Are Interest Rates The Most Critical Aspect of Financing?
During my career as a banker and subsequently as a business consultant, it amazes me the criteria that applicants consider when choosing the financing source for their business. Usually, it consists of - will you give me the money and what will it cost. Totally ignoring many other critical decision points, such as what security do they need to secure the loan and how will this impact on your ability to operate the business and obtain further loans in the future. How will it impact your cash flow (repayment terms)? How will it impact you and your family personally (think personal guarantees and other personal encumbrances)? What are the terms and conditions (demand loans versus term loans)? what constitutes a default under the financing (it may not just be nonpayment)? As you can see the interest rate offered is only one of many criteria that need to be considered. You have to consider the total package being offered and how it will impact you and your business. Not only do different type of financing have different financing packages that they offer but even different entities offering the same types of financing, e.g., chartered banks, may offer different financing packages. Let’s look at a comparison between some of the more conventional sources of financing.
Source: Investing your Own Money
Investing at least some of your own money is important, if for no other reason than, the majority of financial sources want to see that you are invested and therefore committed to your business. However, there are two ways you can invest your own money into your own business. Either by share capital or by shareholder loans. The former is a more formal way of investing in the business and for all intents and purposes is a permanent investment in your business. In the latter instant, you in fact lend the money to your own business. It can be reimbursed to you, if there are no encumbrances on it, tax free in the future once the business no longer needs the money as the source of the money was after tax dollars.
The advantages of investing your own money are that there are no other repayment terms other than those you set yourself. This enables you to manage your cashflow better. You can further enhance this benefit if you are borrowing by way of a mortgage against your personal property, by borrowing in your personal name and then investing this money into your business by way of a shareholder loan. Mortgages against your personal assets are usually repaid over a much longer time period than the more traditional 5-year repayment period attached to commercial loans. Once again improving your cash flow.
Disadvantages It is very difficult to grow your own business using only your own money and at some point in time, it is probable that you will need to approach other sources of financing. Also, there are many tax rules surrounding how you invest your own money in your business and as such you will need advice for your professional advisors i.e., your lawyer and accountant.
Source: ‘’Love Money”
This is money that you borrow from friends and family. The saying is that they have to love you because they may never see their money again. The most important think to consider here is that all transactions such as this need to be properly documented and you should probably get you lawyer involved to avoid potential disagreements over repayment of these monies.
Advantages The advantage of this type of financing is that it is very similar to using your own money and often contains very favourable repayment terms, which again assists your cashflow. Disadvantages
Similar to the comments under investing your own money. The problem is that if your business fails or does not generate the amount of money to repay your friends and relatives at the appropriate time the acrimony that can occur, since its your relatives and friends, can cause much personal discomfort.
Source: Chartered Banks
If you have to borrow from a financial institution, then chartered banks are probably the least expensive form of financing. Most businesses will at sometime in their existence need an operating line of credit. A line of credit is cheap because the bank will set a limit on the account, and you only pay for what you use. Keep in mind, that most of the time the bank will ask for a personal guarantee to provide assurance that if your business cannot repay the loan that you will personally repay the loan. Many people think that the guarantee is just a technicality, however, I can assure you that if the business cannot repay the loan, the bank will turn to the personal guarantee. So, make sure that when you sign a guarantee you get a lawyer to explain to you exactly what you are signing
This is the least expensive form of financing a business, other than investing your own money.
Banks are quite conservative and if your business is less than 2 years old you may be declined because you do not have a track record for them to evaluate your business on.
More importantly, lines of credit are primarily done on a ‘demand basis’. This means that you do not have to be in arrears on your loan for the bank to demand repayment in full. For instance, you will be subject to an annual review and, if during this review, the bank determines that the risk of your business getting into trouble has increased they may demand repayment on your loan. If you cannot repay the loan from your own or other resources, they may use the personal guarantee to recover their money. Demanding payment is a last resource, but nevertheless, it is a possibility that you have to consider.
Leasing Another form of financing that you could consider is the option of leasing the assets that you need. There are two types of leases: capital and operating. A simple way of understanding the difference is that one is capitalised and shown on your financial statements like a loan and the operating lease you are able to expense like any other expense of the business. If you are considering a lease you should check with your accountant before you sign anything to understand which type of lease you are being offered. Leasing is more expensive than bank financing and it is possible that you will be asked for a down payment.
If you sign a capital lease, then your monthly payments should be less than if you borrow money from more conventional sources. This is because leases are more traditionally geared to the life of the asset. For example, the term of your lease may be 5 years, but the asset has a life expectancy of 10 years. An estimated value of the asset at the end of the 5 years will be calculated. This will be deducted from the value of your asset being purchased and your payments will be based on this amount. At the end of the 5 years, the balance on the asset known as the residual will become due and payable or you can re-lease that amount at that time. This is an oversimplification of the process but shows how a lease works. The beauty of a lease is that until the lease is paid the asset technically remains the property of the lessee and as such unless you miss a payment, the asset remains yours to use.
Leases are more costly than borrowing from a bank but are often good options where the bank is reluctant to lend, and lessor only very rarely ask for personal guarantees. Also, assets you buy through a lease cannot be used as security for other types of loan as until the last payment is made the assets belong to the leasing company. If you are thinking of leasing, you should definitely talk to your accountant first.
These are just a few of the financing options open to your business. We will discuss other options in future blogs.
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