When your business needs an injection of cash (and what business doesn’t, at one point or another?) there are two potential routes you can follow. One is debt financing, where you borrow the money you need.
The other is equity financing, where you sell a stake in the company. The latter unfortunately dilutes your ownership, and of course your share of the profits, so we’re going to concentrate on debt financing.
What is debt financing?
As already stated, debt financing involves borrowing the money you need to power business growth. However, if this immediately makes you think of bank loans, think again.
Certainly, a conventional term loan is one avenue for debt financing, and in many instances it’s the right route to take. However, the business finance market has proliferated in recent years with the emergence of alternative lenders, so here are some of the options on the table.
A term loan
This is what most of us think of when we hear the word “loan”: you borrow an agreed amount of money and pay it back, plus interest, over an agreed period.
Line of credit
Acting like an overdraft, a business line of credit allows you to borrow and repay at will against an agreed credit limit. The flexibility is unrivalled, and whilst interest rates tend to be high you will only pay when you are actually using the facility.
A business credit card is once again a fairly expensive way to borrow, but as with a line of credit will allow you to borrow and repay at will.
Merchant cash advance
With a merchant cash advance, you can borrow an agreed sum and repay it via a fixed percentage of your daily credit card sales. The advantage is obvious: you will never have to make a significant fixed payment during a quiet period for the business. The main disadvantage is once again the cost, as this is a notoriously expensive way to borrow.
Invoice factoring or discounting
With invoice factoring or discounting, you can borrow against your invoices as soon as you issue them, with repayment being made when your customers pay you.
This means you effectively get paid immediately and can revolutionise your cash flow; opt for factoring and you can even outsource all collections activity to the finance company.
What are the advantages of debt financing?
The big advantage of debt financing is that you don’t have to give away a stake in your business, and your lender has no control over the way in which it is run. Allow a business angel or other equity investor to take a stake and you could find yourself having to contend with a quite different vision of the company’s future.
What’s more, any interest you pay on your borrowing can be fully offset against corporation tax, and if you opt for a long-term loan you can spread the repayments over quite a number of years, thus reducing your monthly outgoings. Better still, if you opt for a fixed (rather than variable) interest rate loan, then you will always know how much you have to pay.
So, what are the disadvantages?
The first problem you may face is having to provide security for the loan.
Certainly, it’s possible to find unsecured finance, but this will generally require an excellent credit score and a proven track record in business. For relatively new companies, a secured loan may be the only option on the table. Whilst this significantly reduces the lender’s risk, it substantially increases yours.
With an unsecured loan, your lender would have to obtain a court order to seize your assets in the event you fail to repay; with a secured loan, they can simply take the collateral, so be extremely careful about pledging personal assets such as your home.
Secondly, of course, you will need to budget for the repayments, which will significantly reduce your free cash flow and could create problems further down the line. However, as with anything in business, you have to speculate to accumulate – and the rewards can be significant. I would suggest looking at this article on calculating your DSCR to ensure you can afford the loan repayments before leaping in.
What can debt financing do for me?
Take out debt finance when you need it and deploy the money wisely, and you could take your business to the next level. Here are just a few of the things you could with a loan:
Improve your cash flow
Cash flow is the lifeblood of any business, and virtually every company hits a cash flow crisis at one point or another. In fact, cash flow can be particularly problematical for businesses that are profitable and fast-growing.
This might sound perverse, but they will have to purchase raw materials, and potentially take on new people and equipment, to serve major new customers in advance of getting paid. Having a cash cushion on hand can make the difference between staying in business and going to the wall.
Invest in a marketing campaign
One almost universal truth in business is that people are not going to beat a path to your door to use your product or service. If you want to join the big league, you will need to launch a marketing campaign, and these can be notoriously expensive. But by financing the right campaign you can achieve a step change in your company’s performance.
Hire new people
Any company is only as good as its people, and if you want to take on the most prestigious customers in your sector then you will need the very best people to service them. Of course, the best people tend to be the most expensive, hence the need to borrow.
Purchase new equipment
Similarly, it’s important to have the best equipment on hand, and once again there’s every chance that you will need to borrow in order to invest.
Move to larger premises or open additional offices
If you’re running a business where customers come to see you, then you’ll know that first impressions really count. Getting the right premises or opening a network of local or overseas offices can set your business on a very positive route.
Refinance existing debt
Finally, if you already have debts, taking out additional finance may allow you to consolidate them into a single, lower monthly payment, thus freeing up cash flow. As an added bonus, if your business has developed significantly since you last sought finance, you may be able to achieve a much lower interest rate.
A few tips when you’re seeking debt finance
First and foremost, remember to talk to the full range of lenders, as banks and alternative lenders apply quite different acceptance criteria and tend to have very different application processes.
Secondly, consider the possibilities of all the finance options above, and make sure that you understand their relative costs. For this reason, it is vital to find out how much you will pay back in total, including any interest. A simple interest rate won’t communicate this, and to make life more confusing some loans have their costs expressed as a factor rate instead.
Once you have all the options on the table, you can take an informed decision and take a vital step in propelling your business to the next level.
Written by Carl Faulds
As Managing Director of Cashsolv, Carl offers advice and support to overcome cash flow problems and identify possible underlying problems that can be addressed to ensure a positive future for your business.