Debt financing is one of the most common funding alternatives accessible to small businesses in the UK. Debt finance refers to borrowing money to establish or build a firm instead of equity financing, which comprises giving up a portion of your company in exchange for investment.
Bank loans and loans from friends and family were the two most typical types of debt financing. However, several new debt financing alternatives, the bulk of which appeared after the recession, have joined them. These new players, from peer-to-peer (P2P) and invoice financing to challenger banks and internet lenders, have given firms more options and assisted in bringing the debt finance sector into the twenty-first century.
The advantages of borrowing money
Maintaining control over a corporation is one of the key benefits of debt financing. A founder will have to give up some of their ownership or equity in return for the money, even though equity finance sometimes offers larger capital. With debt financing, a company’s sole expenses are the interest on a loan and sometimes some extra fees.
A business owner will often need a personal guarantee to pay back any outstanding debt if the company goes bankrupt. The funding may also need to be secured by corporate or personal assets, such as real estate or equipment. However, this customary practice enables lenders to control the loan risk. A company’s assets won’t be in jeopardy as long as it makes payments following the timetable by its lender.
How can a company use debt financing?
Debt financing may be utilized for any growth-related endeavor, including purchasing new real estate, remodeling current real estate, updating equipment to meet the requirements of lucrative contracts, and initiating multi-channel marketing initiatives. Debt financing may assist spread the cost over many months or years, alleviating the financial pressure on a firm to continue developing. These kinds of projects often demand large capital expenditure.
Debt financing may also assist businesses in maintaining a healthy cash flow as they wait for payment from consumers, which is a challenge that SMEs face more often. Invoice financing, which enables companies to borrow money against the value of sales invoices, is a specialty of several lenders. These lenders often advance a portion of the invoice’s value — typically 80%, but some lenders may go as high as 100% — then release the remaining amount after the invoice is paid, less a charge. Working capital loans and merchant cash advances, which essentially act as a revolving credit line, are additional choices for businesses looking for a flexible cash flow solution.
Seasonal firms often employ debt financing to get through the lean months and finish tasks that are impossible to do during the busy months. For instance, if a hotel requires renovations, the work is often done when there is little occupancy. However, with less money flowing into the company, it could need more money to pay the bills. Some lenders provide specialized hotel financing and even provide companies the choice of revenue-based repayments, which let them pay back more when sales are greater and less when sales are lower. For firms that operate seasonally, this may be preferable to be constrained by set monthly payback schedules.
Debt financing methods
Despite the abundance of choices offered to firms in the market for debt financing today, they may be divided into four broad categories:
- Friends and family
- Business Loans
- Online lenders
- For bank loans
Friends and family
Businesses that have not yet launched or have only been in operation for a few months may find getting bank loans and other types of debt financing challenging. Most banks and internet lenders want proof of income and consistent cash flow, preferably for at least six months. Because of this, many company entrepreneurs seek financial assistance from their friends and family, particularly in the beginning.
The fact that friends and family may be more accommodating with repayment terms and won’t add interest to the loan is a significant benefit of borrowing from them. Furthermore, you generally won’t be in danger of losing any assets should you fall behind on payments until a thorough agreement is drafted and signed by both parties.
But there’s no getting around the truth that borrowing from your loved ones jeopardizes your relationships. Therefore, it is wise to manage their expectations and make them aware of the hazards before asking for or accepting funds from friends or family.
If you cannot get financial support from friends and family to launch your firm, the government may be able to assist. Personal loans up to £25,000 are available from The Start Up Loans Company. These loans may be used to launch a new company or expand an existing one that has been operating for less than two years. All loans have a 6% fixed interest rate with terms ranging from one to five years. There are no setup or early-repayment costs. You must be a UK resident, be 18 years of age or older, and have the legal right to work in the UK to be eligible for a Start Up Loan.
There aren’t many additional debt financing options tailored exclusively to startups, but if your firm offers a ground-breaking solution in industries like healthcare or transportation, you could qualify for a small business grant. While The Prince’s Trust and New Enterprise Allowance provide starting money to young company entrepreneurs, Innovate the UK periodically sponsors funding contests. Scottish Enterprise also offers grants for research and development to Scottish businesses.
According to the British Business Bank, bank lending reached pre-pandemic levels in 2021. Compared to 2020, challenger and specialty banks supplied 51% of loans, an increase from 31%. In addition, 48% of small enterprises intend to ask for external financing in the next 12 months.
Generally, bank loans are smart for companies with less urgent financial needs. It might take a while to apply for a bank loan, and you might be required to provide a thorough business plan as part of your application. Suppose your credit history is anything less than perfect and you’ve been in business for less than two years. In that case, it will be challenging to acquire capital since banks’ lending standards tend to be tighter than those of newer “alternative” lenders.
Many companies go to their bank for financing for various reasons, including not knowing about the alternatives and the possibility of a cheaper interest rate. It’s important to keep in mind, however, that if you want to repay a loan early, certain banks may charge you a fee. Many alternative lenders, in contrast, let firms pay off their loans early and only accrue interest during the period they have the cash. The total cost of borrowing might decrease as a result.
Useful link: – Looking for funding? Find the right finance for your business here
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.
>See also: Fast business funding and loans
The lenders giving a contemporary twist on the conventional business loan are at one end of the range. These organizations not only provide a lightning-fast application process—approval and money may happen in as little as 24 hours—but many also include top-ups and repayment vacations in their loans as normal features rather than charging extra. A lender will often lend money based on its balance sheet, giving it the freedom to determine its lending standards. This indicates that they often finance businesses that, for instance, a bank couldn’t.
Peer-to-peer (P2P) lenders make up most of the alternative finance sector’s remaining market share. P2P platforms connect individual investors with multiple companies eager to borrow money instead of lending money from their balance sheets. There is no assurance of a return since it relies on each firm returning its loan in full, even though they normally give investors a greater interest rate than a bank ISA. When a company borrows the money using a P2P network, the interest rate may sometimes be cheaper, but the process may take longer, and there will typically be a charge.
Further reading on online lenders
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.