Business borrowing

There are many reasons why businesses need to borrow money and almost as many different ways of borrowing the money. The best type of funding for a business will depend on its own unique circumstances and the reason for the loan. The wrong type of funding though may handicap a business with payments that it cannot afford.

Reasons for a business to borrow money:

• temporary cash flow problems
• expanding into new markets
•  launching a new product
• purchase new equipment
• staff training

Types of funding:

Overdrafts

This is the simplest form of funding for your business involving an agreement from your bank to run your business account in the red for a period of time. Overdrafts that are authorised will charge a lower interest rate than if you go overdrawn without prior approval. Both authorised and unauthorised overdrafts will incur other arrangement and managements charges but unauthorised overdraft fees can be very heavy and increase your total borrowing very quickly. Overdrafts may be cancelled at any time and the bank has the right to demand immediate repayment.

Bank loans

Loans are available to new and existing businesses normally for a specific purpose such as purchasing IT equipment and can be secured against company assets or against your home . Repayment periods may be from as little as 12 months up to 25 years.

Interest rates on loans can be fixed or variable.

A business plan will be required by your bank and they may also want personal/ director guarantees.

The Small Firms Loan Guarantee Scheme can help businesses that either do not have security to offer the bank or that are considered too high a risk for the bank to lend to. With the scheme the government guarantees the loan should the business fail to keep up its payments.

Invoice factoring and debtor finance

A very popular way of obtaining finance is to use the invoices that the company issues as security for the bank to lend against.

The bank or other lender will take over responsibility for making sure the invoices are paid and will take a % of the value of each invoice as its fee. In the meantime the bank will have paid a % of the invoice value up front to yourself giving vital cash flow to your business. Typically the bank will pay 70-80% of the invoice value up front with a further payment when the invoice has been paid in full.

Advantages of factoring:

•  improves cash flow - payment can be made within 24 hours of the invoice being passed over to the factoring company
• can help both start up and established businesses and therefore could be a better option than an overdraft
• factoring is linked to sales therefore less emphasis is made of the businesses financial track record
• flexible arrangements to suit the specific needs of  a business
• the factoring company may have expertise in certain industries
• factoring companies can often help with trading internationally and in different currencies/ languages
• removes the stress of debt collecting

Disadvantages of factoring:

• the charges made by the factoring company can be high - typically 1.5% to 3% above bank base rates for the amount lent up front.
• there will also be a service charge based on annual turnover and the number of invoices issued.
• passing the responsibility for collecting money over to a large corporate machine may not suit all types of business especially if personal relationships with customers are important
• the debt collection methods used may not be appreciated by customers of the business who will also have credit limits imposed on them by the factoring company.

Invoice discounting may be preferred by some companies where the responsibility for collecting the debt is still with the business and the relationship with the factor is purely financial. The business will still have to repay the factor for money lent up front against invoices.

Venture Capital & Business Angels

For growing businesses or start-ups with significant potential raising capital in return for equity stake in the business may be appropriate. The investor(s) will take a very close interest in the company and may insist on a ‘seat on the board'. They may however also bring considerable expertise, experience and contacts with them which can be invaluable to the business.

In return for the investment, the investor owns part of the company may be as much as 40% and will generally expect to sell this stake within 3-5 years.

Venture capitalists and business angels will normally specialize in certain types of company or industry reflecting their own experience and expertise. They will be looking for sound investments with quick growth potential and a healthy profit outlook.

Bringing on board investors of this sort may be very helpful to a business but will also bring with it close supervision and disagreement over the future direction of the business and day to day operations. Working with venture capitalists and business angels is as much about the personality fit as it is the money.