Exploring finance: How appropriate debt choices can fuel ambitions

There are two broad ways to finance a business: an injection of equity or taking on debt. Here, we look at debt.

Managing your budget more effectively involves budgeting by department, planning ahead, and preparing for the worst

Managing your budget more effectively involves budgeting by department, planning ahead, and preparing for the worst

One of the first rules of business that entrepreneurs, smaller businesses and start-up companies learn is that securing extra finance is crucial to realising potential and expanding into target markets. Many entrepreneurs and business leaders, however, are not aware of the finance options available to them.

Low awareness is not a new feature of the market, and is a key reason why businesses don’t shop around to find the most suitable finance. Whilst our recent survey results show that some, albeit slow, progress is being made – for example, 50 per cent of SMEs had an awareness of six alternative finance options in 2016, up from 48 per cent in the previous year – this still means that half of those surveyed had little awareness of the growing choice in the market, so there is more that can be done.

At the British Business Bank – the government-owned business development bank set up to improve small businesses finance markets – we are committed to increasing and diversifying the supply of finance available to smaller businesses. This includes supporting many and varied debt finance options in the market, and making sure that businesses understand which one might be most suitable for their needs.

One business that benefitted from understanding the available finance options was high-end patisserie Miss Macaroon. Managing director Rosie Ginday found it difficult to secure finance from both social and traditional lenders and decided to look further afield for finance, before eventually approaching BCRS Business Loans, an accredited lender for the British Business Bank’s Enterprise Finance Guarantee programme. After receiving funding from the BCRS, the business is now expanding rapidly.

What is debt financing?

There are two broad ways to finance a business: an injection of equity or taking on debt.

Debt financing, in its simplest terms, is an arrangement between borrower and lender. Unlike equity, debt does not involve giving away any share in ownership or control of a business. Sarah Hilleary, for instance, used a straightforward Start Up Loan of £15,000 to start gluten-free snack company Birubi Ltd. The company would never have been able to get off the ground without early-stage debt.

There are many different types of debt, each of which can be more or less appropriate to the type of business, the stage it is at in its development or the plans it has to grow. Debt also does not have to be taken in isolation – in fact, as a business grows, it will almost certainly need different types of finance, including equity.

Often, however, an established company will take on debt to fund a business opportunity that gives it the chance to grow. Lauren Taylor’s company, Kokoso Baby, had the opportunity to scale up rapidly following a large order from a major chain shortly after launching in 2014. She applied for, and received, a £10,000 government-backed Start Up Loan to bridge the cash flow gap and drive the business forward.

Debt can be used for longer-term investment and/or to fund working capital. For the former, a loan, leasing arrangement or, for a larger company, a bond can be more appropriate. For the latter, some form of overdraft or asset-based finance (ABF) is likely to be more appropriate.

What types of debt are available?

Different types of debt have their advantages for different aspects of a business’s growth plans. A more diverse and vibrant debt market for smaller businesses, with a greater choice of options and providers, is key for smaller businesses across the UK to grow.

The debt financing landscape has developed considerably in recent years and there is now a wide range of new and more traditional options available. They include:

  • Overdrafts – often what a business uses to help finance working capital and to meet short-term requirements.
  • Loans, leasing or hire purchase agreements – in most cases better suited to larger longer-term purchases, such as investment in plant and machinery, computers or transport.
  • Peer-to-peer lending – internet-based platforms are used to match lenders with borrowers. The UK is at the forefront of innovation in this growing form of alternative online finance.
  • Asset-based finance – a collective term used to describe invoice finance (IF) and asset-based lending (ABL). IF includes factoring and invoice discounting, which will both involve funding provided against outstanding debts.
  • Merchant cash advances – unsecured advances of cash, based upon future credit and debit card sales. These are repaid via a pre-agreed percentage of a business’s card transactions.
  • Bonds and mini-bonds – retail bonds or corporate bonds – a way for companies to borrow money from investors in return for regular interest payments. They have a predetermined ‘maturity’ date when the bond is redeemed and investors are repaid their original investment.
  • Growth capital loans and mezzanine finance (growth finance) – flexible debt financing that are tailored to the specific risks in the business, with a repayment plan to match the forecast cash generation of the business. While they are a form of debt, both share many of the characteristics of equity. However, they rank below senior debt.

Where can I find out more about these options?

The Business Finance Guide, which is jointly published by the British Business Bank and Institute of Chartered Accountants in England & Wales, in partnership with 21 other business organisations, outlines the finance options available to businesses at all stages, taking into consideration their future plans.

Keith Morgan, is chief executive of the British Business Bank.

Further reading on funding

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