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 investment in building the business, leaving them with little or no capital to finance its subsequent growth. Meanwhile, the flexible and mostly beneficial financing environment of recent years has given way to a significant retreat in venture capital funding. Cashflow- or asset-based loans can be an alternative tool to finance future growth.

The terms of cashflow-based loans are based on the strength of the company’s cashflow, while asset-based loans depend on balance sheet assets such as real estate or plant and machinery (the latter is considered to be 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, a structure known as known as HoldCo financing or net asset value 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 this type of financing. If the business defaults on the loan, the assets pledged as collateral are likely to be at risk. This means 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 or other lender seizes the assets provided as collateral. Crucial plant and machinery may also be a problematic option.

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 careful calculations should be made before taking the decision to enter into the transaction.

Interest rate, currency and collateral value issues

If the value of the collateral diminishes significantly, the lender may seek to reduce the size of the credit line or demand other assets to restore the original value 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 partway through a specific investment project with ongoing requirements.

It is also possible that the bank could vary the interest rate on the loan in response to changes to central bank rates and/or fluctuations in the value of the collateral if the loan was not 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 should 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 should be aware of what could happen if exchange rates change significantly and of the extent of their potential exposure.

Nevertheless, in the right circumstances, cashflow-based and asset-based loans represent a flexible, relatively low-cost source of financing that can help businesses use their assets or their cashflow to obtain working capital or resources for investment that can fuel growth.

While risk exists, as with any borrowing, this can be managed by prudent businesses that ensure they get their calculations right and cover all eventualities. However, first you should discuss the risks and opportunities with an adviser who will consider 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.