WHAT SORT OF BORROWINGS ARE AVAILABLE?

The main lending institutions providing funds to small and medium-sized businesses are still the mainstream clearing banks. So the best place to start is with the two main products provided by the banks.

Overdraft

Much UK business funding has traditionally been by way of overdrafts as they tend to be the most flexible banking facility offered.

An overdraft is a short-term borrowing facility on a current account that will be set to an agreed limit. It is intended by banks to finance your working capital requirements, and can be drawn on and repaid on a daily basis. It is therefore very flexible as you are only borrowing what you need while you need it, and you only pay interest on the funds that you have actually needed to draw on.

Think of it as a revolving credit that should cover temporary timing differences between payments you have to make to suppliers and receipts from customers. Banks will therefore expect to see a current account swing back into credit on a regular basis and do not expect to see it used for purchasing long-term assets. As a short-term facility, an overdraft is usually repayable on demand.

The bank will also generally look to take some form of security for an overdraft by way of charges over a parcel of assets.

Caveats

Because of this approach to taking security over a range of assets (some of which, such as stock and debtors, will vary in value significantly from day-to-day), banks will take a relatively cautious view in assessing the real value of their security while specialists at lending against specific types of asset may be able to lend more. Banks will also only put a facility in place for a limited period (say a year in normal circumstances, a few months where there are problems) so that they can review the level of funding they are offering against the current security position. You therefore have little long-term certainty of funding and, of course, each renewal of facilities will cost money in the form of an arrangement fee.

Overdrafts are also time consuming for banks to manage, so expect to see banks moving more and more customers across to factoring facilities as an alternative to overdrafts.

Banks will also apply significant charges if you exceed your agreed overdraft limit.

Term loans

If you are looking to invest in long-term assets, such as plant and machinery or property, you should borrow over a period that matches the expected useful life of the asset being bought so that it repays the borrowing over its useful life.

Fixed rate loans offer you certainty over the payments you will make (but can therefore be inflexible and have repayment penalties built in).

Variable rate loans tend to be more flexible, but leave you exposed to uncertainty as interest rates change over time. If you are borrowing significant sums (say over £250,000) you may be able to buy what is in effect an insurance policy against interest rates going up in the form of a rate cap.

Looking more widely it is easiest to think of lending by the category of asset it applies to.

Property lending

Mortgages

A mortgage is essentially simply an example of a long-term loan secured against a property and all the points above apply.

Where a business has a property that is not fully lent against, remortgaging is usually the cheapest and easiest way to obtain finance.

Commercial mortgages are available from a wide variety of lenders. Clearing banks and building societies are active in this area but will tend to turn down (decline) prospective borrowers who are ‘sub prime’. This means businesses with an adverse track record of County Court Judgements, loan payment defaults or insolvency proceedings, poor interest cover, or a history of losses over, say, the last three years. There are, however, a number of lenders who will cater for such sub prime borrowers, some of whom will offer loans on a self-certification basis where you do not have to prove your business’s income or ability to meet the payments.

Bridging loans

One solution for short-term funding in respect of property is a bridging loan. Bridging loans are normally short-term loans that typically allow you to spend money that is anticipated (usually from the sale of an asset such as a property) before the cash has been received.

They can also be used to raise cash against an already owned property as emergency funding. However, while this can raise say 70% of the security value of a property within two weeks, this type of funding is extremely expensive and interest rates can often run at 1.25% to 2% a month together with substantial arrangement fees.

Banks will generally only be interested in offering closed bridges where an already agreed sale of the property or refinancing with another lender provides an established exit.

Non-bank lenders will also offer open bridges where the lenders’ exit route is not put in place in advance.

Such lenders are generally quite open to sub prime borrowers as they lend on a non-status basis, which is to say they lend simply on the basis of the value of the security and without reference to your ability to pay.

Sale and leaseback

In a sale and leaseback, you sell your property to an investor realising its full open market value for cash (which in some cases may be significantly higher than a valuer may estimate it at for borrowing purposes). You then take out a lease on the property, typically of 15 or 25 years on normal institutional terms (such as upwards only rent reviews every five years). The new owner then holds this as an investment property and will be looking for the rent charged to provide a reasonable current market yield against the price paid for the property, which in current market terms could be anything from 7.5% to 10% of the capital value.

As the property is to be held as an investment, sale and leaseback is usually only applicable to larger properties (say over £500,000 in value). The investors will be concerned to ensure not just the value of the bricks and mortar, but the strength of the rental covenant being acquired which means your business’s likely ability to pay the agreed rent for the period of the lease.

Plant and machinery lending

Hire purchase

Hire purchase involves you in agreeing to purchase an asset by making payments in instalments over a set period.

Hire purchase agreements vary widely in their terms, offering fixed or variable interest rates, and you need to check the rates carefully (particularly where there is an interest free period, as rates for the balance of the term are likely to be high).

Some hire purchase agreements are structured with low ongoing payments and a large (balloon) final payment in settlement at the end.

In general, while you will be responsible for maintaining and insuring the asset from day one, legal ownership will remain with the finance company until the last instalment is paid, but for tax purposes you may be able to claim capital allowances.

Leasing

With leases, the finance company always retains ownership of the asset. There are three basic types of lease.

• Finance leases are usually used for major items of plant and equipment where the finance company buys the asset and the business pays a long-term rental that covers the capital cost, interest and charges, and is responsible for insurance and maintenance. Once the capital is repaid there may be an option to purchase the equipment outright or to continue to rent it indefinitely for a small fee (peppercorn rent).
• Operating leases are typically used for smaller items such as photocopiers, where the equipment is rented for a specified period and the finance company is responsible for servicing and maintaining the equipment.
• Contract hire is a type of operating lease where the renter is responsible for day-to-day maintenance and servicing (for example this approach is often used for motor cars).

You may need to pay an initial deposit on setting up a lease. From a tax point of view, while the rental can usually be treated as a cost, as you do not own the asset, you cannot usually claim capital allowances on it. There is a proposal currently that the tax treatment of leases will be brought into line with what would happen if you had borrowed the money as a loan and bought the asset, which would mean that you could claim capital allowances. However, these are only proposals at the moment and look as though they would only apply to leases of over five years, so the practical impact is likely to be minimal.

You also cannot generally use the asset as security for other borrowings as it does not belong to you.

If you already own valuable plant then using a sale and leaseback arrangement can be a way of raising cash for your business.

Working capital funding

Factoring/invoice discounting

This is allowing your company to raise money against its outstanding debtors by assigning the outstanding invoices to the lender who will advance you, say, 80% of the approved invoices immediately.

In factoring, the lender takes over management of the sales ledger and actively chases in payment, which can in itself be an advantage if the company’s credit control has been poor. In some cases factors will allow a CHOCs arrangement for key accounts (client handles own customers) whereby the company retains control of the contact with the customer.

Invoice discounting is usually only available to businesses with turnovers of greater than £lm and a positive balance sheet, and differs from factoring in that the company continues to run its own sales ledger and collect in the debtors. As the company is continuing to do the work, it is therefore possible to have confidential invoice discounting (CID) which means that the customers will not be aware of the arrangement.

Some invoice discounters will take stock into account and are then able to offer higher levels of advance against invoices (sometimes exceeding 100% of the debtor book).

As the lender takes over the debtors as security, these are then not available for a bank to secure its overdraft. So completion of a factoring deal usually involves paying off any existing overdraft out of the proceeds of factoring the ledger being taken over.

The issues you need to consider are these.

• With factoring you will lose control of how your customers are chased for payment. With invoice discounting, since you continue to run your own sales ledger this is not an issue.
• Your facility will be based on a percentage advance against approved invoices. The actual advance you receive as a percentage of your total debtors can be significantly less than this headline percentage as the factor may disallow debts over three months old, overseas debts; or may set concentration limits where individual customers’ debts cannot be more than a set percentage of your sales ledger. You need to look at the nature of your debts and ensure that you will not run into such problems with your factor.
• Factoring issues arising in respect of age or collectability impact on an individual debt on an item by item basis. With invoice discounting you prepare a monthly return and so such issues impact in a single monthly adjustment to your facility.
• Some debts are difficult to factor. There are only a limited number of factors who will deal with contractual debt involving stage payments (such as construction contracts).
• As the advance is tied directly to invoicing, factoring is well suited to fast growing companies as the financing automatically expands as the business grows, reducing the danger of overtrading.
• However, as the facility is tied to sales volume, if sales fall, so does the funding available (which may be just the moment that you need finance the most).
• Once you have this type of facility in place, it can be extremely difficult to get to a position where you can exit the arrangement.
• There is still a stigma attached to factoring in some circles as it has been seen as financing of last resort. However, as banks have moved more customers to this form of financing, this stigma is disappearing (and of course is avoided with confidential invoice discounting).
• Factoring and invoice discounting are often perceived as expensive. However, when comparing costs against bank facilities it is important to compare against the total cost of equivalent bank facilities including interest, management charges etc, to achieve a fair comparison.

Trade finance

This covers a variety of funding arrangements, the most common of which is in funding the importation of goods manufactured overseas. In cases where you are holding orders from customers that cover either all or a substantial part of the value of a container of goods that you wish to import, there are funders who will step in and finance the acquisition, transportation and clearing of goods through Customs on your behalf. They will then look to be paid from the proceeds of sale of goods. So some of these financiers will work hand-in-hand with a factoring or invoice discounting company so that the moment the goods are cleared, a sales invoice can be raised to your customer and factors, or discounted so that the advance can be used to pay the trade finance company’s charges.

Some of these funders are prepared to finance a wide range of risks (at a price) such as the following.

• Funding transactions which are not backed up by a confirmed customer order, such as the purchase of a quantity of fashionable consumer electronic equipment in the period leading up to Christmas, where the funder took the view that even without an existing customer order, they could rely on the goods being sold. However, in this case the funder took the precaution that the goods were held in their warehouses and were only released as they were sold, so that the lender could ensure their borrowing was repaid.
• Some lenders will also consider purchasing goods and raw materials on behalf of a company in difficulty which is therefore unable to make purchases on its own behalf, and then selling these into the company as required at a mark-up.

There are also specialist products available for specific sectors, for example a facility designed to provide motor and machinery dealers with the finance with which to buy and deal in stock. As a somewhat specialised service with a perceived high degree of risk in the underlying security, these types of arrangements can be expensive, but can still make sense if they allow you to undertake a profitable transaction which you would not otherwise be able to fund.

Away from the normal financial lending institutions, as seen for example in the automotive industry, manufacturers may provide their dealers with favourable stock financing terms or arrangements.

Block discounting

Where you have a long-term stream of income such as rental from property or machinery that is rented out, you may be able to borrow what is in effect an advance against this future income through block discounting. This is a specialist market where each deal is very much a one-off, so you are likely to need to use an independent broker to explore this if it is appropriate.

Other products

Finally there are some other lending products which do not rely on security and therefore are not tied to any particular class of assets.

Mezzanine finance

This is funding supplied by banks and a number of specialist providers which falls between normal secured debt and an equity interest in the business entitled to a full share of the profits. It is therefore applicable to situations where all possible sources of normal secured lending have been used, but where a business’s owners do not want to bring in further equity investors which would dilute their existing share of ownership of the business.

Mezzanine funders may therefore look at situations where a business has a strong potential cashflow, particularly where this is linked to ownership of potentially valuable intellectual property rights over which the funder may seek a specific charge.

As a high risk loan without traditional security, mezzanine finance is both expensive and rare, only usually being available for requirements in the millions as the providers have to tailor each arrangement to the specific circumstances of the borrower and will also need to undertake a detailed review of the proposal (a due diligence investigation) in the same way as a potential equity investor.

Wageroller

Wageroller is a newly developed product targeted at small and medium-sized businesses which are relatively strong credit risks, but which may have for example a seasonal cash requirement, or difficulty in raising working capital finance because for instance they are involved in contracting work which is difficult to factor. Wageroller provides a facility whereby up to two months’ worth of the business’s gross payroll is paid by the finance company, using a payroll bureau to make the necessary calculations if required, and is then repaid by the business on a rolling basis.

The finance company does not take any security for this service, so can be used by businesses without disturbing existing overdraft or factoring/invoice discounting arrangements. It should be looked at as essentially a rolling unsecured bridging loan to cover two months’ wages. Interest rates are higher than normal bank overdraft levels with an initial minimum period of three months, and there is a monthly administration charge, but once put in place the business can reuse the facility at will. For further details contact finance@creativefinance.co.uk

SOURCES OF ADVICE

Given the number of sources of finance available you may want to seek advice as to which is most appropriate for your business. There are number of sources that you might consult. The main ones are listed below.

Your bank manager

Your bank manager will obviously be experienced in finance and will have experience of advising many businesses of your size. The disadvantages are, however, that they will only be selling the bank’s own products (for which they will probably be incentivised by the bank), and of course they are unlikely ever to have actually been in the position of running a small or medium-sized or entrepreneurial business themselves, so this may not be the best option.

Your accountant

Your accountant is a good choice to a degree as they should know your business and understand your objectives. However, when it comes to raising finance for your business their experience may vary, as will the amount of time that they devote to keeping in touch with the market. They may therefore not be particularly up to date with individual lenders’ preferences, or aware of new products coming onto the market that might provide you with what you need. Whilst they can be very helpful in giving you advice as to the general type of finance you need, they can be poor at actually finding you the right deal. In some cases they can even be actually harmful, such as where they adopt a shotgun approach, firing out details of your requirements to every lender in the market, which can actually damage your chances of getting a reasonable offer, or where they are inexperienced at managing the process through to a conclusion. They will also tend to charge by the hour and so their fees are usually not success based.

Business Link

Your local Business Link is intended to act as a signposting organisation directing you to appropriate advisers in all areas including finance. However, due to the way that they had been run in the past some Business Links have a poor reputation and so some advisers are reluctant to work with them. Furthermore, given the hoops through which you have to jump to become a Business Link accredited adviser, many firms providing financial advice, and in particular those with a strong reputation who attract a good volume of work in any event, simply do not bother.

Brokers

A broker is a specialist in raising finance and so will have a good knowledge of what is in the market, particularly in how to combine different pots of lending from different funders into a sensible package; and experience in project management to get a deal through to completion. The disadvantages of using brokers are that they will be sales orientated and will be focused on the type of finance that they raise, so their ability to give you more general advice about the right type of finance for your business may be limited. As this is an unregulated area of business where anyone can call themselves a broker, you should also read the warnings about unscrupulous brokers in this chapter and you should always check that the broker is a member of the trade association, the National Association of Commercial Finance Brokers, and preferably that the bulk of their charges are on a success fee basis.

The best combination for most businesses is therefore probably a mix of advice from your accountant who understands your business and can advise you on the type of finance you need, and working with a good broker who understands the market and how to place and complete the deal.

ISLAMIC FINANCE

Finally, the Islamic world, like everywhere else, has its traders and businesses that require financing and so has developed a financial industry. However since under Islamic law (Sharia) the charging of interest (riba) is forbidden (haram), Islamic banks and finance institutions operate quite differently from mainstream UK lenders.

As there are now Islamic banks operating in the UK which provide finance to customers irrespective of religion, this section gives a very brief layman’s outline based on my understanding of how Islamic finance operates.

Since the charging of interest is forbidden, Islamic financial institutions have had to find an alternative way of being rewarded for providing funds. As a result some Islamic finance arrangements seem to be based around the idea of shared ownership of an asset to be financed between the borrower and lender with shared profit, instead of interest and shared risk. The result of this approach can seem to be more one of a partnership between the lender and the borrower than a traditional UK banking arrangement.

The three main financial instruments to be aware of are the following.

• Ijara, which is equivalent to a leasing or hire purchase arrangement where the funder buys the assets involved, (typically motor vehicles or machinery) and the borrower makes regular payments for its use and, in some variations, obtains ownership of the assets at the end of the period.
• Murabaha, which is a form of trade finance where the funder buys the goods (typically raw materials on behalf of a manufacturer) and then sells these to the manufacturer at a mark-up on cost to give a service charge, which in some variations can be paid by instalments.
• Musharaka is a form of joint venture that is equivalent to a partnership in that investors share the profits in proportion to their investment in the venture. However, they also share the risks in the same proportion and have unlimited personal liability.

The Islamic approach to law recognises that circumstances change over time, and that therefore guidance under the Sharia will need to be provided to cover new situations and issues as they arise. Financial products and services are no exception to this and so Islamic financial institutions will have a group of Sharia advisers or a Sharia board whose job it is to ensure that any new products or arrangements comply with Sharia requirements in that they are not in conflict with the teachings of the Koran or precedents. Internationally the Islamic Financial Services Board has been set up to seek to standardise Islamic approaches to finance.