How can you finance your business’s growth plan?

Lack of working capital can constrain the growth of many early-stage businesses. Founders may have made significant early investments in building the business, leaving them with little or no capital to finance subsequent growth. At the same time, the flexible and mostly beneficial financing environment of the past few years is changing, with venture capital funding significantly diminished. Cash flow- or asset-based loans can be a tool to finance future growth.

The terms of cash flow-based loans are based on the strength of the company’s cash flows, while asset-based loans consider balance sheet assets, such as property or plant and machinery (the latter is considered as secured lending). Such loans may also be taken out by a fund or holding company further up the ownership chain, which can keep the leverage off the balance sheet of the operating company. This is known as HoldCo financing or NAV financing.

Both types of borrowing offer businesses access to a credit line to meet their liquidity and investment needs, and can offer a fast and flexible form of funding, available in multiple currencies, borrowing volumes and loan durations. Cash flow loans tend to suit asset-light businesses with secure and stable cash flows, while asset-based loans are better for companies with strong balance sheets, or whose cash flows may be unpredictable. The interest rate and amount of borrowing depends on the cash flow profile or the value and liquidity of the assets used as collateral. This may change over time if cash flows or the value of the asset(s) changes.

This type of financing will generally be cheaper, because the lender enjoys greater security and can therefore offer better terms and conditions.

Advantages over unsecured loans

Collateral backed financing offers an advantage over a standard unsecured loan. It will generally be cheaper, because the lender enjoys greater security and can therefore offer better terms and conditions.

For growing businesses, this kind of lending offers a means to leverage existing assets or future cash flow to fund expansion of the business, and avoids a situation where assets need to be liquidated to raise capital. They are usually quicker to arrange than other types of financing, making additional liquidity available to take advantage of short-term investment opportunities. This flexibility can be important for small businesses, which generally need to be agile.

There may also be tax benefits, although this will depend on the company structure as well as the jurisdiction. For example, if a company pledges its assets as collateral for a loan rather than selling them to raise money, it will avoid paying capital gains tax. It may also be possible to set off interest payments as a business expense against tax, although this may not be possible in all jurisdictions. It is worth consulting a financial adviser beforehand on whether this opportunity exists.

If the business defaults on the loan, the assets pledged as collateral are likely to be at risk.

Risks to consider

There are a number of caveats for companies that are considering seeking this type of financing. If the business defaults on the loan, the assets pledged as collateral are likely to be at risk. This means that the business needs to be careful in selecting the assets to be used as security.

For example, offering business premises means access could be blocked if, in the event of non-payment, the bank seized the assets provided as collateral. Crucial plant and machinery may also be a difficult choice.

And while interest rates on such loans are generally lower than for conventional borrowing, there is still a cost to the company. Businesses need to be confident that the growth they can generate from their investment will exceed the cost of the loan. For many fast-growing businesses, this may not be an issue, but calculations should be made carefully before taking the decision to enter the transaction.

Interest rate, currency and collateral value issues

If the value of the collateral changes significantly, the lending bank may look to reduce the volume of the credit line or demand other assets to restore the original amount of collateral provided by the borrower. This could cause problems for businesses that are relying on having a certain amount of capital on hand or are part-way through a specific project with ongoing investment requirements.

It is also possible that the bank could change the interest rate on the loan in response to changes to central bank rates and/or fluctuations in the value of the collateral – not all loans are contracted at a fixed rate. In this case, the impact could be positive as well as negative, but it is a risk that business owners and executives need to factor into their calculations.

They may also face exchange rate risk if the loan is issued in a different currency from either that of the assets or of the investments made using the loan proceeds. This can be managed relatively easily through hedging strategies, albeit at a cost, but the business taking out the loan needs to be aware of what could happen if exchange rates shift significantly and the extent of their potential exposure.

Nevertheless, in the right circumstances, this type of loan represents a flexible, low-cost source of financing that can help businesses leverage their assets or their cash flow to obtain working capital or investment resources to fuel growth. While risks exist, as with any borrowing, these can be managed by prudent businesses that ensure they get their calculations right. It is worth discussing the risks and opportunities with an adviser, based on the individual circumstances of your business and its asset portfolio.

For growing businesses, this type of lending offers a means to leverage existing assets to fund expansion and avoids the need to liquidate assets to raise capital.