Debt financing for small businesses

There are many ways a business can get debt financing, such as borrowing from friends and family, crowdfunding, bank loans, or personal loans from the government-funded Start Up Loans Company.

Today’s small business owners can raise money for their business in a number of ways. From selling equity to using crowdfunding platforms, the opportunity to secure funding is increasingly varied. However, more traditional ways of raising money still have a place and debt financing might be a good option for your business.

What is debt financing?

Debt financing is one of the more popular ways for small businesses to get a cash injection. You can borrow money from a wide variety of sources to help kickstart a business idea or grow your company. According to a report by the British Business Bank, gross bank lending excluding overdrafts to smaller businesses reached £57bn in 2017, and remains the single largest source of SME finance. The report found that 72% of new loan applications by small businesses were successful.

How debt financing works

Debt financing works differently to equity financing – another popular way to raise money. Unlike equity financing, debt financing doesn’t involve selling a stake in your business in exchange for cash. Instead, debt financing is a loan that has to be paid back in full, along with interest. Loans are usually – but not always – secured against business or personal assets such as premises, intellectual property or money owed to you by customers.

Loan interest hinges on a number of factors. The amount borrowed, the length of the loan, and whether the loan is secured. Other factors, such as the Bank of England base rate, also play a part in setting the interest rate.

Why choose debt financing?

The key benefit of debt financing is control. Rather than giving away a share of your company to secure investment, you retain 100% of your business. This means you can develop your business without outside influence, and you’re not railroaded into focusing on growing shareholder value or generating profit.

Business loans are relatively cheap. You’ll need to repay the entirety of the loan, along with interest and any administrative fees. As the UK is experiencing a period of record low interest rates, the amount you pay in interest may be low.

You can use most business loans for any purpose. One of the more common uses of debt financing is for managing cashflow – tiding a business over during quieter times or while waiting for customer payments. It’s possible to borrow debt financing against outstanding invoices, making it a boon for smoothing cashflow. It can also be used to hire and pay for staff, buy premises or other assets.

Some interest repayments can prove costly so make sure you understand the amounts required. As many loans are secured against assets such as equipment or premises, be clear what’s at risk if you can’t keep up repayments.

Types of debt financing

There are many ways a business can get debt financing, such as borrowing from friends and family to applying for a loan from the government-funded Start Up Loans Company.

Family and friends – The simplest form of debt financing is to borrow money from friends and family. This can mean low or zero interest repayments and more time to repay a loan, but it can put a strain on personal relationships.

Start Up Loans – The Start Up Loans Company offers personal loans of up to £25,000, which can be used to start a business or grow one that’s been trading less than two years. Loans have a 6 per cent fixed interest rate and are repayable over a term of one to five years. There are no early-repayment or set-up fees, though you must be a UK resident, have the right to work in the UK and be aged 18 years or older.

Bank loans – The local high-street bank is the first port of call for over half of all small businesses. The process for applying for a loan and getting it approved can take time, so it’s not suitable for those needing an urgent cash injection. Credit history and current business performance matters – around half of all applications are rejected, and loans to SMEs by banks have fallen by 20% since 2008.

Debt financing crowdfunding – Known as peer-to-peer lending, small firms list their business on a crowdfunding platform and attract small loans from individuals. Together these form a larger, single loan managed by the crowdfunding platform. The benefit can be lower interest rates, though applying may adversely impact your credit rating making it harder to raise money later on.

Enterprise Finance Guarantee (EFG) scheme – If you’re struggling to get debt financing you can apply to the EFG scheme. This government-backed scheme provides a 75% guarantee against the loan. It covers debt financing between £25,001 and £1.2m for SMEs and has loaned £3.2bn to over 29,000 SMEs since its inception in 2009.

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