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Debt Finance for Business

Posted on Apr 26, 2012 by Sandy Finlayson  | 0 Comments

Raising finance for start-up and early stage business has never been more challenging but a good business will always win through in the end. Perversely, this is a good time to start a new business as it imposes strict financial discipline from which the business will benefit when the economy eventually starts to improve.

Having looked at every available opportunity for “free” finance and grants, the next step for a business is to look at debt. It should however be borne in mind that the provider of debt finance is looking at your ability both to service the interest payments and other charges and to pay back the debt in the agreed timescale. It is therefore unlikely to be appropriate for pre-revenue businesses which, by definition, are not generating any cash to service the debt (as covered in my next blog on equity).

The various forms of debt may be broadly categorised as follows:-

A. Asset Finance

  • Hire Purchase

You acquire possession of the asset at the outset, make regular repayments and title to the asset passes to you with the final payment.

  • Lease

You acquire possession of the asset at the outset and make regular repayments but you never acquire title to the asset although you may go on to a “secondary” period of much lower repayments after the primary period has expired.

B. Finance or Operating Lease

The asset represented by a Finance Lease will appear as an asset in your Balance Sheet and so will the liability for repayments. With an Operating Lease on the other hand repayments are simply shown in the Profit and Loss Account and the asset and liability are not reflected on the Balance Sheet. An Operating Lease is typically for minor equipment such as the photocopier for repayments.

The repayments may be of equal amounts over the period of the contract or, particularly in the case of a hire purchase contract, you may find that there is a large “balloon” payment at the end when you acquire title to the asset. This may seem attractive at the outset but could cause a problem if you are unable to make the large final payment.

C. Maintenance Agreement

If a piece of “mission critical” equipment is financed in this way you should bear in mind that you retain the liability for repayment, even if it breaks down.  You should therefore think about insurance and maintenance agreements to cover those eventualities.

D. Overdraft

Historically, the overdraft has been the simplest and quickest way to obtain finance from a Bank. The overdraft is a fluctuating amount up to some agreed limit and is an ideal way of financing a working capital requirement. It is an essential feature of an overdraft that it is repayable on demand but companies should have “forward visibility” on cash flow for twelve months in order to avoid a qualified audit certificate. It is therefore common practice to ask the Bank for a “Letter of Comfort” confirming that it is not their intention to withdraw the overdraft before the annual review provided there is no breach of covenant.

Security is typically in the form of a normal floating charge over all of the assets of the company. However, overdrafts are now much more difficult and expensive to come by because the Banks are required to “stress test” their Balance Sheets on the assumption that the overdraft is drawn down in full.  In practice across the UK overdrafts are typically only drawn down to the extent of about 60% but because of this new requirement the Banks now prefer to offer cash flow finance in preference to an overdraft.

E. Cash flow finance

This type of finance is also called factoring or invoice discounting.  The principle is quite straightforward. As soon as you supply goods or services to your customer you generate the invoice which is passed to the Bank or their factoring company and they immediately release a percentage of the invoice value (typically between 75 and 90%). They then accept responsibility for collecting payment from your customer and the balance is paid to you less their charges when they get payment.

The facility may be offered on a recourse basis which means that if ever the debt goes bad you have to make good the shortfall or “without recourse” which means that the debt is insured although this will be significantly more expensive.

Larger businesses may have the option of a “confidential” facility which enables them to manage the sales ledger themselves but this is unlikely to be available to an early stage business.

The costs are likely to comprise an arrangement fee for setting up the facility, an ongoing administration fee and a “cost of funds” fee based on the amount outstanding at any time.

Cash flow finance can be a simple flexible way of financing a growing business but if sales decline cash can dry up very quickly.  It is therefore prudent for any business using cash flow finance to build up a cash reserve to give it some protection against a fall in sales. The directors will also be asked to warrant that invoices are due and payable when they are submitted to avoid the temptations of “fresh air” invoicing.

F. Business Term Loan

The Banks may be willing to offer a business term loan, subject to availability of adequate security.The days of highly leveraged cash flow lending to finance acquisitions are gone, at least for the time being although that may not be a bad thing as over leverage and reckless lending were one of the main reasons for the financial crash. The repayments may either be “stepped” ie a fixed capital amount is paid off every year so that the repayments reduce over time, calculated on the “annuity” basis so that there are fixed payments over the life of the loan or on an interest only basis with full repayment at the end of the loan. 

The loan will typically be secured by way of a fixed charge over a property or, if that is not available, some other form of security acceptable to the Bank who may also look for the loan to be written under the National Loan Guarantee Scheme.

G. Loan Stock

Moving away from the banking system, there are a number of providers of Loan Stock or “mezzanine” debt.  Secured and Ranking behind the Company’s principal lenders, typically a clearing bank, or unsecured, it may be convertible giving the lender the right to participate in any increase in the value of the company and the interest rate will be priced according to the perceived risk. The interest may be payable monthly or quarterly or rolled up which means that it is repayable on the maturity of the loan.

H. The Dangers of Leverage

Following the dot.com boom and bust we went through a period of extraordinarily cheap and easy credit resulting in many businesses becoming over leveraged.  When a business is sold, it is typically sold on a “cash free/debt free” basis. This means that, even although the business may have an attractive headline price, the debt must be fully accounted for before there is any value attributable to shareholders.

Far too many businesses fall into the trap of believing they should borrow as heavily as possible in order to retain control of all of the equity.  In reality however they are just giving control of their business to their creditors and putting their directors at risk personally if they agree to sign personal guarantees. The right way to create shareholder value is to ensure that you have the right mix between debt and equity. The Greeks have found out that lesson the hard way – do not let the same thing happen to your business!

Sandy Finlayson

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