As business owners and operators, we all have different appetites for risk. If you are reading this as a business owner, or someone thinking about starting a business, then you must have some kind of tolerance for risk and a certain amount of self-confidence.
Putting your own or your family’s money into a new venture can feel like gambling on your hard-earned savings. Some are not willing to do this and prefer to borrow. Then again, borrowing itself can feel risky, because of the consequences of not being able to repay a loan or clear an overdraft.
Let’s have a look at some business finance products and how they stack up for how risky they might feel for you as well as for your lender.
Unsecured loans
Growing in popularity, unsecured loans are great for the business owner who doesn’t have any personal assets, and for a business that doesn’t tend to have assets, for example professional services (office-based) businesses. These loans are often used by people who have already put everything they have saved into their business, have run out of cash and need more money to take the next step.
From a lender’s perspective, these loans carry the greatest risk, because if the loan is unpaid then there are no assets to sell to get the loan repaid. For this reason, unsecured borrowing does tend to attract higher interest rates. The criteria for approval is much tighter than for secured borrowing, for example the requirement for squeaky clean credit and in some cases, to be up to date with your GST and PAYE payments. Some finance companies don’t care about your personal assets. Others will look at your overall picture and would prefer to offer unsecured loans to people who have personal assets and/or an additional source of revenue outside the business that could support the loan if something goes wrong with the business.
Interest rates vary very widely between unsecured lenders, ranging from 11% to 27%. The interest rate you are offered will depend on the risk profile that the lender calculates for you, taking into consideration things like the industry you work in, seasonality of your business, how many customers you have, and how long you have been in business for.
Unsecured loans often will usually still require a personal guarantee from directors of the business and in some cases, shareholders.
Secured loans
Secured loans fall into two broad categories. The first is loans secured by identifiable (ie with some kind of serial number). This includes plant, equipment and machinery, trucks, trailers, and vehicles.
Secured borrowing in this category is likely to be viewed by business lenders as less risky. If the borrower defaults on the loan, so long as you have signed a specific security agreement and registered it on the PPSR, they have entitlement to seize the property that has been used as security. From the borrower’s perspective, the risk is that your credit score will be impacted, with a default loaded against the individuals named in the lending documents, as well as the business. This can impact on any further borrowing. And of course you could lose the asset you have been paying off.
The second category is business borrowing secured by property. Loans secured by property attract what is called a “caveat”. According to LINZ, a caveat is described as a “notice or warning that the caveator [your lender] has a claim or interest in the land [or property]”. Borrowing against property may feel riskier for you than it does for the lender. It is always advisable to get legal advice before entering into any borrowing against your property as the documentation can be more complex.
Invoice finance
Invoice finance, also known as factoring, is a cashflow facility whereby you get cash up front for your debtor invoices, and your customers pay your finance company. For some, this might seem like a less risky type of finance, because it removes the requirement to meet scheduled loan repayments. Borrowing fluctuates in line with your sales. If a customer’s business fails and they don’t pay your invoices (which is a risk regardless of what type of business finance you are using), it does create a debt that you have to repay to your lender, but this debt can be “repaid” with more invoices. This is problematic if your sales are declining, but often not a problem for a growing business.
From the lender’s perspective, they are looking at risk from a number of different perspectives than for other types of business lending. Your lender will also put some lending criteria specific to you and your business into your loan agreement in order to manage this risk.
Let’s take debtor spread. The more debtors you have, and the more equal the amounts they owe, the better your debtor spread. Single or a small number of debtors, or where you have one or two debtors that owe you far more than the rest put together, creates poor debtor spread. The better spread your debtors are, the less risky your facility will be. In the case of poor spread, your funder will put limits on how much money can be loaned against each debtor, and what percentage of funding can be against individual debtors (concentration). (Look out for our upcoming article about demystifying the terms in your invoice finance facility agreement).
Quite unique to invoice finance, is that your funder is also likely to be taking a closer look at your customers than for other types of borrowing. Your funder may even want to credit check your customers. They will apply certain processes to make sure your customers are going to pay your invoices to the funder rather than direct to you, like signing documents to commit to doing this.
Overdraft
Quite possibly the simplest form of business finance. You get a limit that you can go into negative balance to, in your bank account. There are no repayments to make; and interest rates can be quite high, and the amount of interest you end up paying can surprise you when it is applied to your account at the end of the month. Invoice finance is similar to an overdraft, but at least with invoice finance you can usually log on to a client portal and see how your fees and interest are tracking over the month.
The risk aspect of an overdraft relates to how you spend the money, and whether you are keeping a close eye on the limit and planning well to stay within the limit. Because if you haven’t planned well, and hit your limit, what next?
Your bank may or may not have asked you to sign a general security agreement and lodged it on the PPSR when offering you an overdraft facility. If they haven’t, and there are no other first ranking GSA’s registered on the PPSR, then you could be good to go to get a loan (secured or unsecured) or invoice finance facility to go with your overdraft. If there is a first ranking GSA, then your other borrowing options tend to drop to invoice finance and unsecured borrowing (at low levels). And if you are going for invoice finance, then your funder is going to want the first security holder to sign a deed of priority, allowing your funder to continue to collect your debtor payments if your business fails.
Final word
Whatever type of borrowing you choose to fund your business, there are risks that you and your lender will weigh up. Often your loan broker is often not a registered financial adviser. They can tell you about the features of different lending products, and identify the lender that you fit with best, but ultimately you are responsible for deciding the type of borrowing that you want.