So you’ve got the perfect idea for your start-up and you’re all set to hit the ground running. But before your idea can take off, you’ll need the funding to get things started. A common way to get funding is to take a loan.
Working Capital Loans
One quick way to get funding is to take up a working capital loan with a bank. These are short-term loans that increase cash flow for day-to-day operations.
Banks view working capital loans as less risky when compared to fixed asset loans because they are short-term and for smaller amounts. Hence, it is generally easier for start-ups to obtain a working capital loan since there is yet to be a reputation or client base to bolster creditworthiness.
Moreover, the risks involved in setting up a business from scratch also mean that banks generally require collateral for loans to start-ups. This can come in the form of assets or a personal guarantee, and the extent of the collateral will depend on your banker’s assessment of your creditworthiness.
As the working capital loan is only for short-term loans of smaller amounts, it may sometimes be necessary to take multiple loans. It is therefore essential to repay your loans on time to avoid affecting your creditworthiness and increasing the cost of credit in the future.
Fixed Asset Loans
If you need a longer-term loan for a larger amount to finance the purchase of one-off big-ticket items, a fixed asset loan is a suitable option.
A fixed asset is a property that cannot be easily converted into cash. Under a fixed asset loan, a fixed asset that is purchased with the loan money becomes the collateral for the loan. In the event that you default on the loan, the lender may seize the fixed asset. A mortgage is a fixed asset involving property such as your business premises or a factory.
Lenders usually give fixed asset loans only if it is persuaded that the fixed asset will generate more profits for your business. The loan repayment period will usually depend on the lender’s assessment of how long the fixed asset will take to generate profits.
Interest rates and repayment obligations are generally fixed and regular. This means that you can determine the amount of money needed to service the loan, and will be able to factor the regular repayments into your budget.
However, if your fixed asset is central to your business operations, the failure to service the loan will mean that the lender can seize your fixed asset and this will paralyze your business operations.
Hire Purchase Loan
Another way to finance the purchase of fixed assets is the hire purchase loan. The idea behind a hire purchase loan is that you agree with the seller to pay for the fixed asset in regular installments over a period of time. During this period of time, you can make use of the fixed assets but the legal ownership of the fixed asset remains with the seller until the full price is paid.
This way, you do not need to borrow a large sum from the bank because you can pay the seller in regular installments. The seller will be willing to do this because it retains legal ownership of the fixed asset.
However, this also means that if you default on a repayment, the seller may take back the asset, disrupting your business operations. This is the case even if you have paid the most part of the purchase price. Also, in addition to the interest payable, the seller may quote a higher price under a hire purchase loan than if you made full payment at the outset.
Factoring loans (or Invoice/Receivable Financing) is generally the more expensive option, but it is an option available when it is difficult to obtain other types of loans.
Under a factoring loan, the bank gives you a sum of cash equivalent to a certain percentage of your receivables or trade debts (i.e. the money owed to you by your customers). When the debts are due, the bank collects the outstanding debts from your customers and returns you the difference, minus any applicable bank charges.
The benefit of factoring loans is that you can offer longer credit terms to your customers while immediately getting the cash for the invoices you have issued. This eases your cash flow.
Of course, in order to obtain a factoring loan, you must first have receivables or trade debts that can be pledged as collateral. Also, banks will look at the creditworthiness of your customers in deciding whether to give you the loan. This may be useful if your own business outlook does not appear to be positive and it is difficult to obtain other types of loans.
Just remember, the term of your loan makes a difference as well so, despite monthly payments looking manageable, the cumulative interest incurred should be a factor that’s up for evaluation. Speak to your financial advisor carefully before deciding on your commitment as this will definitely have an impact on your middle and long-term bottom line.