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Corporate & Commercial
The impact of Covid-19 and the resultant financial pressure has raised the question for many entrepreneurs of how to finance their businesses. Helen Ingram looks at what entrepreneurs should consider.
3 minute read
8 January 2021
The impact of Covid-19 and the resultant financial pressure has raised the question for many entrepreneurs of how to finance their businesses.
The Bank of England’s Credit Conditions Survey for Q3 revealed that banks expect the availability of lending for the corporate sector to decrease over the remainder of this year.
With default rates rising, banks have reportedly been taking measures such as lowering credit limits, increasing the premiums charged over riskier loans and widening the spreads on corporate lending.
The scarcity of conventional sources of borrowing will lead business to look at secondary sources of finance, which may be more risky, and be more expensive because of the scarcity pushing up the price, and because secondary lenders are just more expensive.
In the circumstances, it is easy to see why the option of taking an informal loan, for example from a friend or relative may seem attractive to many businessowners. However, given the truism you should never go into business with family and friends, it is important to be aware of the risks which can accompany these arrangements.
When borrowing from a friend or relative, it is easy to fall into the unquestioned assumption that both parties are in agreement on the terms of the loan. However, in reality, the lack of a clear, express agreement can often lead to the borrower and the lender having vastly different expectations which do not come to light until it is too late.
There are numerous terms that should be considered, some of which may seem more obvious such as how much is being lent, the date(s) and manner of repayment (one lump sum or instalments?), and the rate of interest due on the loan.
There are also further questions, including what happens if the business is unable to make its repayments or are there circumstances in which the lender is entitled to recall the loan.
Does the lender expect to receive shares in the company? Do they expect to have input into how the loan is used or the management of the business more generally? If the loan is being paid (or re-paid) in instalments, does the lender have absolute discretion on when the instalments are due, or will the dates be agreed (possibly in advance) with the borrower?
In addition, as the friend or relative is unlikely to be a professional lender, are they aware that tax may be due on the interest paid to them, or even where interest is forgone, and who will be responsible for meeting this cost?
This is a non-exhaustive list of considerations which can often be overlooked when arranging an informal loan and which can result in – sometimes significant – unanticipated costs for the business. An unhappy lender may attempt to recall their loan or refuse to make further payments, denying the business capital on which it may have been relying.
There is also the risk of a lender commencing proceedings against the business to recover their capital or to seek compensation for any losses they may have suffered due to the loan. Such events will damage, often irreparably, the relationship between the lender and the businessowner.
There are several options. Equity investment (where an investor provides capital in exchange for shares in a company) can be a valuable one. The appropriate investor will depend on the stage of the business, for example, venture capital funds and angel investors tend to provide investment for start-ups or very young businesses, whereas private equity funds usually require a business to be more established.
Private equity usually accompanies its investment with expert management. Where private equity provides investment via equity, the borrower’s stake may decrease but their shares may be worth more. Where the business already has shareholders, consideration will need to be given to the impact of the new investor’s requirements (for example, as to the value of their shares or what rights attach to them) on the rights of the existing shareholders.
Asset financing can provide working capital whereby the finance provider gives the business a loan in exchange for a security interest in the business’ assets. . In particular, this can offer an opportunity for businesses which do not yet have a high enough credit rating for other types of borrowing.
The Government offers business loans and grants such as the Future Fund which was announced by the Chancellor on April 20. The fund issues convertible loans to “innovative UK companies with good potential”.
On November 2, the Government announced an extension to the fund until January 31 this year. Similarly, the Government’s Start Up Loans programme provides unsecured loans of up to £25,000 payable over one to five years at a fixed rate of interest.
When planning to start or grow a business, it is advisable to secure formal investment from an early stage. Entrepreneurs should consider whether they want to seek debt or equity financing.
Equity financing has the advantage that the funds will not have to repaid, but debt financing does not require them to give up a portion of the ownership of the business. This safeguards against the risks mentioned above and ensures that the plans for growth and the level of investment available are in-step from the start.
Having the investment in place means that the business has certainty over its rights and obligations under the loan or investment agreement reducing the risk of the problems for informal loans. Informal equity arrangements create havoc where the business is ready to seek growth capital.
Whichever route is chosen (or possibly a combination of the two), it is essential to seek legal advice at an early stage to ensure that the loan or investment is appropriately formalised, expectations managed, and that the business and the individuals behind it are properly protected.
This article was originally published by SME Magazine on 3 January 20201: https://www.smeweb.com/2021/01/03/the-risks-of-informal-loans/?cli_action=1609754132.806
8 January 2021
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