Most UK business lending to small businesses is secured, in that in addition to requiring a demonstrable ability to service and repay the loan from a business’s future cash flows, there also needs to be security for the lender to enable recovery in the event of default. So what happens if security is not available? This article gives a cash flow lending definition and discusses the sources of cash flow funding available to businesses in the UK today.
Cash Flow Lending Definition
Cash flow lending is where a funder advances a loan solely on the strength of the forecast cash flows, as opposed to an asset based loan which is advanced based on the value of the underlying assets offered as security. The lenders involved will usually impose covenants on the borrower concerning the level of its’ profitability at EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) level, interest cover, or its enterprise value. If the borrower breaches a covenant this then gives the lender the right to take action such as requiring repayment.
While this sort of funding is often available through the City to large companies and has been used as part of the lines of funding for large leveraged buyouts, it is much rarer to find it available to SME and mid-market companies.
Commercial Lenders to SMEs and Mid-Market Companies
The main lending institutions in this area are the banks and asset based lenders. While banks will sometimes talk about providing cash flow loans, in practice, particularly in the current circumstances, these are rare other than at a very limited level (up to say £25,000). But they are still possible in some circumstances and there is for example a funder still providing loans of up to three times EBITDA in connection with buying a business.
Paradoxically, the asset based lenders such as factors and invoice discounters have been the most active providers of cash flow lending in recent years, both in a structured way through specific cash flow loans repayable over two or three years and usually given in connection with a buy out, through to more flexible temporary facilities by way of an ‘over advance’ on the ledger, although again, in current circumstances their appetite is reduced.
Pre credit crunch there were a few lenders providing cash flow lending in a relatively pure form through ‘block discounting’ arrangements, involving advances against future contractual cash flows such as lease or rental payments. Most of these lenders have exited the market, although there is one funder which is very active providing finance of this sort at levels of over say £10m for projects which meet their, quite strict, criteria.
The government is aware that there are issues for businesses seeking loans but which do not have assets that can provide lenders with the security they want.
The Small Firms Loan Guarantee scheme and now the Enterprise Finance Guarantee scheme were both intended to address this by enabling firms to have the Government provide a partial guarantee of the loan (in return for an insurance premium). Neither scheme seems to have been a great success, partly since some of the lenders appear to feel they involve a degree of bureaucracy and, more crucially, the guarantee is only a partial one, so the lender will still be at risk for some of the loan in the event of default.
More direct Government help is available in some areas of the country for some projects by way of publicly funded grants and soft loans. The sources available vary widely across the country and so it can be difficult to discover what schemes are actually open to your business; however there are specialist consultancies who can conduct searches for you.
Most grants and other publicly funded support is only available on a matching basis providing part of the cash needed for a project, so you will still need to find the rest elsewhere.
In the absence of institutional lending in this area, many businesses have few options but to turn to seeking business angel finance, but this can be very difficult to secure and involves a sale of a sometimes substantial slice of the company’s equity in return for funding.
There are also a limited number of funders from parts of the venture capital world who are prepared to consider providing high interest short term cash flow loans in situations where there is an urgent cash requirement. They will normally be looking for situations involving a successful business with a profitable track record and a positive balance sheet greater than the loan sought, run by an individual with some net worth, that needs the funding to enable a business to achieve some cash generating objective that can amortise the loan which will provide them with an ‘equity’ rate of return.
The funders will look at deals on a case by case basis and appropriate scenarios might be a business needing to invest in order to secure and deliver a long term contract, or one which has won a large order that creates a working capital requirement in excess of the business’s capabilities to raise from normal sources.
Some of these lenders will also consider distressed business situations.
These funders will put their money in by way of a loan so there is no dilution of the owner’s equity, although there may be some convertibility in event of default, and they will expect to take a full package of company and personal security by way of debentures and personal guarantees, even though there may be no value in these on normal security formulas.