FundOnion's Guide to Business Loans
1) Introduction to business loans
A business loan is any kind of loan offered to a commercial entity, rather than an individual person. As with all loans, it involves the creation of a debt, which will be repaid with added interest. There are a number of different types of business loans available.
The finance industry
The financial services world has seen big changes in the past ten years or so. One of these has been the huge surge in the use of technology – particularly for personal credit after the 2008 financial crisis.
This has led to the rapid growth of financial technology. Also known as “FinTech”, this is an industry made up of new companies that use technology to make financial services more efficient. A whole range of innovative new FinTech banking institutions have sprouted up like Revolut, Monzo and Tide.
There’s been a similar growth in the use of new technology for small business finance too. In fact, an excellent report by 11:FS pointed out that 2013 was the year when many smart new challenger banks across the UK shook up a stagnant lending market.
What we’ve seen since then has been a massive increase in the services offered to small businesses in the UK - from well-known lending brands such as Funding Circle or iwoca, to the more boutique providers who are still just as good.
So, what does this mean for you?
- The business loans market has more lenders than ever before.
- These lenders are competing hard for your business – which is good.
- It’s becoming harder and harder to compare loan products and work out what’s best for your business – which is not so good.
Our Rough Guide to Business Loans (and Working Capital) will help you through it all. You need working capital to keep your business running and help to grow it. Well there are three main ways to get it - regular term loans, revolving credit facilities and merchant cash advances.
We’re going to explain how they work, when to use them and how to apply.
It’s all going to be in plain and simple English with no financial jargon or buzzwords. That makes a change for finance stuff doesn’t it?
2) Term Loans
The most familiar kind of business finance is the good old-fashioned term loan. In recent years, high street banks have been unable to provide smaller-sized business loans because of increased regulation and higher costs.
So who’s lending and what’s available right now?
Check out our FundOnion Decision Engine to instantly see some of the lenders in the market right now, offering term loans from just £10,000 up to £500,000.
What are the fees?
Term loans are a type of business loan that work by giving cash to your business and setting fixed repayments usually monthly. You pay back both the amount you borrowed plus interest over the life of the loan.
The two most common types of term loan repayments are either amortising loans or balloon/bullet loans. These vary on when the amount you borrowed and interest are paid back.
What security is needed?
You can go for either a secured or unsecured loan. With an unsecured loan, you can usually borrow up to a maximum of £250,000.
A secured loan means that the loan is secured against the value of an asset, just in case your business can’t keep up repayments. With a secured loan, the lending amounts can go much higher and are based on the value of the asset being secured against.
In short, secured business loans allow you to:
- Borrow more.
- At a lower interest rate.
- Spreading repayments over a longer period than an unsecured business loan.
This is simply because they represent a lower credit risk to a lender. If you don’t repay the loan, the lender can acquire the asset secured against it.
What are personal guarantees?
Personal guarantees can be a bit of a headache for potential borrowers. These go beyond your business and put your personal assets on the line if you can’t repay the business loan.
Lenders usually ask for these from the directors of the business applying for the loan and perhaps the major shareholders too. So make sure if you’re going to provide a personal guarantee for a business loan or any other kind of finance, that you fully understand the implications.
What’s more, personal guarantees are almost always required by lenders if you’re applying for a business loan. There are some alternative finance lenders who may lend either without a personal guarantee, or a limited personal guarantee, but this is not the norm.
3) Revolving Credit Facilities
Revolving credit facilities (or RCFs) are a less well-known form of working capital, but they can be a really useful product either on their own or alongside a regular term loan.
With an RCF, the lender approves a certain maximum amount (say £100,000), which you can draw on from time to time.
This is sometimes linked to an overdraft but is slightly different. That’s because Revolving Credit Facilities are ongoing agreements between you and the lender for a fixed term, like 12 months for instance. But they aren’t repayable on demand like an overdraft is.
The great thing about an RCF is that you don’t pay any interest on money you’re not using as you would with a term loan, where you get the whole lump sum at the start.
But there is a drawback. If you don’t use the money, lenders usually charge a non-utilisation fee so that they’re not making capital available to you for free! They want to get a return on it obviously.
Example of how an RCF would work:
- A bank authorises you with a revolving credit facility of up to £100,000 for 12 months;
- The fees for this include a £200 setup fee, interest payable on the money you use charged at 2.5% per month, and a non-utilisation fee of 0.05% per month; so
- During that 12 months, you use £50,000 of the RCF for 9 months and pay off the interest monthly.
What are the fees?
- Total interest paid for the 9 months = £11,250
- Non-utilisation payable on £50,000 for 9 months = £225
- Non-utilisation payable on £100,000 for 3 months = £150
What's a Revolving Credit Facility useful for?
RCFs are a useful type of Business Loan. They are useful if you need flexible funding. This isn’t just working capital to keep your business going smoothly, but also for growth such as running marketing campaigns or when revenue is fluctuating.
4) Merchant Cash Advances
Merchant Cash Advances (or MCAs and also known as Business Cash Advances) provide an upfront lump sum to your business. They take repayments based on a percentage of revenue from your business. Therefore, when deciding how much money to advance to your company, lenders usually look at your gross revenue.
MCAs work particularly well if you take a lot of money in credit and debit card payments. That’s because the lenders can simply plug into your payment processing system to deduct their take – say 10% of all sales for example.
The really interesting thing about MCAs is that repayments aren’t on a fixed schedule – they’re linked to your revenue. This is unlike a term loan where you’ll be making regular fixed monthly payments whether your monthly turnover is high or low.
It's not interest rate, it's factor rate
Merchant Cash Advances are also slightly different in that they don’t charge interest rates, but factor rates. These are simply a different way of measuring the cost of the money being borrowed.
They are worked out by multiplying the cash advance you receive by the factor rate. This is because all of the interest is added to the amount you borrow at the start. This then gives the total amount you have to repay.
For example, say you ask for a £15,000 cash advance with a factor rate of 1.2 for 12 months. This means that you would need to pay back £18,000 total (£15,000 x 1.2 = £18,000).
This might look like there’s annual interest here of 20%. But it helps to understand here that the interest cost of the advance is 20%, as it’s all added to the initial cash advance. This is different to an Annual Percentage Rate (APR) where the interest payments will usually decrease over the term of the loan.
How does repayment work?
5) Applying
Therefore, you need to think carefully about:
- The kind of finance that would be best for your business
- How much money you would have left at the end of each month to repay any loan, RCF or MCA you’ve taken on
When applying for a business loan, you should be ready to send to your lender or broker the following information:
- Basic business information such as your trading name, legal entity name, company number
- What your business does and a brief description of your activities
- Your last full filed set of annual accounts
- 6 months’ worth of business bank statements
- Information about any overdraft you have in place
- Information about any other kinds of debt you have outstanding – amount, repayment dates, payback period
Right now, the market has plenty of lenders all with slightly different attitudes to lending and the risks they’re prepared to take with a borrower.
6) Tiers - an industry secret
At FundOnion, we often talk about lenders being Tier 1, Tier 2 or Tier 3. This isn’t a measure of how good that lender is or their quality of service, it’s a reflection of how much risk they are willing to take when lending.
Tier 1 - Institutional lenders
This tier includes high street banks and is the cheapest tier, but least willing to take on any risk when lending.
Tier 2 - Merchant banks
These are specialist banks who filled the gap when high street banks stopped providing smaller-sized business loans.
Tier 3 - Specialist lenders
Includes independent financial organisations who may be able to help businesses which can’t tick all of the ‘bank’ boxes.