Plenty has been written about the difficulties that small businesses experience in obtaining loan-based finance from banks. However, even if you can access them, the disadvantages and downsides of term loans need to be considered carefully. In our experience, growing businesses usually need a revolving credit facility, like an overdraft, rather than a loan that needs to be fully repaid in a short space of time. You need finance to grow - this is not something than needs a short-term fix.
A term loan has a few advantages over other forms of finance. Unlike overdrafts, they are not repayable on demand and unlike equity finance there is no requirement to give up a proportion of your ownership shares or profits.
However, the negative impact on your business can be considerable:
- Structurally, they are totally inflexible: the borrower often ends up paying for funds that they don’t need or ever use
- As you start repaying principal from the first month, the schedule of monthly repayments inevitably adds a growing burden on businesses struggling to maintain a positive cashflow - the last quarter of the term loan period is painful
- Additionally, loans can be an expensive form of finance, particularly if unsecured. Interest payments, set-up charges and sometimes renewal charges all add to the costs - the actual rate is usually double or more the quoted flat interest rate
In addition to the financial costs, there’s a significant time cost. Borrowers may be required to submit quarterly management accounts or other financial statements, particularly if the loan is large. Even at the outset, applying for a bank loan can involve a lengthy application process with unpredictable results.
Overall, for many businesses, bank loans are plainly an inappropriate form of raising finance, particularly if they are taken out to solve working capital needs. Taking out a loan to meet a short-term crisis over payroll commitments, for instance, is likely to lead to more cashflow challenges in the future.
A term loan only delays addressing the basic cause of the problem - the business needs permanent working capital, especially if the business is growing.
Increasingly, business owners are fed up with traditional loans, writing them off as an out-dated solution, being expensive, unnecessarily burdensome and hard to source in the first place. They are turning instead to working capital solutions that recognise the value of proven sources of income in the form of existing contracts or regular work for large customers.
Contract finance can work just the same as invoice finance. Essentially any business that undertakes project work for large clients can benefit. So creative industries, such as advertising and marketing services companies or technology businesses can take advantage of this form of finance, unlocking the value that exists within contracts they have won.
Like invoice finance, we release a proportion of the contract value in advance, auctioning the staged payment of a contract on an online platform to a pool of investors. Instead of waiting for their clients to sign off invoices and then pay out, the recipients receive funds from the platform. Typically, they receive an advance on around 80% of the value of the staged payment, which is repaid, along with a fee, when the staged payment is received. Before the arrangement is set up, the contract must be shown to be valid, with a recognised mechanism for checking that work completed at each stage is of a sufficient quality for the customer to ultimately pay out.
Contract finance frees up funds tied up against long-term arrangements and has the potential to free entrepreneurs from the administrative hurdles and costs of more traditional funding mechanisms.