WHAT IS DEBT?

At its simplest, debt is simply borrowed money. Looking at a balance sheet such as Widget Co Ltd’s (as shown in Chapter 2) some borrowings are easy to both see and understand. These are what could be regarded as formal borrowings, such as the overdraft and the mortgage, and are likely to be familiar to most people who have ever had a bank account or bought a house.

However, in addition to these formal borrowings, as discussed in the last section, essentially every liability on your balance sheet represents a source of cash that you have used and which you will eventually have to repay. So in addition to the obvious formal borrowings, all of the other current and long-term liabilities shown on your balance sheet, such as trade creditors and the tax man, should be regarded as sources of funding or debt to be used and managed to support your business.

Off balance sheet debt

Going even beyond this, debt can also take forms which are more complex and difficult to spot at first sight as they do not appear on the balance sheet at all. In fact some borrowings, such as the two examples below, are sometimes described as ‘off balance sheet debt’.

It is easiest to see this by taking a couple of practical examples. So, if your business needs a machine, the shareholders could either invest their own funds in order to buy it or you could borrow money with which to buy it. If you were to borrow money you will have bought an asset, so putting an asset on the balance sheet; but you will also have to show the corresponding liability for the loan.

Alternatively, you might find a finance company which will be prepared to buy the machine for you and put it into your factory. It won’t be your machine, so the asset will not appear on your books but neither will you be taking out a formal loan that does so either. The finance company, however, will only have undertaken this transaction on the basis that you have signed up to an agreement that you will rent the machine over a period of time, at a cost that will cover the cost to them of the machine, plus their charges and an interest rate that is their profit on the deal. As a rental agreement stretching into the future this will not normally appear on your balance sheet as a liability.

Yet really this is still debt.

• The funding to buy the machine for your business’s use has come from someone and it isn’t the shareholders, who would otherwise have had to put up shareholders’ funds to do so.
• Your business will be committed to making the rental payments over the next few years as if it were repayments of a loan.
• You are committed to a set level of payments every month or quarter the way you are with any loan (as opposed to dividends which you might choose not to pay to the shareholders if they had funded the machine) so the financial risk to the business is the same as a loan.
• The rental cost includes an element which is undoubtedly interest on the sum ‘borrowed’.

As a second example, if you have a valuable asset such as a property and your business needs some funds, you might arrange to borrow money against this by way of a commercial mortgage at say 70% of the property’s value. Again this will show up clearly on the balance sheet as cash having come into the business, matched by a liability for a new loan.

Taking this further, however, in order to raise more cash for your business than you could get through a normal mortgage, you might enter into a sale and leaseback arrangement instead. This is where you arrange to sell one of the business’s assets, such as plant and machinery or property, to a finance company or investor at its full open market value. This enables you to release the entire value of the asset into the business as cash, but at the same time you agree to rent it back for a specified period (in some cases with an option to buy the assets back again at the end of the arrangement) so that you can continue to use the asset.

In this case what would appear on the balance sheet would again be an inflow of cash, but this time matched not by a loan but by the disposal of the asset involved.

Essentially, as in the ‘rental’ scenario discussed above, this type of transaction is still really a form of loan.

• Your business has the cash without the shareholders having to put up funds.
• Your business still has use of the asset.
• The lender has the security of the asset (it’s just that they actually have ownership of it rather than the mortgage company’s claim to seize it and sell it if they are not paid).
• Your business has a regular stream of payments that it needs to make monthly or quarterly that will include an element of what is clearly interest on the sums involved.

For the sake of this book, these types of financing sources, which might be described as quasi debt, such as say operating leases, are included in the section on debt as they are ways of obtaining assets for your business, are clearly not equity sources and are usually provided by very similar financial institutions to more mainstream lending.

So debt can involve:

• formal borrowings such as a loan or an overdraft;
• informal borrowings such as credit extended by a supplier;
• arrangements which provide the equivalent of a loan in terms of cash or an asset received, with a matching obligation to make payments, even if they do not appear as a liability on the balance sheet.

What you can see from the balance sheet is that debt divides into short- and long-term funding. For accounting purposes, anything due for repayment on demand (such as an overdraft), or due within the next 12 months (such as trade creditors or the next year’s worth of lease instalments), will count as current liabilities on the company’s balance sheet, whilst money not due in until over a year’s time will count as long-term liabilities.

This chapter will therefore give a brief overview of the main sources of borrowings and types of lending available.

The following chapters will look more closely at bank borrowings, and issues such as security, before then reviewing the alternatives to banks that are now increasingly available in respect of borrowings for both investment and working capital.

WHO CAN YOUR BUSINESS BORROW FROM?

Your business can borrow from a number of different types of lender.

Yourself

You can obviously lend money to your company in a number of ways. In fact in many start-up situations it is very common for the owner of the business to do so by, for example, personally bearing expenses on behalf of the business which are only reclaimed from it later.

However, there is nothing to stop you as a director lending money to the business more formally by way of a director’s loan rather than by injecting equity, if you have the funds available. This should be considered when discussing the appropriate financial structure of the business with your advisers. Obviously repayment of the loan principal is payment of a debt by the business and is therefore not taxable in your hands as income.

If you are lending money to your business, though, there is also nothing to stop you charging the business a reasonable commercial rate of interest and this interest income would be taxable.

You can also lend money to the company by way of some of the quasi debt approaches discussed above. So you could, for example, do the following.

• Purchase an asset that the business needs (such as a property) in your own name and rent it to the business at a commercial rate (but it may be more tax effective to do so through your pensions scheme if you have one available, see Chapter 8).
• Act as a sale and leaseback financier to the business by purchasing assets from it and renting them back.

If you are considering such a sale and leaseback transaction you will need to be careful of the following issues.

• There are restrictions imposed on the sale of substantial business assets from a company to the directors under Section 320 of the Companies Act. These rules are designed to prevent directors looting a company’s assets without the knowledge of the shareholders and so the purchase by a director of any substantial assets (in effect anything over the value of £100,000 or 10% of the balance sheet value) requires the approval of the shareholders in advance.
• Transfer at an undervalue, which is where an asset is sold at less than its fair value. In the event of an insolvency, the administrator or liquidator will review transactions going back over the two years leading up to the business’s failure and can take action to set aside transactions at an undervalue.

Many of the above approaches will have significant tax planning implications so you should always seek advice on any proposed lending from your tax adviser.

If you are considering lending money to your business you should always ask yourself why it is required and what are the risks. If necessary, for example in a situation where the business’s solvency may be an issue, take professional advice and resist the temptation to send good money after bad. After all, the business’s cash requirements may still be more than you are able to afford and as an old saying popular amongst insolvency practitioners has it, ‘There’s no point putting enough fuel in the airplane to fly halfway across the Atlantic’.

For example, the managing director of a north-eastern business was coming up to retirement and had cleared the mortgage on his house. The business, however, got into difficulty and he decided to take out a mortgage on his matrimonial home in order to generate cash to put into the business. Unfortunately the business then failed, which of course meant he had no income from the business with which to make the mortgage repayments.

However, if you are lending to your business, don’t forget that you can arrange to take security for your loan to help protect your position.

Related parties

The next group of potential lenders are related parties such as family and friends who may be interested in advancing money by way of a loan.

Family members or friends can be a good source of funding for you. First, they already know you and your character and abilities. They may therefore be more willing to lend to you than an institution which does not know you, and are less likely to want to see a detailed business plan and sets of forecasts. They may also be more flexible and willing to lend without taking formal security, or to lend to you at lower interest rates than commercial lenders.

The disadvantages of borrowing from family and friends can be that they:

• lend you more than they can really afford so causing a high degree of stress;
• can find that they need the money back at a time when you cannot afford to pay it to them;
• may not understand the difference between a loan on which they are paid interest and an investment where they are entitled to a share in the profits of the business, or even to become involved in helping to run it.

Think carefully before accepting money from such sources as to the risks involved and the impact it might have on your relationships if it all goes wrong. For example, a retired professional invested a large proportion of his pension pot in backing a new company which was developing a new product. Eventually this business had used up all of his available cash and needed more. The individual involved persuaded his brother to put in a sizeable loan, only to find that the business went into insolvency the following month.

In particular, if your business plan has been turned down by normal commercial funders, think very carefully about why they have done so, before being tempted to use family and friends as lenders of last resort.

If you do borrow from family and friends then you should draw up a written loan agreement clearly setting out the arrangements including the rate of interest, length of the loan and the scheduled repayment dates, as well as any other conditions agreed such as a share of profits (if any), role the lender is going to have in the business (if any), as well as how any disputes may be dealt with. To minimise any possibility of subsequent problems it is probably worth having this drawn up by a solicitor.

Having a written agreement will also help you should HM Revenue & Customs ever take a look at the interest you are paying out or the interest the lender is receiving, which they will have to declare on their tax return.

Involving a pension scheme

Another related party that is sometimes overlooked is your pension scheme. A personal pension scheme is essentially a pot of money held in a trust that is controlled by the trustees of the scheme in accordance with the scheme’s rules. The trustees’ job is to both protect the funds received into the scheme and invest these so they grow.

As a result, pension schemes can be involved in funding a business in two ways.

• In some circumstances the trustees of the fund may be able to invest part of the fund by making a loan to the business at the appropriate commercial rates of return and terms for such a loan. It must be said, however, that such loans are rare.
• As a pot of cash and investments, personal pension schemes are usually by definition in a good position to borrow money at cheaper rates than the underlying business with its mix of assets and liabilities. So if the business is in need of cash and the pension scheme has sufficient assets and borrowing capacity to do so, it can make sense for the scheme to borrow sufficient funds in its own right to purchase the company’s property from it on a sale and leaseback basis. Indeed if you are contemplating buying a commercial property personally, with a view to letting it to your business, then you should take advice about doing so through a pension scheme so as to obtain the maximum tax benefit available.

The ability of any pension scheme to engage in these sorts of activities is a complex area and will be dependent on the type of scheme involved, the rules of the scheme and its financial position including its capacity to borrow. To undertake any such loan you will need to take expert professional advice from an IFA experienced in this area. Finance brokers who organise such borrowings can arrange an introduction to such an adviser if required (see the Useful Contacts section at the back of the book).

Trading partners

The third general category of lenders are those people, businesses and institutions with which you are engaged in trading from day-to-day.

When suppliers provide goods and allow your business time to pay, this is in effect an interest free loan (although the supplier should have costed in the credit they will allow the company in pricing the job). The more that your business is able to borrow from suppliers with their agreement in this way, the less you have to borrow elsewhere.

Managing and maximising the financing available, through trade creditors and other sources such as the Crown in respect of PAYE/NI and VAT, has already been discussed in the need to manage your working capital covered in Section A.

The level of credit you will be able to obtain from trade suppliers is, however, increasingly becoming dependent on your business’s credit rating as the role of credit insurers grows in the UK. Credit insurers are companies through which a supplier can take out a policy that you will pay your debt to them. This service is increasingly being used in connection with invoice based finance such as factoring or invoice discounting which are themselves growing in importance (see Chapter 9).

Simplistically, credit insurers work by allocating a total level of risk that they are prepared to take in respect of your business across their portfolio (say for example this was £100,000). They will then parcel this amount out to a series of credit limits (which might be ten limits of £10,000 each) to their customers who wish to trade with you until this limit is used up.

Obviously therefore, in order to maximise the credit available from your suppliers, you will want them to be able to find as much cover from insurers as possible. You therefore need to manage your credit rating so as to avoid problems by doing the following.

• Filing your accounts on time; late accounts are considered a significant early warning sign by most lenders.
• Filing profitable accounts that show a positive balance sheet and most importantly demonstrate, when the insurer prepares an SSAF (see Chapter 4) from them, a business that has been generating cash.
• Avoiding an adverse credit history such as County Court Judgements, loan arrears and so on.

The dangers of failing to manage the position can be significant.

A company turning over £20m failed to file its accounts on time at Companies House and the credit insurers contacted the finance director to request copies of the accounts and management information. When they did not get a reply, the credit insurers cut the company’s credit limit by 50%. The effect of this on the business was that major suppliers who had previously been willing to allow credit of up to £200,000 and £300,000 in some cases immediately reduced these limits by 50%, in turn resulting in an immediate cash crisis for the company.

If you have a poor set of accounts to file and are concerned about the impact this may have on your credit rating, supply the following to the ratings agencies at the same time as the poor accounts are filed:

• an interim set of accounts for the following period that demonstrate a return to profitability; or
• a set of projections that show how this is to be achieved.

If you can do this, you can then contact the ratings agencies direct to discuss the position, although I would always recommend doing so through a professional adviser such as a member of the Society of Turnaround Professionals (www.stp-uk.org).

There are some other potential sources of finance that may fit with this category of lender, the key ones of which are as follows.

Trade or joint venture partners

Your business may have strong trading links with another business, acting for example as one of their key suppliers or developing new products for them, or be involved in a joint venture to developing or supply a particular market. As part of such arrangements there may be scope for your business to borrow money from the other party.

Dealer facilities

Where you are a franchised main dealer for a manufacturer such as a car maker, it is in the manufacturer’s interests to enable you, for example, to carry a stock of their goods for use as demonstrators. Manufacturers may therefore have in-house financing arrangements to assist their dealers in carrying appropriate levels of trading and demonstrator stock.

Brewery loans

The breweries are amongst the biggest lenders to the licensed trade, offering a variety of property and trading loans as a way of tying in licensees.

Vendor finance

Where you buy a business, the seller may allow you a period of time to pay either a specific amount of the sales price (known as deferred consideration), or part of the price of the business may be determined by the trading performance over a period following the sale (known as an earn out). In both cases the seller is providing you with what can be a substantial amount of credit.

Banks

The obvious first source of formal finance for your business is from the high street clearing banks. Their operations are covered in more detail in the next chapter.

The advantage of the banks is that they can act as a one-stop shop for finance as they can offer:

• short-term working capital finance through an overdraft and longer-term finance for investment in assets through term loans;
• a reasonably full range of specialist financing products (such as leasing or factoring) through specialist in-house subsidiaries.

Banks traditionally see themselves as cashflow lenders in that they are first and foremost interested in assessing the business’s ability to make repayments out of its trading cashflow. But as demonstrated in the next chapter, other than in the case of either very small loans, or in some specialist situations such as funding an MBO, the banks are in practice actually only happy to lend when they also have security in position that can be taken if required at a later point.

One point that it is worth making here is that the appetite for deals, efficiency of operations, and approach to risk or even lending into entire sectors of individual banks and other lenders will vary markedly over time. The following are examples.

• The institution decides it wants to grow its market share and therefore presses for new business.
• In some of these cases the lender has not kept up its investment in its back office functions and therefore its efficiency in handling your loan or account can suffer as these systems are unable to keep up with its growth.
• After a period of growth the lenders might become concerned about a level of potential bad debt in its book and decide to reduce its exposure to new business to concentrate on dealing with what it already has.
• In some cases the lender can simply run out of funds to put out into the market (an issue usually only for smaller private lenders) and is therefore unable to write new business.
• A lender may feel it is becoming over exposed to a particular sector (such as say, property development) or it may have caught a significant cold on a particular type of loan or in a specific industry and as a result decides to restrict or avoid further business in this area.
• The departure of a specific individual or team with particular expertise within the lender leaves the lender unable or unwilling to become involved in further lending of this type.
• The lender’s parent decides to sell the business to a new owner or even occasionally to shut it down.

As a result we find as brokers that the lenders we deal with on a regular basis will generally change over, say, a three year cycle as the active lenders of one year are replaced by others. Knowledge of these market trends is part of the value that a good commercial finance broker can add to your business.

Because of this cyclical nature, this book will generally avoid recommending any particular lender or institution, as a source of finance’s stance may be very different at the time you want to use it from the position at the time of writing.

Other financial institutions

As alternatives to the bank’s one-stop shop there is a wide range of independent funders and specialist finance providers who can provide lending against specific types of asset. You may be familiar with some, eg building societies, but many, such as the factors and invoice discounters or plant and machinery sale and leaseback funders, you may not.

This type of lending is generally known as asset based lending as it is focused on a particular class of asset. Some lenders are much more focused on the asset valuations on a pawn broking basis than on the borrower’s ability to pay the debt or the interest (to service the debt).

Asset based lenders

Asset based lenders have traditionally been stand-alone, independent specialist funders who would finance against any one particular class of asset. As will be discussed in Chapter 7, using a mix of such specialist lenders (such as a factor to lend against debtors, a building society to lend on the property, and an asset financier to cover the plant and machinery) can provide the ability to borrow more than could be obtained from a bank.

Over the last few years, however, many of the specialist funders have been extending their operations to become full asset financiers or asset based lenders (ABLs). So you will find that many of the invoice discounting firms have expanded the range of financing they have on offer in-house to include property lending and plant and machinery finance (and even become accredited for SFLG loans) so as to be able to provide a full package of funding across all types of asset, including stock in some cases.

This type of structured finance started with the larger players and is used extensively in many MBO/MBI transactions. It is becoming more and more mainstream, such that these ABLs are now increasingly providing a direct one-stop shop, competitive financing option to the banks. In doing so, however, these lenders are having to become more concerned with businesses’ underlying cashflows and monitoring of performance and so start to act more like banks.

One symptom of this is that these lenders, which are generally factoring or invoice discounting houses, will try to limit their overall exposure to say 150% of the total debtor book value, so as to keep their lending focused on the area and type of asset where they have most experience.

As a result, as shown by comparison in Chapter 7, this means that you can generally borrow more through a structured finance ‘package’ from such a provider than you can from a bank. But you can still generally borrow more by using a mix of specialist funders.

Other options

Going beyond these there are also the following possibilities.

• Venture capitalists, which will often structure part of any investment funding package as debt to be repaid by the company as swiftly as possible. This approach means that many venture capital funded MBO/MBI companies are under extreme cash pressure right from the outset in order to meet the repayment schedule.
• Merchant banks, which are firms whose main activity is using their funds to participate in transactions as financial partners and providing funding to trade and industry by doing so. They tend to become involved in higher value transactions where they are able to generate minimum fees themselves of say £50,000, and where the more traditional routes of funding may not be available because of the risk or a lack of security. From this point of view they may be looked at as really being involved in:
  • cashflow-based transactions;
  • specialised bridging requirements; or
  • quasi equity risks; and as a result expect to charge fees giving closer to an equity rate of return.

The public

Finally, for quoted businesses there is also the ability to borrow money directly from the public and from investing institutions through the markets by issuing debentures.

A debenture is a form of bond issued by a company which entitles the holder to receive a payment of interest at set intervals until the bond is redeemed by the issuer, at which point the issuer pays the holder the nominal value of the bond (or in some cases an additional amount as a premium).

As a publicly issued security your business would require professional assistance in issuing debentures in the same way as you would in listing shares for sale on the stock exchange.

KEEPING YOURSELF SAFE

While talking about the large range of lenders who you can borrow from, if your circumstances mean that you need to arrange to raise money from non-mainstream sources then you also need to be careful about how you find a lender and who it is. Particular dangers are finding that you are dealing with any of the following.

• Loan sharks are unregulated lenders who charge extremely high rates of interest.
• Predatory lenders, by which I mean lenders who may have another agenda, or unfair terms such as excessive repayment penalties or the ability to impose changes in their terms at short notice, or hidden charges.
• Advance fee fraudsters who will take an upfront fee to arrange financing, together with collecting cash to arrange valuations and sometimes even a monthly retainer until such time as they manage to raise finance (so how is that designed to incentivise them to succeed?), but who never deliver the funding promised. While the cash paid out to this type of fraudster is bad enough, things can get even more serious when the victim then goes ahead with a transaction based on the understanding that they have finance in place when this is not the case. In the past two years we have come across what appear to us to be a number of examples of this problem including:
  • an individual who put down a multi million pound deposit on the purchase of a commercial development property based on an offer of funding, but who was then unable to complete and not only lost his deposit but was also facing an action for costs and interest from the vendor;
  • an individual who had completed on the purchase of a development property using a bridging loan at high rates of interest, and who then thought that they had arranged replacement finance, only to find that when they went to sign the completion papers for the loan they were dealing with an empty accommodation address.

A good way of finding the best loan for your business, and hopefully therefore avoiding these risks in the process, is by using the services of a commercial asset finance broker.

Such a broker may take a small commitment fee to enable them to ensure that you are serious about raising finance through them, but the bulk of their fee should always be based on success. You should check any brokerage’s terms of business carefully on this point as the fee should be based on your successfully completing a loan; not just on the brokerage providing you with an ‘in principle’ offer. This is because these offers are only intended by lenders to be indicative of the terms on which they will offer a loan to you, are subject to a number of conditions and are not contractual commitments which can be easily generated by a broker from lenders and may be on terms not acceptable to you. So an unscrupulous broker could charge you a success fee for obtaining an indicative offer, that you may never actually be able to use and which may not actually meet your requirements.

Creative Business Finance Limited’s terms of business for example are currently based on the following lines.

• No upfront fees.
• 1 % success fee on your acceptance of an offer of funding (so it has to be an offer that you decide to take).
• A right to charge 0.25% fee if the brokerage obtains a formal contractual offer of funding (known as a sanctioned offer) that matches your requirements which you then decide not to accept, to compensate for the work they have undertaken.
• No fees to you as a customer in respect of arranging factoring or invoice discounting arrangements, as lenders all pay similar rates of commission for business that is introduced.

These general principles will also apply to brokers or other organisations who raise equity finance, although as this is generally a more difficult and risky exercise, rates of contract fees and success fees are generally higher. For example 5% plus a share in the equity raised seems common. Brokerage rates may vary significantly, however, so it is always worth shopping around. I have for example come across clients whose accountancy firms have talked about charging a 10% fee for finding and arranging finance.

However, you also need to be careful to find and use a reputable broker where you can have confidence that they will look after your interests.

We have for example come across cases where the following happened.

• A broker arranged a multi-million pound bridging loan for a client to buy a development property. In doing so they did not arrange for the interest to be rolled up until the bridging loan was repaid. Instead they put the client into a loan where the interest was due monthly on the basis that they would also arrange development funding which would be used to pay the loan interest as it went along and fund the build. The broker collected his fees for arranging the bridging loan but failed to put the development finance in place. The result was that the client was unable to pay the first month’s interest and was immediately liable for default rates of interest (which in bridging can run at 3% to 5% a month) and then faced a bankruptcy petition from the lender.
• A client found a development site and spoke to a broker to arrange financing, but it appears that the broker brought in his own property investor and bought the site to undertake the development themselves instead.

The National Association of Commercial Finance Brokers (NACFB) is the trade body for asset finance brokers and was set up in the first instance to tackle the issue of advance fee fraud. Any reputable brokerage should therefore be a member and a list of members can be found on their website www.nacfb.org.