How do Small Businesses Lend Cash to Pay Their Invoices? Traditional Invoice Financing vs. the Blockchain.

For small businesses, poor cash flow is a serious problem that could potentially lead them to bankruptcy. Small companies often have to borrow money, but this can be problematic for several reasons. In this article we discuss what problems small businesses face with regards to borrowing money, how invoice financing helps solve these problems, and how the blockchain can improve the situation even more.

We would like to thank the team at Traxia for their contributions to the design and implementation of the research and to the analysis of the result.

Why cash flow matters for small and medium enterprises?

A common problem for small and medium enterprises (SMEs) is the gap between the time when they spend money and when they receive income. The average number of days that a business takes to pay its creditors is typically between 30 and 60 days.

This lag caused by the businesses’ inability to immediately gain profits is a result of a lack of liquidity. Companies often have to pay suppliers and employees well before they actually sell their products to customers. On average, private companies have to wait around 39 days to receive the money due from customers, and for some industries this period is much longer. For instance, the companies involved in the management of enterprises have to wait for their revenues for about 125 days.

This problem is far more severe than you might think. According to US Bank, 82% of startups and small enterprises in the US fail due to the poor cash management, and CB Insights found that a cash crisis was the cause of bankruptcy for 25% of all startups.

Problems with bank loans

The lack of cash to cover current expenses might force companies to turn to the banks to get loans. However, this solution does not work for everyone. A business might not be consistent with the bank’s expectations. Besides, usually securing a loan from a bank requires a lot of paperwork.

For example, to get a loan from the Small Business Association in the US one has to submit the following documents:

  • Personal background – Information such as the business owner’s previous addresses, names used, criminal record, educational background, etc.
  • Business plan – The business plan should include a complete set of projected financial statements, including profit and loss, cash flow, and a balance sheet. It is typically between 25-100 pages long, so it requires a lot of work from the business owner.
  • Personal credit report – Business owner should get a credit report from all three consumer credit rating agencies before submitting a loan application.
  • Business credit report – Those who already have a business and need money to expand it or deal with cash flow and other problems should submit a credit report.
  • Income tax returns – Business owners will have to submit personal and business income tax returns for the past three years.
  • Financial statements – The lender may require owners with more than a 20% stake in the business to submit signed personal financial statements.
  • Bank statements – You may be required to submit one year’s worth of personal and business bank statements.
  • Other legal documents – For example, business licenses or registrations, articles of incorporation, copies of contracts with third parties, franchise agreements, or commercial leases.

As you can see, applying for a loan requires a lot of paperwork. And even if you manage to get all the paperwork done, you have no guarantee that your loan request will be fulfilled. In March 2018, for instance, only 25.5% of the funding applications filed to the banks by small businesses were approved in the US. Small companies are especially vulnerable in this respect as their negotiation power is relatively low compared to large corporations.

In March 2018, for instance, only 25.5% of the funding applications filed to the banks by small businesses were approved in the US. Click To Tweet

Luckily, there are other solutions for SMEs struggling with cash flow problems.

Invoice financing: What it is and how it helps SMEs

Invoice financing is a common solution for small businesses that are facing cash flow problems. For instance, in the UK around 22 billion pounds of funding to small companies was provided through invoice financing in 2017. This number is 13% higher than in 2016, marking an all-time high.

Invoice financing is a form of short-term borrowing where investors lend money to companies against the amount due from customers. In this case, the invoices from customers act as collateral.

There are two major types of invoice financing: factoring and discounting.

Factoring

This type involves a financier that purchases the debts owed by the customers to the company. For instance, when a customer has ordered a product and promised to pay for it but have not done so yet, they are now in debt to the company. The company then gives the unpaid invoice to the financier. Such financiers collect the money from the customers themselves and manage a company’s sales ledger.

After an invoice is raised by the company, a financier buys the debt and makes a percentage off of it (usually around 85%) available to the company right away. The other part of the cost is paid to the company after the financier receives the money from a customer.

Such financiers usually charge service fees and a percentage on each “debt.” The fees vary for different financiers and company sizes. But just to give you a hint of how much these companies charge, here are the rates of the British financing company, Close Invoice: 0.5%-2% of turnout per month as a service fee plus 2.5%-3.5% of interest rate for each debt. You should note that if you use invoice factoring, your clients will know.

You should note that if you use invoice factoring, your clients will know. Click To Tweet

Discounting

This type is very much similar to a bank overdraft. In the case of discounting, companies borrow cash on their invoices. The invoices serve as the collateral for the loan.

A financier gives money against unpaid invoices, and the exact sum of money is usually a certain percentage of the customer’s debts. In exchange, the company pays an agreed upon fee. The fees usually vary from financier to financier. At Close Invoice, they amount to 0.2%-1% of turnout per month as a service fee, plus with a 2.5%-3.5% interest rate.

With discounting the customers won’t know that you use invoice financing services.

Each type of invoice financing method has its own pros and cons. Factoring’s advantage is that it allows you to outsource the management of the sales ledger and allows you to focus more on your business. Besides, factoring financiers usually check the customers’ credit history so you will likely deal with the customers that pay on time. On the other hand, when you use factoring, clients know about it and it could inadvertently damage your company’s image. If you have concerns about that, discounting would be better since you can use invoice financing confidentially. But unlike factoring, you will have to collect the debts from the customers yourself.

Overall, the major advantage of invoice financing over bank loans is that it usually helps one to get money faster and it requires far less paperwork. Usually you will need to submit only the following documents to become a client of an invoice financier:

  • Account receivables/payables aging report – details of your current and most recent invoices (usually going back 90-days).
  • Articles of organization or incorporation – your business’ identifying documents such as the business license.
  • Invoice financing application – a standard application form you have just to fill in. Different financiers have different application forms.

How the blockchain can change invoice financing?

Invoice financing is a good option for SMEs struggling with cash flow. But still, in its traditional form it is not without its downsides. Two major problems for traditional invoice financing are fraud and difficulty of implementing international solutions.

The potential fraud problem makes financier conscious about the ingenuity of the invoices they get. They also have to worry whether a company could try to get finance backed by this invoice from two financiers at the same time. Also, there is no guarantee that customers will eventually cover the invoice. All these problems generate a lack of trust between the actors in the system and make it less efficient. This is where the blockchain and smart contracts come in.

Blockchain-based SME solutions use smart contracts which are automatically implemented once all the conditions laid out in the contract are fulfilled. They ensure that the invoices are genuine and used only a single time. The use of smart contracts helps to solve the problem of trust for invoice financing.

The decentralized nature of blockchain platforms and the tokenization of assets also solve the issue with cross-border payments. With traditional solutions, an SME usually has to look for an investor in the country where the company is registered. Blockchain solutions find investors regardless of their place of residence, which opens up great opportunities for both SMEs and those interested in investing in them.

Blockchain solutions find investors regardless of their place of residence Click To Tweet

Blockchain solutions: Populous and Traxia

Blockchain systems sound like a wonderful solution for invoice financing, but how do they work exactly? Now we will cover in greater detail the two blockchain-based invoice financing platforms – Populous and Traxia.

Populous

It is a peer-to-peer invoice discounting platform that connects invoice sellers (SMEs) to invoice buyers (investors). Populous hosts the invoice marketplace where buyers have to compete for invoice sellers.

  • Actors: Populous has only two type of actors on its platform – sellers (SMEs) and buyers (investors). The first ones have to be registered either in the UK or in China/Hong Kong, as only these countries are supported for now. Investors can be from anywhere, they just have to have an Internet connection.
  • Tokenization: On Populous, all transactions are made in Pokens – the platform’s internal token. They are pegged 1:1 with the national government’s currencies involved in any given transaction. For example, $8 are represented by 8 Pokens (USD). Money can be deposited in Bitcoin, and it is then converted to Pokens according to the current exchange rate between BTC and the relevant fiat currency. To give you an example, you can deposit the amount of BTC equal to $8 according to the current exchange rate and then convert it to Pokens (USD). Pokens are only used internally on the platform and are not traded on the external exchanges, but they can be converted into fiat directly from the platform, making the process quite easy for SMEs that want to get funding.
  • Fees: Populous does not charge the fees themselves. Fees charged to SMEs for financing in each case are determined by investors. First, investors compete for the invoices to buy. Through this “auction” SMEs can choose investors with the lowest fees.

Traxia

This platform also facilitates invoice financing, but the mechanism is more complex than that of Traxia.

  • Actors: There are six types of actors on the platform – sellers, buyers, issuing providers, liquidity providers, investors, listing providers.
    • Sellers are SMEs. They upload their 30/60/120 invoice into the system and let professional investors trade them. In exchange they receive fiat money minus the commission.
    • Buyers are SME clients. They have to confirm the ingenuity of the invoices and their intentions to pay them using their private keys.
    • Issuing providers are technological partners who, for a commission, create and operate smart contracts based on the invoices uploaded by SMEs, turning them into digital assets that are traded on the platform.
    • Liquidity providers are be funds or financial institutions. They buy the debts (in this case, the digital assets created by the issuing providers based on the invoices) in the first place and then resell them to smaller investors, receiving spread in return.
    • Investors are professionals who trade invoices and their parts (as the invoices are now digital assets) through Traxia’s marketplace.
    • A listing provider is an exchange where new digital assets are listed. It matches liquidity providers to investors for a commission.

      For all of these actors, geographical location is irrelevant – they can be from anywhere given that they abide by international laws and are not under international sanctions. It means that shady companies and or countries under sanctions will not be allowed on the platform. For instance, North Korean companies will not be permitted as the country is under international sanctions.
  • Tokenization: For SMEs and their customers, all transactions take place in fiat. Tokenization takes place when invoices are converted into digital assets. Traxia uses the TMT token, and it is necessary for the investors and liquidity providers because the access to the listing platform is facilitated once the service fee in TMT is paid.
  • Fees: Fees here are decided by the liquidity providers or investors. Also, an additional service fee of around 1% is charged for listing the invoices as digital assets on the marketplace.

To register on both Populous and Traxia the businesses will have to submit identifying documents and invoice reports. As stated in the platforms’ white papers, before getting access to the platform each business will undergo a check-up, but the platforms so far do not really elaborate on the details of this.

What’s better: the blockchain or traditional solutions?

Both the blockchain and traditional solutions have their advantages and disadvantages.

We’ve created an infographic to better explain this idea to you:

Bank loans are probably the most traditional and well-known solution for businesses struggling with cash problems. However, bank loan applications require a lot of paperwork and only a thin minority of these applications are eventually approved.

Invoice financing requires far less paperwork than bank loans, and it’s much easier to get financing through this system than through a bank loan. One of the major disadvantages of invoice financing is that it is not universally available and that the number of financiers is scarce. Besides, traditional invoice financing is prone to fraud. However, these disadvantages are likely to be compensated by the blockchain solutions.

The main pros of blockchain-facilitated solutions are their trust-facilitating mechanisms based on smart contracts and the global outlook allowing SMEs to connect to the investors not only in their country, but around the world. Another advantage is the potentially lower fees, since the fees are decided individually on a case-by-case basis. SMEs can choose the best offers for themselves.

The main advantage of blockchain-facilitated solutions are their trust-facilitating mechanisms and the global outlook Click To Tweet

On the other hand, blockchain solutions are currently under a certain legal scrutiny as regulations for blockchain platforms are not in place in most countries yet. Another point is that all transactions are made online, and if the platform you use is hacked, you are likely to lose your money. However, this should be less of a concern due to the high security found on blockchain platforms.

We at Howtotoken believe that the blockchain solutions’ global outlook is their major advantage over traditional solutions, and the reason why it’s worth giving these platforms a shot. If you are a business owner from a country where invoice financing and other financial solutions are not well developed, platforms like Traxia are a perfect option for you to improve your cash flow. Also, if you are an investor looking for new investment opportunities, blockchain platforms now allow you to profit from buying the invoices of businesses from all over the world.

All materials on this site are for informational purposes only. None of the material should be interpreted as investment advice.

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