In the late 1980s, investment bankers had to hit the phones to verify whether there was enough debt capacity in the entire world to finance the buy-out of a single company – RJR Nabisco. Times have changed a lot since then, and aspects of the tale of this deal from the bestseller, Barbarians at the Gate: The Fall of RJR Nabisco (by Bryan Burrough and John Helyar), seem quaintly old-fashioned.
That perception may hold true for large multinationals, but many business owners face a struggle to access such debt. A company can bring capital into a business in the form of either share or loan capital. The capital clause of a company’s memorandum gives it the authority to issue shares, whilst the object clause gives it the authority to borrow. This note looks at the latter – how business owners can raise debt to support the development of their business.
Although banks still account for a significant proportion of small business financing, the relationship between lender and borrower has not always run smoothly. This was particularly the case in the early 1990s, with the combined pressures of both the recession and fall in the property market (many business owners’ homes having been pledged as collateral), a scenario that we have seen again recently.
The regulators have tried in recent years to promote more constructive and effective relations. One of the results has been an increase in the use of fixed term loans and a drop in overdrafts. Furthermore, whilst security is still very important to banks, there has been more of a willingness to look beyond secured lending to what is known as cash-flow lending, i.e. basing lending decisions on an analysis of the borrower’s cashflow and business projections. So, what do banks have to offer?
For businesses starting out, and where the need for money is of a relatively short-term nature, an overdraft may be the most suitable form of finance. Whilst quick and relatively cheap to arrange, the drawback is that the bank can withdraw the facility and demand instant repayment. In addition, if there are no assets, the bank is likely to want some form of personal guarantee – this will commonly result in a charge over the business owner’s home.
For longer term funding needs, a commercial loan is likely to be more appropriate. These are normally available over fixed terms (2-25 years), with interest being either fixed or variable (a variable rate will be set at a certain number of percentage points above a bank’s base rate, depending on its assessment of the risk). Due to the financial pressures often placed on a business while it establishes itself, a capital repayment holiday may be available. This will commonly be in the form of interest payments only, for the first year or two. Stepped payments are another possibility.
In most cases, banks tend to be happiest where they are committing no more than about half of the initial start-up funding to a business venture.
A bank will always want to look very carefully at a number of issues. These include:
- the client, in terms of his or her experience and qualifications
- the business plan
- the extent to which the borrowers and others are personally financing the start-up.
Business owners are expected to have contributed all available personal assets and the lender must be content that the business will continue to be viable.
These are usually available up to 70% of the bricks and mortar value of the commercial property being purchased. There are many similarities with domestic mortgages: terms are normally for 15 years or more, variable or fixed rates are available, and repayment holidays and interest-only loans are all normal options.
Enterprise Finance Guarantee
If a business is experiencing difficulty in raising a loan, perhaps due to lack of assets or business track record, then the bank can apply to the Department for Business, Energy and Industrial Strategy (BEIS) for a guarantee. This will cost the borrower a fee of 2% per annum as a premium on the outstanding balance of the loan.
The maximum guarantee under this scheme for businesses is £1.2m (minimum £1,000) and applies to loans lasting 2-10 years. The scheme guarantees to repay 75% of the outstanding debts to the lender if the business fails. The scheme is available to sole traders, partnerships or limited companies which have operations in the UK, qualifying business activities, and turnover under £41m per annum.
Bank Referral Scheme
November 2016 saw the launch of new rules forcing big banks to redirect to alternative finance brokers any small business loan applications that they reject. The initial success of this has been questioned, although it does provide an extra option for would-be borrowers.
Alternatives to bank loans and overdrafts
Factoring and invoice discounting
These schemes are designed to address working capital issues and combat the problems of the late payer, by providing financing based on a company’s outstanding invoices – its debts.
A full factoring service takes over the entire administration of the sales ledger, attempting to ensure customers pay on time and chasing up slow payers. Invoice discounting on the other hand is less intrusive and is solely concerned with providing funds against outstanding invoices. Costs range from 0.5% to 2.5% over base rate for a full factoring service, to 0.2-0.5% for invoice discounting. The principal benefits are:
- up to 80% of the value of the invoice becomes available as soon as it is issued
- time is saved by not having to chase slow payers
- it can be less expensive than paying a bank overdraft which would typically be 2.5-3.0% over base rate
- credit checks are made on existing and new customers.
Leasing or hire purchase
For many established businesses, capital expenditure will be partially funded using a lease or hire purchase arrangement. Many organisations provide this finance and there are a wide variety of products on the market. The best option for a particular business will depend on factors such as cash flow, taxation status and the degree of risk. This form of finance may not be available for start-ups as most providers like to see a track record or obtain additional security.
There are a number of grants available from local authorities, the government and the EU, examples including:
- government development grants, where technological innovation is concerned (contact the BEIS)
- assisted area grants such as the regional select assistant grants that are designed to cater or safeguard jobs in designated areas (contact local business links)
- financial support schemes available through the training and enterprise councils (TECs) where weekly payments may be available for selected periods
- local authority assistance, details of which are available from either local enterprise agencies or the TECs
- EU grants and subsidies.
Personal wealth – mortgages and pensions
It is often the case that an individual commits a substantial proportion of their personal wealth to a particular venture, and there are tax breaks to encourage this. If a business owner raises a mortgage against his or her home to finance a business, the interest payments can be offset against profits before tax.
Where there is an executive pension scheme, small self-administered pension scheme or self-invested personal pension with sufficient assets/investments, subject to HM Revenue & Customs approval, the pension scheme may provide finance to the business. However, it must be in relation to a specific qualifying activity such as the purchase of plant or machinery or commercial property.
Your St. James’s Place Partner should be your first port of call for further advice, as we can assist in a number of different ways with raising finance.
The property on which the mortgage is secured may be repossessed if repayments are not maintained. Commercial mortgages are not regulated by the Financial Conduct Authority.
Paul Emery, Head of Client Banking, St. James’s Place