Expert opinion from Helen Ingram
The effects of Covid-19 and the resulting financial pressures have raised the question of how to finance their business for many entrepreneurs.
The Bank of England’s third quarter credit terms survey found that banks expect the availability of credit to the corporate sector to decline for the remainder of this year.
Faced with rising default rates, banks have reportedly taken measures such as lowering credit limits, increasing premiums on riskier loans and widening spreads on corporate loans.
The scarcity of conventional sources of credit will lead companies to look for secondary sources of funding, which can be riskier and more expensive, as the scarcity drives up the price and because secondary lenders are simply more expensive.
Given the circumstances, it is easy to see why the opportunity to obtain an informal loan, for example from a friend or relative, seems attractive to many entrepreneurs. However, given the truism that you should never do business with family and friends, it is important to be aware of the risks that can come with these arrangements.
When borrowing from a friend or relative, it is easy to fall into the unquestioned assumption that both parties agree on the terms of the loan. In reality, however, the lack of a clear, explicit agreement can often result in borrowers and lenders having very different expectations that are not revealed until too late.
There are numerous terms that should be considered, some of which may seem more obvious, such as: B. how much is loaned, date (s) and type of repayment (a lump sum or installments?) https://greendayonline.com/personal-loans/
Since the friend or relative is unlikely to be a professional lender, is they aware that tax may be due on the interest paid?
Other questions also arise, such as what happens if the company cannot make its repayment or there are circumstances in which the lender is entitled to reclaim the loan.
Does the lender expect to receive shares in the company? Do they expect to have an impact on how the credit is used or how the company is run in general? If the loan is repaid (or repaid) in installments, does the lender have the due date of the installments at its own discretion or are the dates (possibly in advance) agreed with the borrower?
Additionally, since the friend or relative is unlikely to be a professional lender, are they aware that the interest paid to them may be taxed or even waived, and who will bear these costs?
This is a non-exhaustive list of considerations that are often overlooked when arranging an informal loan and can result in unexpected costs to the business, sometimes substantial. A dissatisfied lender may attempt to reclaim their loan or refuse further payments, denying the working capital they may have relied on.
There is also a risk that a lender could initiate legal proceedings against the company to reclaim its principal or seek compensation for any losses it incurred as a result of the loan. Such events will often cause irreparable damage to the relationship between the lender and the entrepreneur.
What are the alternatives?
There are multiple possibilities. Equity investments (where an investor provides capital in exchange for shares in a company) can be valuable. The right investor will depend on the stage of the business, for example venture capital funds and angel investors tend to provide investments for startups or very young companies, while private equity funds usually require more business start-ups.
If you are planning to start or grow a business, it is advisable to secure formal investments early on. Entrepreneurs should consider whether they are looking for debt or equity financing
Private equity usually accompanies its investment with expert management. When private equity offers investments over equity, the borrower’s stake can decrease, but their stake can be worth more. If the company already has shareholders, consideration needs to be given to how the requirements of the new investor (e.g. regarding the value of his shares or the rights attached to them) will affect the rights of the existing shareholders.
Asset financing can provide working capital, with the financier providing the company with a loan in exchange for a security interest in the company’s assets. . This can be an opportunity especially for companies whose creditworthiness is not yet high enough for other types of borrowing.
The government offers corporate loans and grants such as the Future Fund announced by the Chancellor on April 20. The fund makes convertible loans to “innovative UK companies with good potential”.
On November 2, the government announced an extension of the fund until January 31 of this year. Similarly, the government start-up loan program offers unsecured loans of up to £ 25,000 payable at a fixed rate over one to five years.
What entrepreneurs should consider
If you are planning to start or grow a business, it is advisable to secure formal investments early on. Entrepreneurs should consider whether they are looking for debt or equity financing.
Equity financing has the advantage of not having to repay the funds, but debt financing does not require them to give up any part of the ownership of the company. This hedges the above risks and ensures that the growth plans and available investments are in line from the start.
The investment made means that the company is certain of its rights and obligations under the loan or investment contract, which reduces the risk of problems with informal loans. Informal equity arrangements create chaos when the company is ready to seek growth capital.
Whichever route (or possibly a combination of both) is chosen, it is important to seek legal advice early on to ensure that the loan or investment is adequately formalized, expectations are managed, and the company and those behind it are properly are protected.
Helen Ingram is a Corporate and Commercial Associate at Collyer Bristow