One of the challenges of growing a company is satisfying the voracious appetite for cash that growth requires. The faster the growth, the greater the supply of cash needed to fund it. While many business owners try to fund this growth through internal cash flow generation (i.e. the cash generated from sales) this isn’t possible when you’re growing aggressively. Customers don't pay instantly. It can easily take 60 or 90 days to actually collect cash from customers after a sale is made. In the meantime your employees need to get paid, your vendors want their invoices settled right away, and you need to pay for all of the other expenses associated with servicing the client that won’t pay until much later in the future.
Companies that are experiencing this type of growth need to consider multiple funding options. Asking a bank for a loan or a revolving line of credit won't be enough in the current market. Banks are still gun shy when it comes to small business lending. If the bank won't loan your company money or if it will do so only at unattractive terms then it’s time to knock on the door of other funders. One option that may be available to your company is the issuance of commercial paper.
Commercial paper is basically a promissory note or IOU issued by a company for periods ranging from 1 day to 270 days. Most commercial paper is issued at 30 day maturities. It’s a way for companies to finance their daily operations without using more expensive lines of credit from a bank. Typically a company issues commercial paper and sells it at a discount to face value. At maturity the company repays the investors for the full face amount. For example a company may issue $100 in commercial paper maturing in 180 days for $98.75. The $1.25 difference represents the interest costs. Commercial paper can be unsecured, meaning that there is no recourse to investors should the issuing company default. It can also be backed by specific assets owned by the company.
Because it does carry some risk, commercial paper is usually issued by companies that have a high credit rating. The amount issued is impressive. As of the end of July there was over $1.2 trillion in outstanding commercial paper. About half of the commercial paper outstanding is issued by financial companies. Non-financial companies have around $200 billion in non-recourse commercial paper outstanding with an additional $426 billion in asset-backed commercial paper.
The reason why commercial paper is so prevalent can be understood by taking a quick look at current borrowing rates. A non-financial company, for example, that issues 90-day commercial paper will pay around 0.12 percent in annualized interest. For companies with good credit rating the rate increases significantly but remains a rock bottom 0.34 percent. One million dollars in borrowing would cost $3,400. With rates like that, any company that can issue commercial paper should consider it.
If your company is large enough and has a high enough crediting rating to qualify then commercial paper is an effective solution to meet short-term funding needs.