Debt finance for innovative businesses

Innovative businesses often rely heavily on grants and equity finance for funding, but have you considered debt finance as an option?

By always chasing the next grant for their small business, founders can become too risk-averse and miss out on opportunities.

Meanwhile, focusing on equity finance can lead to a dilution of a founder’s ownership of their business and pressure from investors to grow.

An alternative option is debt finance, when a business borrows money from a lender and pays it back with interest. 

Benefits and drawbacks of debt finance for innovative businesses

here are several pros and cons to using debt finance.

The advantages include:

• retention of business ownership – unlike equity funding, you don’t need to provide a debt finance provider with a share of your business
• tax benefits – interest payments for lending are classified as deductible business expenses, which you can use to reduce your tax bill.

The disadvantages include:

• paying the debt back – you have to repay debt finance, so taking on debt could cause cash flow challenges for your business
• impact on credit rating – your credit rating is affected when you take out a loan, and if you default on repayments, it can be negatively impacted, which could reduce the likelihood of securing more funding in the future.

Debt finance options for innovative businesses

There are different types of debt funding, which may be more suited to different sectors, businesses, or circumstances.

Business loans

A business loan involves borrowing funding and repaying it with interest.

Loans can be secured or unsecured.

Secured loans require an asset as security, while unsecured loans don’t (although you’ll often have to provide a personal guarantee).

Specific types of loans include:

• Start Up Loans – a government scheme providing personal loans of between £500 and £25,000 to new businesses, and loans are paid back over one to five years at an annual fixed interest rate of 6%
• bridging loans – short-term funding used to bridge a gap in a business’s finances, with loan amounts typically a minimum of £10,000 and usually require assets as collateral
• overdrafts – a line of credit provided by a bank allowing you to withdraw more money than you have available, with interest paid on the finance you use plus potentially a fee to arrange the overdraft.

Venture debt

This is debt funding for businesses that are already supported by venture capital.

Venture debt acts as an additional source of liquidity for businesses during the intervals between equity funding rounds.

Invoice financing

Invoice finance involves a lender using an unpaid invoice as security for funding and providing the business with quick access to a percentage of the invoice's value. 

There are two main types of invoice financing:

• invoice factoring – the lender provides the business with a percentage of the value of an invoice and collects payment of the invoice directly from the customer
• invoice discounting – this works in a similar way to invoice factoring but the business keeps control of collecting payments from the customer –invoice discounting is usually used by established businesses with larger turnovers.

Asset-based lending

Asset-based lending uses assets on a business’ balance sheet as security against the funding.

Examples of assets are debtors, stock, machinery, property, and intellectual property.

It is typically aimed at established businesses with measurable business assets.

Merchant cash advances

A merchant cash advance (MCA) is short-term funding for businesses that accept debit and credit card payments.

It can be used for purposes such as increasing revenue, retaining customers, and investing in stock.

A lender provides the business with an upfront sum of money, which the business repays using a percentage of its card transaction sales, plus fees.

How innovative businesses can access debt finance

Step 1 – Assess your needs

The first step to accessing debt finance is thinking about why you need it in the first place.

For example, is it to meet a short-term financial need or for a longer-term purpose?

You must also understand how much funding you need, whether you have assets (if required) to secure the loan, and whether you can repay it.

To determine suitable funding for your business, use our Finance Finder.

Step 2 – Prepare your business for debt finance

To get ready to apply, prepare documents so the lender can understand your business, know how you will use the money, and be confident you can pay it back.

A key document is a strong business plan that outlines your business strategy, market analysis, and financial projections.

Other documents you may need to provide include:

• bank statements
• financial accounts
• business and personal tax returns
• incorporation documents
• balance sheets.

Step 3 – Identify suitable lenders

There are many lenders offering a wide range of debt finance.

Your options include high-street banks, online lenders, and alternative finance providers.

To find suitable providers, search online and speak to other business owners for recommendations.

Find out more with our list of accredited lenders that are part of the government’s Growth Guarantee Scheme.

When comparing lenders, make sure you understand their criteria and the terms and conditions, including the interest and fees charged.

Step 4 – Application process

To boost the chance of your application being successful, consider doing the following:

• carefully prepare all the required documents
• understand and refer to the lender’s criteria
• present a convincing case for why your business is worth funding
• show that you can repay the loan amount.

Documents must be correct and submitted on time.

For example, to apply for invoice finance you need to provide details of invoices that might be suitable, including the customers’ details.

Managing debt finance effectively

Managing debt finance effectively is crucial for maintaining your business’ financial health, while also using it to help its growth and innovation.

It’s a good idea to only borrow money with a clear plan for what you’re going to do with it and how you will repay it.

Create a debt repayment schedule to avoid defaulting and the accompanying negative impact on your credit score.

Regularly monitor how you’re managing the debt with the help of an accountant.

If cash flow becomes a problem, consider renegotiating the finance to extend the payment term or lower the interest rates.

Track the return on investment from the funding to ensure the returns outweigh the cost – investing the money in revenue generating activities or using it to scale can help to do this.

Find out more about how an accountant can help manage your debt.

An over-reliance on grants and equity finance can limit a business’ innovation, growth, and success.

By diversifying funding sources to include debt finance, a founder can build long-term sustainability.

For everything you need to know about the difference finance options available for small businesses, read the British Business Bank’s guidance.