrate understanding of your market

Having in-depth understanding of your market is crucial. You must be able to identify potential customers’ current habits, needs and expectations. Explain how you are going to attract and retain them. Demonstrate that you have a clear picture of your positioning in the market and how you intend to stand out from the competition.

4. Choose the right financing products

When choosing the products best suited to your needs, you should consider:

• Your current financial situation
• Your short- to long-term goals and projects
• Your risk tolerance

Look into the various types of financing options that lending institutions can offer you. Make sure you understand their criteria and conditions and compare them using calculations.

Also look into other available sources of financing, such as lines of credit, crowdfunding, venture capital investments and grants.

5. Make your mark on the market

It may be difficult to accept launching a product that is not perfect. However, Dubé stresses how important it is not to wait too long before bringing your products to market, provided that they work and are in demand. Demonstrating that there is a market for your products and that your business is viable will make your application much stronger, allowing you to finance the development of at least some new versions or products.

“When Apple released its first iPhone, it wasn’t perfect compared to today’s models,” says Olivier. Managers knew that they could deliver a better product. However, they still brought that first version to market, which helped finance the development of subsequent versions. The launch also proved to investors that the company had a customer base.

Next step

Check out our tech business toolkit to plan your business growth, attract investors and find new customers.