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What Kinds of Financing do Local Foods Businesses Need and Why?
Anyone starting or expanding a business needs to get financing from somewhere, whether it’s personal resources, family members, credit cards, community-based lenders like Community Development Corporations (CDCs), local banks, or investors. Financing allows a business to cover start-up and operational costs until revenues begin flowing in. To be eligible for financing, a business needs to prove to lenders or investors that it is likely to succeed, and often must provide capital sources with either collateral (to protect against borrower default) or equity (a partial ownership stake in the business). Riskier business models need to find sources of capital that are willing to accept a higher level of risk.
The chart below, created by the VT Sustainable Jobs Fund, provides a visual representation of different kinds of financing, levels of risk and cost, and availability in the Pioneer Valley. Each financing tool has its own costs and requirements, and may be appropriate for businesses at a different stage in their life cycle. Filling the gaps in financing options will help local food system businesses by making optimal financing available to them when they need it.
Debt financing is the kind of loan most of us are familiar with. In most cases, the borrower provides collateral—something the lender could own if the borrower never paid back the loan. Over the lifetime of the loan, the borrower pays back the principal—the money borrowed—and the interest. These loans are available from local banks, from community-based lenders, and, in some cases, from the federal government.
Although many banks and other lenders have become more risk-averse during the current recession, making it more difficult for businesses to access credit, it’s also true that in the Pioneer Valley local banks are becoming more familiar with farm and food businesses, and interested in supporting the growth of the local food economy. One new farmer reports, “We got our first loan from our local bank. It was a little scary, because they did not understand how our needs were tied to the seasons. Spring was coming soon and we needed our loan so that we could buy equipment for planting and field preparation. But they really wanted to help our farm get started, and we liked the idea of working with the bank in our neighborhood and helping them understand farm businesses. In the end, it all worked out well.”
Community-based lenders provide loans to businesses that may not qualify for a conventional bank loan, perhaps because they do not have appropriate collateral or have no track record of sales. These lenders include some community development corporations (CDCs) and community development financial institutions (CDFIs). The lenders receive funds from the federal government at below-market rates, which they use to finance loans. In the Pioneer Valley, the Franklin County CDC in Greenfield has financed many food businesses, in part because they operate the Western Massachusetts Food Processing Center, a shared use incubator kitchen, and provide additional planning services to food businesses. Holyoke’s Common Capital has received funding from the USDA’s Healthy Food Financing Initiative to support the development of healthy food businesses in communities that have limited access to good food, and they too are building a strong portfolio of local foods businesses.
Debt financing may not work for a business if they don’t have assets that can be used as collateral, already have too much debt, or appear too risky to conventional or community lenders. In that case, different financing structures may be appropriate. Here’s a brief explanation of some additional options, which—if available at all—can be combined with each other and with conventional debt financing:
Subordinate or “sub” debt financing provides loans that are paid after other loans are paid. These loans are more risky to the lender—if the business runs short, the sub-debt holder will not get paid—and as a result, they cost the borrower more. On the flip side, a business considered too risky for conventional debt may qualify for sub-debt, and the business can access additional financing while retaining control of ownership.
Royalty financing gives the investor a return tied to monthly sales or profit. This structure can be useful for businesses with seasonal sales variation or an uncertain growth rate.
Convertible Debt allows the lender to convert the debt to some other format, such as an ownership stake, if it is not repaid on schedule.
Equity financing gives the lender—or investor—an ownership stake in the business. Traditionally, equity financing is predicated on the potential for significant growth and returns, and that expectation may not be met by local foods businesses.
Matching these additional financing tools with local foods businesses is challenging for a number of reasons, including availability, expertise, and expectations. First, these financing options may not be available from local lenders (see chart). Second, business owners may need help understanding these options and weighing their costs and benefits, and that assistance may not be readily available. Third, most traditional sources of equity financing are looking for high growth and returns, and local foods businesses may not offer that promise. In addition, the owners of local foods businesses may be leary of financing options which result in a loss of control, fearing that equity investors could force them to diverge from their local foods mission in search of higher profits.