Project financing: The right type of financing for your business project

Buying or building commercial real estate: Commercial mortgages

The best option for buying and building commercial real estate is generally a commercial mortgage. That’s a type of term loan where the land and the building itself serve as collateral. It generally has to be repaid over 15 to 30 years.

You’ll make monthly payments throughout the life of the loan. Payments normally include principal and interest. The loan is secured on the land and the building. That means that if you can’t repay the loan, your financial institution can seize the property and sell it. That way they can recover the money they lent you.

Interest rates as well as terms and conditions vary from one financial institution to another. “You might find, for instance,” says Landry, “that some banks will lend you a higher percentage of the value of the property than others.”

So, it’s a good idea to shop around and pick the offer that works best for you.

Getting machinery and equipment: Equipment loans

Here, the lifespan of what you’re buying should influence the repayment period of the loan. For example, computer equipment has a relatively short lifespan. So, you’ll want to repay the loan over two to four years. Manufacturing equipment, on the other hand, tends to last longer. So there, you might choose a longer-term loan.

“You don’t want to end up having to buy a new piece of equipment while you’re still making payments on the old one,” Landry says. “Then, you’ll have to make loan payments on equipment that’s not bringing anything in. That’s hardly a recipe for success.”

Here too, the value of the equipment you’re buying is collateral on the term loan. A financial institution then lends you a percentage of the assessed value of the equipment. And remember that equipment depreciates in value over time.

Sometimes you can come out ahead by leasing. Under a leasing arrangement, you pay a monthly fee for using the equipment, but the supplier still owns it. When the lease expires, you can generally either return the equipment or buy it.

Leasing works best with equipment that becomes obsolete quickly. That way you can update your equipment under your original contract.

Increasing working capital: Working capital financing

Fast-growing companies need extra working capital for things like the following:

• meeting operating costs
• boosting inventory
• increasing production
• paying salaries 

Generally, a line of credit can cover such expenses. But, in times of rapid growth, you might max out your credit limit. For Landry, a working capital loan can make up the shortfall.

“In a period of strong growth, orders may be coming in faster than payments,” she says. “If you don’t have the cash flow, you could be in trouble. You could lose contracts you’ve already spent money on. That’s when a working capital loan can be a real lifesaver.”

Bankers grant working capital loans based on past and forecasted cash flow. They don’t ask for collateral.

Developing new markets: Working capital or quasi-equity financing

Numerous projects fall under the umbrella of market expansion. Here are some examples:

• developing new products
• opening new markets in Canada or abroad
• covering additional marketing and sales expenses

It may be tempting to use day-to-day cash or your line of credit to finance such projects. But doing so can put the financial health of your business at risk. You could find yourself short of cash if your business experiences a growth spurt or unexpected slowdown.

There are much better financing options. Working capital financing and quasi-equity financing are two attractive alternatives for fast-growing businesses.

Working capital financing lets you pay for your projects over a longer period of time. That way, you can reserve your working capital and line of credit for operating costs. Business assets don’t always need to be put up as collateral. Approval is based on cash flow instead. You’ll also need a personal guarantee.

Another option is quasi-equity financing. This one is for companies experiencing strong growth but with not much in the way of assets to put up as collateral. Quasi-equity financing is a hybrid. Its origins lie in debt financing and equity financing. Repayment terms can be extremely flexible.

Buying a business: Flexible financing packages

Business owners can use a variety of financing products to buy a business. You might need financing for either of the following:

• transferring a business by facilitating the current owner’s exit
• acquiring another business to grow your own faster

“Repayment flexibility is extremely important to a financing package and a successful ownership transition,” says Landry.

Successful business acquisitions depend on a proper assessment of the risks of the financing package and on flexible repayment terms. A good financing package will include some or all of the following:

• Senior debt—the purchaser can get a loan secured on the company’s assets. It has to be paid off before any other debts if the company goes into default.
• Equity—the buyer generally has to put some money into the acquisition. That reduces the amount of the loan and demonstrates their commitment.
• Seller financing—The person or entity selling the business often agrees to be paid a percentage of the purchase price in cash. The buyer then pays the rest, with interest, over a period of time.
• Mezzanine financing—These loans generally aren’t secured by company assets and have very flexible repayment terms. That makes them a good complement to senior debt.

Mezzanine financing has a lower repayment priority than secured debt if a company defaults. That makes it riskier for lenders, so they charge higher interest rates on it.

Financing new tech: Avoiding dilution

The long research and development cycles in technology lead to higher financial risk. So, tech businesses need specialized financing to buy or develop new technologies.

They often rely on equity investments until their products can be commercialized. That can leave shareholders with less control.

But if your business is well established, you can take out a loan instead. Quasi-equity financing or term lending lets you avoid ownership dilution. Business decisions remain in your hands.

If your business has recurring monthly revenue, for example, both financing options are available to you. You can make the payments out of regular cash flow.

“Loans can be a good option for companies poised to grow their revenues right away without reducing their ownership stake,” says Landry.

Next step

Prepare a successful business loan application by downloading our free guide for entrepreneurs: How to Get a Business Loan.