Loan Funding – Benefits and Drawbacks
Companies looking for funding often choose to raise funds via loans. Compared to the other options available, loans are often able to be arranged quickly and allow the business owner to retain full ownership of their company.
Benefits of a Business Loans as a funding Source
There are a number of benefits of using a loan to finance your business.
Quick to Access
The process of applying for loan is normally very quick in comparison to seeking other forms of funding.
Many of the more innovative lenders now require that established and profitable companies supply only company accounts and director identity documents in order to make a loan decision. That decision is often made in a matter of hours rather than days or weeks. For companies that are offered a loan the funds can often be in their bank account shortly after this. These lenders are typically found on online platforms and often have an approval process that interfaces the client with a web based application process rather than requiring the client to interact with representatives of the lender.
More traditional style lenders, such as high street banks typically have a higher information requirement than online lenders and the decision-making process and receipt of funds by the applicant is normally a lengthier process. Unless the applicant is an existing and well known client the bank will often require a business plan and financial forecasts as well as historic company accounts and director identity documents in order to consider a loan. Often, banks still rely on a centralised credit team (the decision making part of the bank) which means that your local branch manager may not have the ultimate say in whether you are provided a loan or not. Due to this decentralised, human based decision making process, the time taken can be significantly longer than the algorithmic systems used by many online lenders – however, they are able to consider certain circumstances, which an online lender’s application systems may not be flexible enough to consider.
No Loss of Ownership or Control
One of the benefits of loan funding is that a business owner is not required to give away any ownership of their company, as would happen if they were looking to raise equity investment funds. Because loan funding is repayable, the benefit to a lender of making a loan is that they receive the interest charged on the borrowed funds. The interest is their return from the investment. Therefore, they do not require a stake in the company as an equity investor would require. This means that should the business be sold in the future the lender does not hold any equity and the proceeds from the sale would go to the existing equity holders.
Additionally, in an equity investment, the investor will become a shareholder and often also a director in the business and (depending on the stake held) able to exert influence over business and board decisions. Many business owners are reluctant to give away equity if they can avoid doing so since having the maximum possible control of a business is traditionally considered favourable. However, in certain circumstances the added experience and skills that an equity investor may bring to a company can be invaluable. We will consider this in more detail in future blogs.
Drawbacks of a Business Loans as a funding Source
Loans are repayable which means that the business must be able to meet the regular repayments due on the loan out of its cash flow. Meeting these repayments will mean that the company will hold less cash than it would have done had it received equity funding since equity funds are not repayable. Therefore, when taking a loan, a borrower needs to be certain that, not only have they borrowed sufficient for their purposes but that they will also be able to repay the loan. If a lender does not think that a company will be able to meet its repayments it would be very unlikely to make a loan to that company in the first instance.
If a company misses repayments the lender will typically start to look at ways of protecting itself from losses should the company be unable to repay the remainder of the loan – there are numerous methods available to the lender to achieve this and often there are restrictions or obligations placed on the borrower, which can mean a loss of control to the lender or, where personal guarantees have been given, demands for repayment from the borrowers personal estate. Borrowers in this position are often said to be “in special measures” which is normally a very stressful and disruptive situation to be in.
Loans are commercial transactions, they earn interest and often initial fees on the loans that they make. The interest is an expense for the borrower and therefore it has a negative impact on profitability versus an equity investment in which interest bears no part. Even when the interest rates appear attractive the upfront fee can add a further 5-6% on the overall costs. An important point is that a loan will show on a borrowers balance sheet as a liability so, a company receiving a loan will have a weaker balance sheet than one receiving equity investment of the same value.
Directors of small and medium size enterprises are often asked to provide personal guarantees to lenders which would make them liable for any outstanding loan funds should the borrower become insolvent. This is of course an important consideration, and directors should only ever provide guarantees after a very careful process of considering the likelihood of the business becoming insolvent and their own appetite for personal financial risk. If directors are uncomfortable providing guarantees of this nature they will very often look at equity funding as the alternative option.
Loans can provide a very fast way of accessing funds required for a business, however if it is anticipated that repayments would create a burden on the cash position of the businesses other options may well be better suited. Loans should only ever be taken if the confidence that the business can meet loan repayments is very high. There are many things to consider such as interest rates, fees, personal guarantees, early repayment fees and non debt clauses which can all equally affect the suitability of the product dependent on the individual circumstances. To understand the full range of potential funding options for your business, come and talk to us at Access to Finance.