Navigating Debt Financing: Startup Loans, P2P Lending, and Business Lines of Credit
Debt financing refers to funding or financing a business by borrowing money. More precisely, debt financing occurs when you are loaned money that you must later pay back in full. Due to the well-known risks involved in investing in startups, finding investors via debt financing can be a challenge, but can also be relatively cheap to repay once secured, resulting in a potentially rewarding way of raising funds for your business.
This article focuses on debt financing as a way to raise capital for your business. This article is part 3 of a Finance for Startups series, in which we detail several ways to fund your startup and to help you manage extra expenditure, including part 1 on government funding and part 2 on equity financing.
Startup loans
A startup loan is one of the most widely used funding options available. The government supports funding for startups by backing the Startup Loans Company. They offer new businesses a loan of up to £25,000 with a 6% yearly fixed interest rate of up to 5 years.
This popular route offers a safe and secure method of kick-starting your business. The scheme is free to apply for and offers support and guidance to prepare all the documentation you will need for the application. You can find the application form here.
Advance funding
Advance funding (AF) is an advance made on any future payment. An advance is a payment made prior to any receipt of consideration in return. For example, literary writers may claim an advance in the form of payday loans. Advance funding provides the capital required for your startup without any restriction to your available cash flow.
The advantages are many, but arguably the most important is the retention of control within your company. Lenders have no decision making authority within your business and will often have your funding in less than 24 hours of your application.
On the other hand, high interest rates, averaging between 3-5% on each advance you request, is a notable disadvantage of debt financing. It is important to weigh the risks associated with repayment and note that any debt must be repaid to your lender despite your business’s profits. Consequently, debt financing can be a risky option for startups which may have unpredictable levels of cash flow.
Peer-to-peer lending
Financing your business can seem daunting and inaccessible, especially for small early-stage businesses. Peer-to-peer lending is designed to lessen imbalances of power between lenders and borrowers, as it operates through smaller loaning institutions, or through peer-to-peer lending sites with individuals acting as investors. This allows startup founders to access lending and borrowing services without going through a bank.
The advantages of this method are apparent by way of flexibility and convenience in comparison to borrowing from larger financial institutions, as the P2P process is conducted online and you have the ability to borrow money for a range of purposes. Furthermore, interest rates for entrepreneurs with good credit tend to be lower than the average rates that leading financial institutions provide, making this a cheaper alternative.
While this method provides great benefits over banks, you must ensure there is no oversight on the charges that may apply to you. Lending sites may charge additional fees for commission. These sites may also charge late payments or loan origination fees. Peer-to-peer lending may be an interesting option for your business, provided you carefully read all the terms attached to your loan.
Convertible Loans
A convertible loan is a loan that can be repaid, or alternatively, can be converted into equity at a later stage. These loans are alternative sources of capital that often require less time than equity funding. For more information on equity funding, see our Equity Funding article.
Converting a loan into shares can occur upon a ‘trigger’ for the conversion. This can be a predetermined time, a change of control, or can be triggered upon liquidation of the company.
You may find this method beneficial, as it allows your company to raise funding quickly, before equity funding can be sought out at a later stage. It may also be ideal for an investor given that in the event the company is successful, the investor may subscribe for shares at a lower rate. Furthermore, convertible loans do not usually require interest to be paid on them, as they can be balanced out through additional equity.
It is important to note that with this type of investment, you may get a shareholder. If this is an investment you are willing to make for your business, it may be worth considering selling your shares through equity funding, and gaining an active and experienced shareholder who will not only monetarily invest in the company, but personally invest to help it develop.
Unsecured business loans
When an investor loans money to a company, they generally take security. Security is where an investor can take control of a particular asset of the company in the event that the company fails to repay their loans. A loan that doesn't require security is referred to as an unsecured business loan.
An advantage of an unsecured loan is that no valuations are required, making the legal process considerably simpler and enabling the business to access the funds much faster. Additionally, since no assets are needed, it is a more approachable form of financing, suggesting startups are welcome to the process.
However, because there is no security, the total loan is generally lower than secured loans. Furthermore, some unsecured loans may require a personal guarantee from you. Upon providing this, in the event the company cannot pay, you become personally liable and the investor can pursue you personally in an effort to fulfil the loan.
Short-term business loans
With a short-term business loan, business owners can borrow money from companies for a period of time of up to 12 months, with the loan usually repayable within another year.
You may consider this kind of loan to fund certain events over your company’s lifetime, including moving to a new location for instance.
Short-term business loans tend to be unsecured, and therefore may require a personal guarantee. As they are comparatively quicker to arrange, this typically means higher interest rates compared to longer-term loans, given the risk to investors.
Business Line of Credit
A business line of credit is a type of loan where you have a limit up to which you can borrow, and you can withdraw from that limit. You only pay interest on the amount you have borrowed, rather than the full sum. In many ways, this is similar to a credit card. The difference between a business line of credit and a regular credit card is the security. While a credit account generally provides unsecured small loans, a business line of credit may be secured.
This will typically apply to business models which include being paid after providing a good or service to a customer, as it allows cover of short-term costs. Therefore, it can be advantageous, for instance, when you are waiting to be paid by a customer. Furthermore, repayments are more flexible and can be paid in a lump sum, unlike other loan schemes.
A business line of credit is a short-term solution to managing finances, and should not be used as a long-term method. You are more likely to be approved for a business loan where you have a good credit history and healthy cash flow. Continually depending on this loan for expenses could mean your business has a cash flow problem.
We hope this article has provided you with helpful insights into methods of debt financing, together with part 1 and part 2 of this series to provide you with an overview of the financing options for your business.
Authors: Tanisha Shah, Sofia Martiello & Rita Almazuri - Editor: Gaia Freydefont -
Authors: Tanisha Shah, Sofia Martiello & Rita Almazuri - Editor: Gaia Freydefont -
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DISCLAIMER
This article has been written by law students for the sole purpose of providing informative insight. The information in this article is intended for educational purposes only and does not constitute legal advice, nor should the information be used for the purpose of advising clients. You should seek independent legal advice before relying on any of the information provided in this article.
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