Whether you’re a new entrepreneur or an established company looking to grow, at some point you’re likely going to need to obtain some form of funding for your business.
Fortunately, there’s a vast array of options when it comes to raising capital, from debt, to equity and beyond. This guide will take you through all the major sources of funding available to businesses in three key sections:
Debt Finance
Debt financing is a way of raising capital through borrowing funds. It’s referred to as debt finance, as the borrower must pay back the funds at a later date.
Debt finance can be a good option for businesses seeking funding to support growth its also usually tax-deductible which doesn’t hurt. The main downside is that lenders charge interest, meaning you have to pay back more than was initially invested – depending on the interest rate the sum repaid may be far larger than the initial loan.
This obligation makes it a riskier way of raising capital, this is why early stage businesses don’t opt for debt financing. Below you’ll find the key forms of debt financing available to businesses.
1.Business Loans (Secured)
Secured business loans are secured against assets owned by a business, such as commercial property, vehicles or machinery. Using assets to secure a loan means that the company director doesn’t have to put themselves on the line by personally guaranteeing the borrowed funds (you might also further look to protect directors against other risks through Directors’ and Officer Liability insurance).
With a secured loan, if you can’t repay the borrowed money, the lender has the right to sell the asset/s in question to get their funds back. Secured business loans are a way of unlocking cash tied up in your business assets, using them as security in return for cash.
If you’re a company with high value physical assets, you’re likely to be readily accepted for a secured business loan. Owing to the reduced risk for the lender, this type of borrowing also tends to be a cheaper form of lending versus other options.
It’s important to remember though that secured loans mean your assets are at risk if you fail to repay or miss payments. If you come into financial difficulty, the lender can usually seize and auction your assets. If your asset is your warehouse, essential to the business’ daily operations, that could mean the end of your company.
2.Unsecured Business Loans
An unsecured business loan does not involve any security or collateral. Instead, lenders judge whether or not to lend based on your company’s ability to repay the loan. They do however often ask for a personal guarantee from a company director to repay the loan if the company defaults (this is also common with overdrafts). Typically, applying for an unsecured business loan involves a deep check into your credit history, income, savings and employment.
Unsecured business loan have the advantage that you don’t have to put up anything as collateral, which means it is open to businesses without physical assets. There are also typically no restrictions on how you spend the borrowed money.
However, interest rates tend to be significantly higher on unsecured loans, due to the higher risk for the lender.
3.Commercial Mortgages
Companies looking to invest in land or property for business purposes, often turn to a commercial mortgage as a source of debt finance. This product is basically a mortgage but instead of an individual the company borrows money secured against the property purchased or owned (it’s not uncommon for businesses to mortgage commercial property later on to free up capital).
A commercial property mortgage tends to be a long-term loan between 10 and 25 years. Commercial mortgage lenders typically lend between 60% to 75% of the value of a property. The loan is repaid monthly as with a standard mortgage charge including interest, unless otherwise agreed (some insurers offer quarterly payment schedules).
There are several key benefits to using a commercial mortgage as a source of business funding. Starting with value, if you’ve made a wise commercial property investment an increase in the value of the property may end up outweighing the mortgage (you are however at risk from a drop in value).
Instead of losing money to rent an office or factory space, by purchasing and mortgaging a commercial property you are building long term equity. You also have the option to sublet or lease unused space with your property to make extra income.
Most commercial mortgage providers will however require a substantial deposit to secure a mortgage, usually between 25% and 40% of the price/value of the property (unless you already own it in which case you can often release 100% of the equity via a commercial mortgage).
Companies should also factor in the extra expenses that come with owning property as opposed to renting, such as building repairs, security, insurance costs as well as responsibility for the fixtures and fittings.
4.Asset Financing Or Leasing
Asset financing is a way of quickly accessing a loan that is secured against a high value asset or assets (either to purchase or release equity).
The borrowing company uses its balance sheet assets, such as short-term investments, accounts receivable, machinery or even buildings as collateral to borrow money.
Typical forms of asset finance include equipment leasing, hire purchase, finance leases, operating leases, asset refinance and invoice finance (detailed later on as it differs to traditional asset finance in function and process).
Companies mostly use this form of finance to acquire high value equipment. Typically, this process works via the asset finance provider buying a capital asset that the company needs, with the company agreeing to paying for it in instalments with interest (similar to secured loan).
It’s also common for companies to release cash from existing equipment by selling it to a finance provider and leasing it back from them instead, known as asset refinance.
Asset finance is a preferable form of financing for many businesses and lenders, as it is based on the assets themselves which provide security for both parties. It’s often more flexible and cost-effective than getting a commercial bank loan to purchase equipment and tends to be a quick way for companies to access the capital, resources or equipment they need.
However, it is important to note that it’s a more expensive way of buying an asset than purchasing it outright. On top of that, if you default on a repayment, you could lose the ownership of the asset.
5.P2P Lending
Peer to peer lending allows businesses to borrow money through online platforms which match lenders with borrowers. Peer-to-peer lending companies tend to offer their services more cheaply than traditional financial institutions, which enables lenders to earn higher returns and borrowers to borrow funds at lower interest rates. Some P2P websites allow lenders to choose who borrows their money, while on others the money they lend out is divided between lots of borrowers.
P2P lending hugely simplifies the borrowing process. It’s far easier for many businesses to find funding than going down a more traditional route, such as through a bank. Many companies can receive funding within just a few days through a P2P site, or even a few hours. P2P loans are also typically more affordable than other forms of credit or finance.
The biggest downside to P2P lending is the increase in risk. Without restrictions in place and thorough credit checks imposed by banks, many companies borrow more than they can realistically afford, putting them at financial risk. What’s more, many P2P lenders only permit loan-to-value ratios, usually around 65%, which means companies need to find other ways of supplementing their loans.
6.Overdraft Financing
Using a bank overdraft is a way for companies to obtain short-term funding. In essence a company agrees on an overdraft limit with the bank, known as the ‘facility’, and the bank charges interest on the amount of the overdraft the company are using (overdrawn). Some banks also charge an overdraft facility fee. Often overdrafts require a director guarantee and assets put up as collateral for larger overdraft facilities.
Most businesses use overdrafts to offset cash flow issues, where the business is healthy but because of outgoings/income coming at different points throughout the month, an overdraft facility is need to pay bills.
Overdraft are typically an easy, quick and flexible way for businesses to borrow money in the short term. Businesses only pay interest when they are overdrawn, and they can review and adjust the overdraft facility limit with the bank.
However, overdraft interest rates are typically higher than business loan interest rates, so it may be worth considering other forms of finance for anything other than balancing cash flow. Most business banks also charge an overdraft fee to keep the facility in place, even if you aren’t using it. Finally, the bank could rescind your overdraft at any time.
7.Business Credit Cards
Commonly used as an alternative to an overdraft, a business credit card allows the owner to pay for items such as supplies or equipment and pay the cost at a later date. Credit card companies will typically charge a standing fee and agreed interest on purchases, some however have an interest free period or 30 or 45 days, which can be extremely attractive.
Using a business credit card responsibly can also go a long way to building your business credit, which can help your company secure a bank loan in the future. Many credit card companies also offer purchasing incentives to businesses such as airline miles, cashback or other perks.
It’s also important to know that most business credit cards require a personal director guarantee, which can have an effect on your personal credit rating, and may mean that you become liable for late credit. They’re also typically expensive, as interest rates are high beyond agreed periods and there are several fees, such as maintenance fees and late payment fees (many businesses and individuals fall into this trap, it’s worth considering setting up automatic payments will pay anything owed on your credit card monthly).
8.Hire Purchase
One of the more popular forms of asset financing is hire purchase, this is where a finance company buys an item that you need, such as a piece of equipment and you pay monthly instalments with interest to purchase ownership over the equipment over time. Asset ownership is transferred to your business once all payments have been made. It’s ideal for any company that needs immediate use of expensive equipment to grow that they cannot afford.
It’s advantageous for companies as they don’t need to raise capital for the full amount, meaning they can make essential purchases quicker. Spreading the cost out over time often also allows companies to opt for newer, better equipment than they would otherwise be unable to afford.
The drawbacks are that the items can be repossessed if you default on payments. This reduces the risk for the financer but can mean the end of your business if the asset is essential to ongoing trade. Defaulting on a hire purchase payment will also harm your company’s credit score.
9.Trade Credit
Trade credit can facilitate business to business transactions to go ahead even if the purchasing company doesn’t have enough working capital available for the trade, these type of facilities are often protected by trade credit insurance.
With a trade credit agreement, business customers can buy goods or services from their supplier and pay for them later on (typically 30, 60 or 90 days). Trade credit is particularly useful for smaller businesses or companies who struggle to reconcile the timings of their cash in and cash out and need to purchase stock to grow (it’s also worth exploring stock insurance to protect your assets/debt obligation).
However, trade credit is notoriously risky and many suppliers will not offer it. While it can be invaluable in driving short-term growth, allowing companies to purchase goods and services they need to grow before they have the cash to hand, puts the supplier at serious risk if something we’re to go wrong.
That said, there are some attractive benefits to using trade credit. It makes business-to-business transactions far easier, allowing the business to align their payments with their outgoings and access resources they need when they need them. It also promotes growth for both parties and is far easier to obtain than traditional forms of funding such as a bank loan, as your dealing with a trusted supplier. The flexibility of trade credit can also go a long way to establishing positive, loyal relationships with clients.
10.Invoice Finance
Invoice finance involves companies selling their individual unpaid invoices or entire accounts receivable, to a third party for a percentage of their value, usually around 80-95%. This method of finance means that, for a fee, businesses can unlock cash tied up in unpaid invoices, accessing the funds before the customers pay.
It’s a type of business funding often used by companies that work in trades where customers have extended payment terms of 30, 60 or even 90 days. When the customers pay, the lender receives their money, and the business gets its remaining 5-20% of the invoice, minus the fee.
There are two main types of this type of finance being invoice factoring and invoice discounting. They work broadly the same way, except that with invoice factoring, it is the finance company that deals with collecting the debt from the customers.
With invoice discounting, you retain control of your customer accounts, and it’s down to you to chase late payments. For companies that only need help to bridge their cash flow gaps due to one or two customers, its preferential to opt for selective invoice discounting, rather than commit to a contract for their entire sales ledger.
The main advantage of invoice finance is that it steadies your cash flow. Getting a large portion of your invoices paid straight away boosts your working capital, allowing you to purchase more materials, accept more jobs and grow your business without having to wait. It can also be confidential if you choose, which protects your customer relations, as they won’t know that you’re using invoice finance.
Invoice finance does come with some disadvantages. The main one is the price, as invoice finance remains one of the more expensive ways to finance a company. It can also have a negative impact on a company’s reputation, as customers tend to perceive companies that factor their sales ledger as less stable and potentially high-risk suppliers.
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