An introduction to debt finance for small business operators

Here, Adam Pescod of Fleximize explores today's debt finance options available for small businesses.

Debt finance is one of the most popular funding options available to small firms in the UK. Unlike equity finance, which entails giving away a share of your business in return for investment, debt finance involves borrowing money to either start or grow a company.

Not too long ago, the most common forms of debt finance were bank loans, along with loans from friends and family. However, they have now been joined by a raft of new debt finance options, the majority of which emerged in the wake of the recession. From challenger banks and online lenders to peer-to-peer (P2P) and invoice finance, these new players have delivered greater choice to businesses and helped bring the debt finance industry into the 21st century.

The benefits of debt finance

One of the main advantages of debt finance is that it allows a business owner to stay in control of their company. While equity finance tends to offer higher amounts of capital, a founder will have to sacrifice a portion of their ownership – or equity – in exchange for the funding. With debt finance, the only cost to a business is the interest charged on a loan, plus additional fees in some cases.

A business owner will usually need to provide a personal guarantee to repay any outstanding debt in the event of company insolvency, and may also have to secure the finance against company or personal assets, such as property or machinery. This is common practice, however, and simply allows lenders to manage the risk of lending. As long as a business repays according to the schedule agreed with their lender, their assets won’t be in any danger.

How can a business use debt finance?

Debt finance can be used for any purpose related to business growth, whether it’s buying new premises, refurbishing existing premises, upgrading machinery to fulfil a lucrative contract or launching a multi-channel marketing campaign. These sorts of projects typically require significant capital investment, but debt finance can help spread the cost over several months or years, easing the financial burden on a company so that it can continue to grow.

With late payments an ever-growing problem for SMEs, debt finance can also help companies maintain a healthy cash flow while they await payment from customers. There are numerous lenders specialising in invoice finance, which allows businesses to borrow money against the value of sales invoices. Such lenders will usually advance a percentage of an invoice’s value – generally around 80 per cent, although some lenders will advance up to 100 per cent – and release the balance once the invoice is paid, minus a fee. Other options for companies seeking a flexible cash flow solution include working capital loans and merchant cash advances, which basically serve as a revolving credit facility.

Seasonal businesses often use debt finance to negotiate the slow months and complete projects that wouldn’t be possible in peak season. For example, if a hotel needs renovation work, it would normally be carried out when occupancy is low. However, with less revenue coming into the business, it might require additional capital to cover the cost. Some lenders offer specialist hotel finance and will even give businesses the option of revenue-based repayments, allowing them to repay less when sales are lower and more when they’re higher. This can be a better option for seasonal businesses than being tied into fixed monthly repayments.

Types of debt finance

Despite the plethora of options available to businesses in today’s debt finance market, they can be grouped into four general categories:

  • Family and friends
  • Startup Loans
  • Bank loans
  • Online lenders

Family and friends

Bank loans and other forms of debt finance can be hard to come by for businesses that are yet to launch or have only been trading a matter of months. Most banks and online lenders will need to see evidence of revenue and stable cash flow, ideally over a period of at least six months. That’s why many business owners turn to their friends and family for funding, especially in the early stages.

A key advantage of borrowing from friends and family is that they may be more flexible on repayments and won’t charge any interest on top of the loan. Furthermore, unless a comprehensive agreement is drawn up and signed by both parties, you probably won’t be at risk of losing any assets should you fall behind with payments.

However, there’s no escaping the fact that borrowing from your nearest and dearest puts personal relationships on the line. So, before you seek or accept funding from a friend or family member, it’s worth managing their expectations and reminding them of the risks involved.

Start Up Loans

If you can’t raise funds from friends and family to help start your business, the government might be able to help. The Start Up Loans Company offers personal loans of up to £25,000, which can be used for starting a business or growing a business that’s been trading less than two years. All loans come with a 6 per cent fixed interest rate and are repayable over a term of one to five years. There are no early-repayment or set-up fees. To be eligible for a Start Up Loan, you must be a UK resident, aged 18 years or older, and hold the right to work in the UK.

There aren’t many other debt finance facilities that cater specifically to startups, but your company may be eligible for a small business grant if it delivers an innovative solution in fields such as healthcare or transport. Innovate UK regularly runs funding competitions, while The Prince’s Trust and New Enterprise Allowance offer startup funding to young business owners. Companies in Scotland can also apply for a research and development grant through Scottish Enterprise.

Bank loans

It’s been well documented that banks scaled back their lending to small businesses following the financial crisis of the late noughties and early 2010s. According to figures from the British Bankers’ Association (now UK Finance), monthly numbers of approved small business loans in the UK decreased from 32,000 in 2011 to 15,000 in 2015. Despite this, the British Business Bank reports that over half of smaller businesses still approach their main bank first when they require funding.

Bank loans are generally a good option for businesses whose need for finance isn’t particularly urgent. Applying for a bank loan can be a lengthy process, and you might be asked to prepare a comprehensive business plan as part of the application. The lending criteria of banks also tends to be stricter than that of newer ‘alternative’ lenders, meaning it’ll be difficult to secure funding if your credit history is anything but spotless and you’ve been trading for less than two years.

Aside from not knowing about the alternatives, one reason that many businesses seek funding from their bank is the opportunity of a lower interest rate. However, it’s worth bearing in mind that some banks may impose a charge should you decide to pay off a loan before the end of its term. In contrast, many alternative lenders allow businesses to settle their loan early and only pay interest for the time they had the funding. This can make the overall cost of borrowing lower.

Useful link: – Looking for funding? Find the right finance for your business here

Online lenders

The internet has given rise to a host of new lenders that can fund businesses quicker than banks and are more flexible with their lending criteria. While awareness of ‘alternative finance’ remains relatively low, the market is growing rapidly and has already provided a route to funding for thousands of SMEs that have been rejected by their bank or become fed up with waiting for a decision.

At one end of the spectrum are the lenders offering a modern spin on the traditional business loan. Not only do these companies provide a lightning-fast application process – with approval and funding in as little as 24 hours – but many will offer top-ups and repayment holidays as a standard feature of their loans, rather than an expensive add-on. In many cases, the money will be lent off a lender’s own balance sheet, allowing them to set their own lending policy. This means they’ll often fund a company that a bank, for example, couldn’t.

The remainder of the ‘alternative finance’ market is largely occupied by peer-to-peer (P2P) lenders. Instead of lending money off their own balance sheets, P2P platforms match individual investors with numerous businesses that are looking to borrow. While they typically offer a better interest rate to investors than a bank ISA, there’s no guarantee of a return as it depends on every business repaying their loan in full. Businesses can sometimes enjoy lower interest rates when borrowing through a P2P platform, but it can take longer to receive the funds and there’s usually a fee to pay.

Further reading on online lenders

Why it’s time to look online for business funding

What else should I know about debt finance?

The debt finance industry is becoming increasingly crowded, which means there’s more choice than ever for small businesses. By spending some time exploring the various options on offer, you should be able to find a funding solution that suits the needs of your company.

If you’ve never applied for a business loan, utilising the services of a broker could help remove a lot of the legwork. Bear in mind, however, that anybody can set up online as a broker, so it’s worth doing some due diligence beforehand. To ensure you’re working with an honest and professional broker, check that they’re a member of the National Association of Commercial Finance Brokers (NACFB). This is generally a good sign that they’ll have the interests of your business in mind.

Alternatively, if you’re an early-stage company that can’t afford to pay a broker fee, impartial websites like Better Business Finance will point you in the direction of lenders that can support your desired funding type, amount and purpose. Some of the leading price comparison sites also have a business loans section, and there are a handful of online platforms that work as matchmaking services for SMEs and alternative lenders. One of these platforms, Funding Xchange, doesn’t charge a fee to businesses. It is also one of the designated platforms for the government’s bank referral scheme, which compels banks to refer businesses they’ve rejected to alternative finance providers.

There’s a good chance you’ll be quoted a range of different rates when applying for debt finance. Whereas some lenders will give you a monthly interest rate, which is the most common way to display the cost of a loan, others might present the price of their funding using less conventional rates such as factor rate or yield. Using a rate comparison tool, you can easily compare quotes that are based on different rates, and make sure you’re getting the best deal for your business.

Adam Pescod is content manager at Fleximize.

Further reading on debt finance for small business

Related Topics

Debt Finance

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