25 Apr Forms of Financing – Traditional is not always trump
Finding a means of inexpensive, accessible funding is something that most, if not all, businesses will need to do at one time or another – and perhaps even more so now in the current economic climate. While the first port of call for a small to medium enterprise (SME) seeking financing is likely to be a bank or other traditional lending institution for a loan, there are other roads to accessing funding that should be considered depending on the objectives and needs of that business.
In this Article, we aim to highlight some of the traditional and “not so traditional” sources of financing available in the local market.
Financing from a bank or financial institution is one of the most common sources of credit for any business. These transactions include a typical bank loan or line of credit secured by a SME’s assets, an overdraft facility, business credit cards and other traditional forms of finance. These facilities are usually transparent and at arm’s length, available at competitive rates and are predictable both in terms of the process and management during the life of the facility. Depending on the purpose for which the financing will be used and the assets which a business can provide as security, the terms of the financing can also be fairly predictable.
While not the cheapest form of financing – most facilities will include establishment and other bank fees, legal fees and stamp duty, in addition to incurring interest – the predictability, transparency and certainty of this form of financing can be a real attraction to a business.
But to borrow from a commercial bank, your ducks must be in a row: you will need up to date financial statements showing your historical performance, your corporate filings must be in order and you will need to demonstrate your ability to meet your obligations to the bank by, for example, producing projections of your revenue. The due diligence or ‘know your customer’ process alone can take several weeks and requires you to undress your business. Fortunately, with SMEs being a relatively untapped market for lenders, some finance houses now have specialized units for assisting SMEs with the process. New SMEs looking to borrow for the first time should therefore be sure to do their homework in identifying a lender well placed to provide the support needed in what can otherwise be a daunting process for a small enterprise.
Equipment Leasing or Hire Purchase
Equipment leasing or hire purchase arrangements are both available in the local market. Ownership of the asset is the distinguishing feature here:
In equipment leasing, a lessor owns the asset and leases it to the lessee at a rate equal to the cost of the asset amortised over a specified term. The typical terms of an equipment lease can vary extensively depending on the nature of the asset. For example, some leases may place the cost and obligation to maintain, service and replace the asset on the lessor – removing that burden and risk from a business. In others, the lessee takes on these obligations but has an option to purchase the asset at the end of the lease at an agreed price.
A hire purchase arrangement is an option available to SMEs seeking to purchase an asset for its business without immediately dipping into its capital reserves for the full purchase price. In this arrangement, the SME usually pays a deposit to the hire purchase company with the balance plus interest being paid over a specified timeframe. Following repayment, the SME will own the asset.
While the economic impact of either arrangement will be greater than if the asset was purchased outright by the SME, these options provide attractive solutions to a SME in need of specific assets to operate its business, but also seeking to make the most of its available cash. Depending on the nature of the asset in question, these facilities are usually medium to long term arrangements which enable a business to predict its cash flow requirements. SMEs should bear in mind that there are tax and accounting consequences of this type of arrangement which can make equipment leasing more (or less) attractive depending on a SME’s needs.
Sale and Leaseback
A sale and leaseback transaction is suitable to a SME that has a valuable asset sitting on its balance sheet but needs access to cash to fund its operations. This transaction involves the transfer of the asset to a finance house at a price which is equal to the value of the asset, putting a lump sum of cash in the hands of the SME, and the leasing of the asset to the business, so that the business continues to have use of the asset for its operations.
Oftentimes, this type of financing has greater flexibility in the terms and allows an SME to maximize the value of its asset versus traditional bank loans where credit approvals usually require a prescribed loan to value ratio to be maintained.
The costs of a sale and leaseback facility are not inexpensive – often the lender will require the borrower to bear all associated costs, including the cost of any stamp duty payable on the transfer of the asset. However, the flexibility of the facility, the ability to maximize the value of the asset and the fact that a SME’s exposure is usually ring-fenced around the asset are all attractive factors for a SME seeking a quick capital injection.
Raising new equity is an option available to any business, but it comes with a significant, usually long-term, commitment and requires the right kind of investor for the business. Regardless of the type of investor, a business seeking third-party investment will need to have a clear understanding of what the business is worth in order to ensure that the terms of the deal are fair to the business while being attractive to the investor.
This option involves an investor making a cash investment in a business in exchange for the issue of new shares. Depending on the kind of investor, the formalities for this arrangement can vary, but should at least include a subscription agreement establishing the terms on which the investment is made and a shareholders agreement setting out the rights of each of the shareholders and terms and conditions on which the business will operate following the investment.
Raising additional capital by issuing new equity has the potential to be a relatively low-cost option. Costs will usually be limited to transaction costs, such as the costs of any advisors engaged by the business in negotiating and executing the deal. However, inviting a third-party to invest in your business usually requires its own level of undressing to the new investor and an enhanced (or altogether new) operating framework in which corporate governance becomes critical.
Factoring or sale of receivables
A factoring transaction or a transaction in which a company’s receivables are sold to a third party is a means for the company to improve its cash flow. These transactions often involve a company whose customers or clients enjoy credit and, as a result, the payment for the goods/services received by the customer are not paid for immediately. Instead, payment becomes due at a deferred date, usually sometime between 30 to 60 to even 90 days later. While such flexible payment arrangements usually enhance the attractiveness of a company’s product or service, they negatively impact the company’s cash position and can hamper the company’s ability to continue to fund its business.
Factoring allows for a third party to purchase those receivables, usually at a discounted rate and on agreed payment terms. The company receives cash in hand in an amount equal to a “factor” of the aggregate receivables sold and the third party is entitled to the full sum of the receivables collected.
While this form of financing can be attractive for a SME in high growth whose profit margins are wide, it has the potential to substantially dilute or even wipe out a company’s profits in circumstances where growth is stagnant and/or profit margins are small.
The above forms of financing are only a few of the types available and the market continues to signal a focus on making affordable and responsible financing available to small to medium businesses. There are many forms in which financing might be available and the form that is right for you may vary depending on several factors: the cost of finance; the needs of your business; the security available to support the facility; the time for which the facility is required (both in terms of how quickly you need access to funds and the length for which such funds are required). The maturity of your business will also influence the nature of the financing which is most suitable to you.
SMEs should take the time to understand of the needs of their business and the value of their assets in order to match these to a suitable form of financing in order to create the ideal environment for the stability and growth of their business.
Disclaimer: This Document Provides General Guidance Only And Nothing In This Document Constitutes Legal Advice. Should You Require Specific Assistance, Please Contact Your Attorney-At-Law.