Legalease
Finance and funding

 

Borrowing money

Contents:

Introduction


Overdraft


Term loan


Revolving facility


Invoice financing


Interest rate hedging


Asset finance


Commercial mortgages


Debentures


Non-bank lenders


Security and personal guarantees

 Floating charge

 Registration of charges

 Personal guarantees

Government guarantee schemes

Bank Referral Scheme


Introduction


This section provides a brief overview of the subject of borrowing money to finance a business and the different forms of borrowing, , mainly from the point of view of the owner or manager of an SME. There are separate sections on Government and other financial assistance and Equity funding sources of finance for a business. SMEs should consider all these forms of finance.

GOV.UK has a section on business finance, and aids to sources of finance and grants, and provides an “interactive tool” to help choose and secure the right finance options.

The British Business Bank

The British Business Bank ('BBA') is a 100% Government owned but independently managed organisation which aims to bring expertise and Government money to the smaller business finance markets. It does not lend or invest directly but works with over 130 partners such as banks, leasing companies, venture capital funds and web-based platforms.

The BBA and the ICAEW has published the Business Finance Guide.

The BBA offers The Finance Hub to help businesses understand and discover the finance options.

SMEs should consider all forms of funding: borrowing; governemboth borrowing money and equity funding as sources of finance. These are explained below.

Legaleze comment: contact us for the Legaleze equity fund raising toolkit.

The need to borrow money for business purposes may arise in various circumstances. Typically these will include an individual borrowing to start up a business or an individual or company borrowing to fund working capital, the acquisition of a business franchise, an existing business or business premises.

The legal basis for any loan is a contract between the lender and borrower. From the point of view of the lender if not the borrower as well, the loan contract should be in writing. The exact wording will depend upon the purpose and structure of the loan, the borrower’s circumstances and the practice of the lender.

The main types of loans may be categorised broadly as follows:

Overdraft


Term loan


Revolving facility


Invoice financing


Asset finance


Commercial mortgages


Debentures


Non-bank lenders

These types of borrowing are considered below. The subject of providing security, floating charges and personal guarantees is also briefly covered below.

Overdraft


An overdraft facility is the simplest form borrowing. It depends upon the borrower having a current account with the lender, normally the bank where the business maintains its current account. The borrower may draw on facility and repay amounts borrowed from time to time up to a maximum set by the lender. The facility is usually reviewed annually and a fee is payable for renewal.

However, an overdraft facility is normally subject to reduction or cancellation at any time, and the lender may demand repayment of outstanding loans at any time, without giving a reason. The lender may sometimes state that its intention is to continue to provide the facility until the next review date, perhaps subject to certain conditions. Such an intention will not however be legally binding upon the lender unless (very rarely) stated otherwise.

The interest charged will normally be a fixed margin over the lender’s current rate for lending and will be variable. If permitted at all, borrowing more than the agreed limit will usually incur additional fees and interest for the borrower.

An overdraft facility is designed to provide flexible funding to meet fluctuating needs of the business for working capital. It is not designed to provide medium or long term finance.

Term loan


Under a term loan, the lender agrees to advance to the borrower a fixed sum repayable by instalments over a fixed period, usually 3 to 10 years. In some cases, the lender may agree a "repayment holiday" whereby the borrower is not required to repay instalments for an initial period. The rate of interest is normally fixed.

A term loan agreement will usually be more formal and contain heavier “covenants” or obligations on the borrower, such as maintaining a certain level of sales and profits, taking out insurance, providing regular accounts and other matters. Subject to a possible period of grace or warning, a failure to make any payment on time or a breach of covenant may entitle the lender to demand immediate repayment of the loan.

Revolving facility


A revolving facility has some features of an overdraft and some of term loan. The borrower may draw and repay parts or “tranches” of the available funds as required, usually for short periods of time e.g. one, three or six months. If the borrower still requires the loan at the end of such period, the tranche will be technically repaid and redrawn. The lender will agree to continue to make the loan facility available subject to a maximum amount and to the borrower complying with the covenants in the loan agreement.

Invoice financing factoring and discounting


For larger, established businesses which sell goods or provide services on credit terms to business customers, invoice financing is a means of obtaining finance by selling or borrowing against the amount invoiced and due from customers to a third party in return for payment of part of the invoice (perhaps 85%) and provision of a sales ledger and debt collection service.

Invoice financing: includes two types of arrangement: invoice factoring and invoice discounting.

Invoice factoring: this involves the business which requires the facility (i.e. the borrower) selling to the factoring company (the “factor”) the right to collect payment for goods and services invoiced by the borrower to its customers. The factor will charge a fee for each invoice and a discount charge (in effect similar to interest on a loan) on the total amount advanced by it against unpaid invoices of the borrower calculated over each month or other fixed period.

Customers of business will be aware that the invoice has been factored and may (usually without justification) draw an adverse conclusion about the financial status of the business.

Recourse and non-recourse factoring
The factoring may be either on a recourse or non-recourse basis. In the former case, the factor does not take on the risk of bad debts, so that the factor may demand the repayment of the amount advanced to the borrower against an invoice if the borrower’s customer does not pay. The factoring agreement will specify the period (e.g. 90 days) within which the borrower must repay the amount advanced after the due date for payment of the invoice. Whether or not the borrower has to repay the advance, he will still be required to pay the fee and discount charge.

In non-recourse factoring, the factor assumes the bad debt risk. However if the customer fails to pay because of a dispute, the factor will be entitled to resell the invoice debt back to the borrower. The increased risk will mean that non-recourse factoring will be more expensive than recourse factoring. The factor will assume all rights to pursue the customer for payment including the right to take legal action.

Invoice discounting: this is similar to recourse invoice factoring but is confidential so that customers of the business are not normally aware of the arrangement. The business will normally retain control over the administration of its sales ledger.

Restrictions on assignment of receivables

Comment: some contracts used by purchasers of goods or services contain a clause which forbids the assignment of the debt owed for the supply to a third party. This practice has caused problems for some suppliers because the clause makes it impossible those suppliers to raise finance against those receivables.

The Small Business, Enterprise and Employment Act 2015 empowered the Secretary of State to make regulations to say that a ban on assignment clause has no effect. The Business Contract Terms (Assignment of Receivables) Regulations 2018 (SI 2018 No. 1254) came into effect on 31 December 2018. The regulations provide that a term in a contract has no effect to the extent that it prohibits or imposes a condition, or other restriction, on the assignment of a receivable arising under that contract or any other contract between the same parties.

There is an exception in relation to the assignment of a receivable if at the time of the assignment the supplier is a large enterprise or a special purpose vehicle.

Interest rate hedging


Interest rate hedging products can protect customers against the risk of interest rate movements and can be appropriate when properly sold in the right circumstances. However, there are some products that are particularly complex, and that also introduce a degree of interest rate speculation. This is particularly the case with ‘structured collars’ which can effectively result in customers paying more if base rates fall below an agreed level, requiring a very finely balanced judgement on the part of a customer.

In 2012 it became clear that some banks has mis-sold interest rate products to some customers, particularly SMEs. Read more

Asset finance


Asset finance includes the purchase of vehicles, plant, equipment and other assets either on lease (i.e. long term hire) or hire purchase (i.e. lease with the option to purchase). Leasing and hire purchase are treated differently for income/corporation tax and VAT purposes. Further information on this type of facility is given on GOV.UK

Commercial mortgages


A commercial mortgage is a term loan designed to purchase business premises and secured usually by a mortgage on the premises. Again, Business Link provides information on this type of loan.

Debentures


Debentures (sometimes known as "bonds” or “loan notes”) are a form of borrowing by businesses trading as a limited company. The debentures normally provide for the company to repay the borrowing for a medium or long term period; in some cases, the borrowing may be repayable only in the event of the liquidation of the company.

Debentures may or may not be secured by a charge of the assets of the company or by personal guarantees (see below). Debentures are normally transferable by the holder. Because of the risk attached, debentures are not normally issued by SMEs (unless part of the loan documentation required by a bank or commercial lender).

The issue of a debenture may however be of interest to lenders with a special relationship to the company, e.g. family and friends of the founders.

Regulation: the communication and offer of debentures is strictly regulated in the same way as shares. See: Equity funding: regulation of financial promotions and public offers.

What’s new on this topic [see What’s new page or archive for full item]:

20/06/2020: FCA to ban permanently retail marketing of mini-bonds

Source: Financial Conduct Authority

The Financial Conduct Authority (FCA) has announced proposals to make permanent its ban on the marketing to retail investors of mini-bonds and other ‘speculative illiquid securities’. The FCA introduced the ban without consultation in January 2020 following concerns that speculative mini-bonds were being promoted to retail investors who neither understood the risks involved, nor could afford the potential financial losses.

The term ‘mini-bond’ generally refers to a debenture or bond (i.e. a loan taken out by a company from a single or multiple lenders upon the terms of one debenture agreement) issued by a small or medium-size company, repayable at the end of a fixed period (usually 2-5 years), at a high rate of interest and which is not listed on a stock exchange or if listed is not easily realisable.

The FCA ban will apply to certain types of mini-bonds and fixed rate redeemable preference shares where the funds raised are used to lend to a third party, or to buy or acquire investments, or to buy or fund the construction of property. There are certain exemptions including listed bonds which are regularly traded, companies which raise funds for their own commercial or industrial activities, and products which fund a single UK income-generating property investment.

The FCA ban will mean that products caught by the rules may only be promoted to investors that firms know are sophisticated or high net worth. Marketing material produced or approved by an authorised firm will also have to include a specific risk warning and disclose any costs or payments to third parties that are deducted from the money raised from investors.

Non-bank lenders


SME owners and managers should be aware that there is a growing range of alternative lenders, other than simply family and friends. These include

:
* Commercial lenders
* Peer-to-peer lending (i.e. organised groups of individuals and companies willing to lend to businesses)
* Co-operative and community finance (aimed at social enterprises, co-operatives and charitable businesses)
* The Prince's Trust: for persons aged between 18 and 30, unemployed and unable to raise finance from other sources.

For further information, see GOV.UK and for peer-to-peer lending, MoneySaving Expert.com

Security and personal guarantees


Banks and other lenders will usually require some form of security for lending to SMEs. From the lender’s point of view, the best security will be a first mortgage on real property; otherwise, the lender may well require personal guarantees from one or more of the directors and shareholders of the borrower.

Floating charge


An incorporated business (as distinct from a business carried on by a sole trader or partnership) has the advantage of being able to offer a type of security known as a "floating charge" over its assets. This type of security attaches to all the assets of the company (except any real estate or other assets which are subject to a fixed charge or mortgage). However, because the security "floats" over the assets so long as the company is meeting its interest and repayment obligations under the loan, the company may continue to trade normally and to receive payment of invoices from customers without needing permission from the lender.

Registration of charges


Lenders and company borrowers should be aware that security in the form of a fixed or floating charge must be registered on the borrower's file if it is a company registered at the UK Companies House or is a foreign company with secured assets in the UK.
See the Companies House guidance on registration of charges.

Personal guarantees


If an individual gives to the lender a personal guarantee of the loan, the lender may recover the loan from the guarantor if the borrower fails to pay. If as is usually the case, the guarantor is a director and shareholder the borrower, the liability under the guarantee diminishes the benefit of trading through a company with limited liability. It may be possible to include a degree of protection for the guarantor by including in the guarantee a maximum liability and a definite time limit, or the ability for the guarantor to terminate the guarantee by giving notice to the lender.

There is an important legal distinction between a guarantee and indemnity. A guarantee creates a secondary liability on the guarantor; broadly, this means that the creditor must first attempt to recover payment from the borrower before seeking repayment of the debt from the guarantor. It also means that if for some technical reason the debtor is not legally liable to pay the debt, or the creditor agrees with the debtor to vary the terms of the debt without the guarantor’s agreement, the guarantor may be released from any liability under the guar

antee. For historical reasons a guarantee must be in writing (Statute of Frauds (1677) s.4)

An indemnity need not be in writing (though it almost always will be) and creates a primary rather than a secondary liability for the debt upon the person giving the indemnity. The almost invariable practice of banks and other commercial lenders is to require as security an indemnity rather than a guarantee.

Government guarantee schemes


If you or your business are not able to provide a lender with sufficient security, you may be entitled to a government backed guarantee under the Enterprise Finance Guarantee scheme or the Export Enterprise Finance Guarantee. For further information, see the section on Government and other financial assistance.

The Bank Referral Scheme


On 18/12/2014, the Government confirmed new rules to improve SMEs access to finance.In the paper ‘Help to match SMEs rejected for finance with alternative lenders: summary of responses’, HM Treasury confirmed that large lenders to will be required to forward details of small and medium-sized enterprises (SMEs) they reject for finance, HM Treasury has confirmed. The information will be passed to a platform which will join up SMEs looking for finance with alternative lenders.

The Small and Medium Sized Business (Finance Platforms) Regulations 2015 (SI 2015 No. 1946) came into effect on 1 January 2015. The regulations place an obligation on designated banks to refer small and medium sized businesses (“SME”) customers that they reject for finance, with the SMEs permission, to finance platforms that can match the SME with alternative finance providers. The regulations give HM Treasury the power to designate which banks and platforms to which the regulations apply.

The Bank Referral Scheme was launched in 2016 to help businesses who have been rejected for finance by one of the major banks in the UK by referring them to alternative providers. Businesses must agree for their details to be shared but if they are, your details will be passed to the following three designated platforms:

Funding Xchange

Funding Options

Alternative Business Funding

[Page updated: 24/06/2020]

 

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Historical note: Statute of Frauds 1677