One of the most common ways for small businesses in the UK to get money is through debt financing. Debt financing means borrowing money to start or grow a business. This is different from equity financing, which means giving up a piece of your business in exchange for investment.
The most common types of debt financing were bank loans and loans from friends and family. But they have been joined by a number of new ways to pay off debt, most of which came about after the recession. Peer-to-peer (P2P) and invoice financing, as well as challenger banks and online lenders, have given businesses more options and helped bring the debt finance industry into the 21st century.
Why it’s good to borrow money
One of the best things about debt financing is that it lets a company keep control over itself. In order to get the money, a founder will have to give up some of their ownership or equity. However, equity finance can sometimes offer more money. When a company uses debt financing, the only costs are the interest on a loan and sometimes some extra fees.
If a business goes bankrupt, the owner often has to promise to pay back any outstanding debts on their own. The money may also need to be backed up by personal or business assets, like real estate or equipment. But this is a common way for lenders to control the risk of a loan. As long as a company makes payments according to the schedule set by its lender, its assets won’t be in danger.
How can a business borrow money?
Debt financing can be used for any growth-related project, such as buying new property, remodelling existing property, updating equipment to meet the needs of lucrative contracts, and starting multi-channel marketing campaigns. Debt financing can help spread the cost over many months or years, which can make it easier for a business to keep growing. Large amounts of money are often needed for these kinds of projects.
Debt financing may also help businesses keep their cash flow healthy while they wait to get paid by customers, which is a problem that SMEs face more often. Several lenders offer invoice financing, which lets businesses borrow money based on the value of their sales invoices. Most of the time, these lenders advance 80% of the invoice’s value, but some may go as high as 100%. After the invoice is paid, less a fee, the rest of the money is released. Working capital loans and merchant cash advances, which work a lot like a revolving credit line, are two more options for businesses that need a flexible way to manage their cash flow.
Seasonal businesses often use debt financing to get through the slow times and finish things that they can’t do when they’re busy. For example, if a hotel needs to be fixed up, the work is often done when there aren’t many guests. But if the company gets less money, it might need more money to pay its bills. Some lenders offer hotel-specific loans and even give businesses the option of making payments based on their sales, which lets them pay back more when sales are high and less when sales are low. For businesses that only work during certain times of the year, this may be better than having to stick to set monthly payback schedules.
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
For businesses that haven’t started up yet or have only been in business for a few months, it can be hard to get bank loans and other forms of debt financing. Most banks and online lenders will want to see proof of steady income and cash flow for at least six months. That’s why, especially in the beginning, many business owners ask their friends and family for money.
One of the best things about borrowing from friends and family is that they might be more flexible about payments and won’t add interest to the loan. Also, if you fall behind on payments, you probably won’t lose any assets unless you and the other person make and sign a detailed agreement.
But you can’t get around the fact that borrowing from your closest friends and family puts your relationships at risk. So, before you ask a friend or family member for money or accept it, you should set their expectations and remind them of the risks.
If your friends and family can’t help you get money to start your business, the government might be able to. The Start-Up Loans Company offers personal loans of up to £25,000 that can be used to start a business or grow a business that has been open for less than two years. All loans have a fixed interest rate of 6% and a term of one to five years to pay them back. There are no fees for paying it off early or setting it up. For a Start Up Loan, you must live in the UK, be at least 18 years old, and have the right to work in the UK.
There aren’t a lot of other debt financing options for startups, but your company may be able to get a small business grant if it offers an innovative solution in fields like healthcare or transportation. Innovate UK often holds funding competitions, and The Prince’s Trust and New Enterprise Allowance help young business owners get started by giving them money. Scottish Enterprise is also a place where companies in Scotland can apply for a grant to help with research and development.
The British Business Bank says that bank lending went back to where it was before the pandemic in 2021. Over half of loans (51%) were given by challenger and specialist banks. In 2020, only 31% of loans were given by these types of banks. Also, 48% of small businesses want to apply for some kind of outside funding in the next 12 months.
Bank loans are usually a good choice for businesses that need money but don’t need it right away. Applying for a bank loan can take a long time, and you might have to make a detailed business plan as part of the process. Banks also tend to have stricter lending standards than “alternative” lenders. This makes it hard to get funding if your credit history isn’t perfect and you’ve only been in business for less than two years.
Aside from not knowing about other options, one reason many businesses go to their bank for funding is the chance of getting a lower interest rate. But it’s important to remember that some banks may charge you if you decide to pay off a loan before it’s due date. Many alternative lenders, on the other hand, let businesses pay off their loans early and only pay interest for the time they had the money. This can make the cost of borrowing less in the long run.
The internet has led to a lot of new lenders that can give money to businesses faster than banks and have less strict rules about who they will lend to. Even though most people don’t know about “alternative finance,” the market is growing quickly and has already helped thousands of small and medium-sized businesses get funding when their bank turned them down or made them wait too long.
On one end of the spectrum are the lenders who take the traditional business loan and make it more modern. Not only do these companies have a lightning-fast application process, with approval and funding in as little as 24 hours, but many of them also include top-ups and repayment holidays in their loans for free, instead of charging extra for them. Money is often lent from a lender’s own balance sheet, which lets them set their own rules for lending. This means that they will often fund a business that a bank, for instance, wouldn’t be able to.
Peer-to-peer (P2P) lenders make up most of the rest of the alternative finance market. P2P platforms don’t lend money from their own balance sheets. Instead, they connect individual investors with many businesses that want to borrow. Most of the time, they give investors a better interest rate than a bank ISA, but there’s no guarantee of a return because it depends on each business paying back its loan in full. When a business borrows money through a P2P platform, the interest rates are sometimes lower, but it can take longer to get the money and there is usually a fee.
What else should I know about debt finance?
The market for debt financing is getting more and more crowded, which gives small businesses more options than ever before. If you spend some time looking into the different options, you should be able to find a way to fund your business that works for you.
If you’ve never tried to get a business loan before, hiring a broker could save you a lot of time and trouble. Keep in mind, though, that anyone can set up as a broker online, so it’s important to do your research first. Check to see if the broker is a member of the National Association of Commercial Finance Brokers to make sure they are honest and qualified (NACFB). This is usually a good sign that they will look out for your business’s best interests.
If you’re an early-stage business that can’t pay a broker fee, you can use independent websites like Better Business Finance to find lenders who can give you the type, amount, and purpose of funding you want. Some of the best sites for comparing prices also have a section for business loans, and there are a few online platforms that help SMEs and alternative lenders find each other. Funding Xchange is one of these platforms that doesn’t charge businesses a fee. It is also one of the places where the government’s bank referral scheme works. This is a programme that forces banks to send businesses they have turned down to other places where they can get money.
When you ask for debt financing, it’s likely that you’ll be given a range of different rates. Some lenders will give you a monthly interest rate, which is the most common way to show how much a loan costs. Other lenders may show the cost of their loans using less common rates, such as a factor rate or a yield. You can easily compare quotes based on different rates with a rate comparison tool to make sure your business is getting the best deal.