Most businesses are familiar with traditional equity (stocks) and debt (loans) financing options. However, alternative methods like issuing bonds or offering royalties can provide strategic advantages under the right circumstances.
Bonds: A Strategic Financing Alternative
A corporate bond is an investment where investors lend money to a company in exchange for periodic (often quarterly, semi-annually, or annual) interest payments plus the return of the bond’s principal at maturity. Unlike a loan, bondholders do not receive monthly principal and interest repayments but rather periodic interest payments and a lump sum at the end of the bond term.
When my service-based business was awarded a one-year contract valued at approximately $100,000 per month, we faced a significant cash flow challenge due to the payment terms. Although we used a Factoring company that cost us dearly, here’s a step-by-step breakdown of how we could have used a corporate bond to manage this situation more cost-effectively:
Initial Problem: Our company immediately started incurring operational costs upon securing the contract. In our business, which operates on a 7% margin, monthly expenses were approximately $93,000 based on $100,000 worth of billings. After invoicing, the customer took 45 days on average to issue the payment. By the end of the second month, while we issued a second invoice, we had still not received payment for the first, resulting in a substantial shortfall in revenue to cover expenses. On average, it took about 2.5 months from when operating expenses started to accrue until we received payment.
Financing Solution: To address this cash flow challenge and cover operational expenses, we could have issued a corporate bond for $250,000. This amount would have covered all operational expenses for the initial 2.5 months. We would have set the bond’s term at 14 months for the 12-month project, ensuring that all invoices were paid before the principal to the bondholders was due. This strategy would have helped us maintain stable cash flow throughout the project’s duration.
Interest Payment Management: Had we issued the bond, we would have made regular interest payments to the bondholders throughout the duration of the term. This arrangement would have allowed us to use the capital for daily operations without the immediate need to repay the principal, thus alleviating financial pressure during active project phases.
Completion of Project: After the project completion and delivery of all services, there would still have been a waiting period of about 45 days to get paid for all the outstanding invoices.
Bond Repayment: Once all receivables were collected, the resulting income—free from any additional project expenses—would have been utilized to fully repay the bond’s principal.
This strategic use of a corporate bond would have ensured that our business maintained robust operational capabilities and financial health throughout the contract term despite the delayed payment schedule.
Royalties: Aligning Interests Without Diluting Equity
Royalties provide investors with a percentage of gross revenue, distinct from equity distributions, which are derived from net profit. This method is particularly attractive in industries like licensing, where direct control over operations is not a priority.
The Advantages of Royalties are:
Predictable Revenue Share: Investors receive returns based on sales, independent of business profitability.
Less Influence on Management: Investors do not get a vote in company decisions, making it simpler for owners to maintain control.
When to Consider Each Financing Type
Choosing between bonds, royalties, and traditional financing depends on your business’s cash flow needs, growth stage, and strategic goals. It’s crucial to consider how each option aligns with the business’s long-term objectives and operational structure.
Practical Tips for Implementing Alternative Financing Methods
Approaching Investors:
Bonds: When seeking to issue bonds, prepare a detailed financial forecast showing the use of funds and the expected cash flow to cover interest and principal payments. This will assure investors of your ability to repay.
Royalties: Clearly outline potential revenue streams and set realistic expectations for gross revenue. This will make the royalty agreement appealing to investors looking for regular income without the hassle of equity management.
Legal and Regulatory Considerations:
Ensure compliance with securities regulations, which may require disclosures and registrations when issuing bonds or royalties. Consult with a financial advisor or attorney to navigate these complex legal landscapes effectively.
Conclusion: Strategic Financial Planning for Future Growth
Both bonds and royalties offer unique advantages that can be suitable for businesses looking to finance operations without diluting ownership or taking on restrictive debt. Bonds can provide a lump-sum capital infusion with a clear repayment plan, making them ideal for projects with delayed revenue streams. On the other hand, royalties allow businesses to share a portion of revenue without impacting operational control, perfect for creators and inventors.
By carefully evaluating these financing options and understanding their implications, businesses can make strategic decisions that align with their growth objectives and operational needs.
Is issuing a corporate bond or making royalty payments an option for you?
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