Secured loans and Unsecured loans
Business loans are one of the most common sources of finance and traditional banks are probably the first lenders on your call list. However, there is a wide array of other debt lenders out there all vying for market share and they should not be ignored. A competitive tendering process that includes a carefully targeted list of lenders will ensure you get the most flexible terms and cheapest pricing for your business.
Before you start approaching lenders, it is worth understanding some of the basics of a business loan.
What is a term loan?
A term loan is an amount of capital borrowed from a lender and repayments made at fixed intervals over a period of time. The term can be as short as a few months or a longer period of five years or greater. Interest rates are charged on the loan either at a fixed or variable rate.
Business loans can be provided by one lender also known as ‘bilateral loans’ or by several lenders forming a ‘syndicated loan’
Lenders can provide either an unsecured loan or a secured loan. Secured loans require you to provide assets or other collateral held by the business as protection for the lender whereas unsecured loans typically will require personal guarantees by the directors of the business instead.
Why take on a term loan?
Term loans are normally taken out for a specific purpose such as acquiring new equipment or inventory providing ample time for it to start contributing back to the business before the loan matures.
Always ensure the loan is used to generate a positive return on investment. Taking a term loan to simply cover a cash shortage or cover an expense when the business is not expected to grow in the future may drag your business further down rather than help boost your business. Benefits of taking the loan to enhance growth could include:
Unlocking discounts from bulk buying raw materials
Covering upfront costs required to open new sites for retail roll out
Making a complimentary acquisition with synergistic effect
Bringing in new staff hires to prepare in advance of seasonal upticks
New product or service development to improve bottom line margins
Test new expansion plans
Avoiding cash shortfalls allowing the business to breathe
Refinance debt to reduce the cost impact to the business
What are some of the potential benefits taking out a term loan?
Lower interest rates than shorter term debt financing such as overdrafts
Releases cash to be utilised in other parts of the business
Predictable payment structure allowing better forecasting
Interest is tax deductible usually meaning the effective interest rate paid by your business may be materially lower than the paper interest rate charged by the lender
On time payments improve your business credit score for future financing opportunities translating to better terms and cheaper interest rates
You keep control of the company’s decision making as debt does not dilute shareholding unlike equity funding
What are some of the risks of taking out a term loan?
Onerous covenants and limitations imposed by the lender restricting the business from making further acquisitions, raising additional debt or making payments (e.g. dividends) to equity holders
Lenders will impose financial maintenance covenants which are quarterly performance tests and are usually secured by the assets of the borrower
Any default on repayment of the debt could result in the lender forcing through a sale of assets or the business through a liquidation process
Poor credit and trading history and limited assets to provide as collateral can mean higher interest rates are imposed which could be detrimental to the business and work against the original aim of growing it
What types of term loans are available?
The two key categories of term loans are unsecured loans and secured loans. The type the loan taken will be linked to your ability to pay down the loan.
Unsecured loans
Unsecured loans are suitable for companies with few assets available. Typically, unsecured loans have shorter terms and are used for the following examples:
Working capital and cash flow management
Meeting immediate bills such as tax
Short term business growth
Purchase of lower value assets
The key benefit of an unsecured loan over a secured loan is there is no need for any assets to be used as collateral. This can also mean faster access to the loan as no asset valuations are required. However, be aware that lenders will normally expect personal guarantees from the directors.
Unsecured loans usually attract significantly higher interest rates than secured longer term loans. They should, therefore, only be used to cover expenses when the business can quickly generate a positive cash flow to repay the loan off.
Conversely, lenders do not tend to penalise early repayments unlike secured lenders so they do provide more flexibility.
Secured loans
Secured loans could be most suitable for businesses which have significant assets to leverage off. It can mean that you can access more capital funding and rely less on you current trading history as the assets provide sufficient security for the lender.
The loans tend to be longer terms and also attract lower interest rates than unsecured loans. However, lenders often charge an early repayment penalty so you need to factor other costs such as this into your calculation. Secured loans are more common for:
Big ticket capital expenditure
Long term growth such building teams and rolling out new locations
Supporting the acquisition of a business or for a management buyout
The main downside with secured loans is you could potentially risk losing your assets if you default on your repayments. The lender will take ownership of those assets to sell as a way to reimburse themselves. There are various securities that a lender can include:
Fixed charge
Floating charge
Lien
Mortgage
Pledge
When determining the security imposed, a lender will need to take into account the current securities held to ensure it has sufficient protection to lend against.
Fixed and Floating charges explained
Fixed charge - security is attached to a specific asset in the business allowing the lender to recoup its investment by selling the specific asset in the event the company defaults or a liquidation commences.
Floating charge – rather than attaching the security to a single asset the charge is attached to an asset class such as stock, cash or work in progress. In the event of a default or liquidation, the floating charge crystallises into a fixed charge on the associated assets.
Seniority of the debt
The ‘seniority’ of the loan determines the relative importance of the lender for repayments and the security it holds over an asset. For example a ‘2nd ranking’, ‘2nd tier’ or ‘2nd lien’ loan is a loan secured on the same assets of a 1st ranking debt but has second priority (or subordinated) over those assets. Often the debt may rank equally in terms of repayment priority but in the event of a liquidation the proceeds from the asset sales will be used to pay the 1st ranking debt first before any remaining proceeds are used to pay the 2nd ranking debt.
The subordination of the debt usually results in higher interest rates demanded by the lender and are often used, like mezzanine loans, to bridge the gap between senior debt and equity. Mezzanine loans will not normally amortise and usually are both subordinated in ranking and payment.
Loans in tranches
Quite often the same lender will provide loans in two or more tranches payable with different terms. Typically this is split between:
Term A loan with the amortising (repayments) over the life of the loan also known as an amortising tranche
Term B loan with nominal or no repayments during the term and a large bullet repayment payable at the end of the loan term /maturity
The interest rates, charges, security and other terms will differ. For example, a Term B loan usually allows borrowers to defer repayment of a large portion of the loan, but is more costly to borrowers than a Term A loan.
Depending on the size of the loan requirement additional tranches may be provided all with their own payment profiles.
Drawdown facilities
Quite often a business will to need to draw down funds as and when they need rather than in one lump sum. This helps minimise interest exposure to the amount being drawn down rather than the entire loan amount agreed. You may, for example, use an acquisition facility when making a series of acquisitions as part of a buy and build strategy. The facility will give you quick access to draw down funds as and when each deal is agreed, giving you the competitive edge to move faster than other buyers vying for the same acquisition target as you.
The most common type of facility used for short term financing is a Revolving Credit Facility which gives you the ability to draw down and repay the loan as often as required over its life, making it ideal when there are cyclical cash flow encounters, such as VAT bills or seasonal trading low periods. Typically you draw down funds to cover a business expense and then repay the facility down to zero.
Interest rates charged
The interest rate charged by the lender is often a variable rate linked to an index, typically a floating rate equal to LIBOR plus a premium or a discount. In some cases the rate offered will be fixed.
Fixed rates tend to provide you with more visibility of your costs but can be more expensive than a variable rate on offer. However variable rates can jump significantly if the index being used jumps.
Fees
Don’t forget that the amount you borrow is net of any fees charged on providing the loan facility and there are also a number of charges that can be levied in addition to this. Fees come in many different disguises and you will need to factor these into your assessment such as:
Arrangement fees – upfront fees charged by lenders
Underwriting/Processing fees – usually covering underwriting costs
Utilisation fees – based on how much of the loan is drawn down
Documentation fee – for completing an application
Prepayment fee – premiums for the principal being paid ahead of schedule
Late fees – when payments are not made on time
Commitment fee – sometimes required to guarantee the availability of any undisbursed amount of loan in the future
Monitoring fees – ongoing fees to recover the costs of monitoring the loan
Origination and broker fees – i.e. commissions charged for finding or arranging the loan
What will be needed to apply for the loan?
The amount of debt a lender will be prepared to offer will depend on the cash flows generated by the business, the assets or collateral that is available as security and any personal guarantees the directors of the business can provide. Therefore lenders will want to see:
proof of trading history including management accounts, financial statements and tax returns
bank statement records to demonstrate the business has the ability to repay the debt
credit rating assessments of the business including the business credit score as well as personal credit scores of directors in the business
an operating model showing the forecast cash flows with a clear set of operating assumptions
a funding schedule outlining all the debt and equity obligations to show the businesses’ ability to add new debt. Ideally this should be included as part of the financial model as will allow you to stress test the business forecasts and funding structures under different sensitivities to ensure lending ratios/covenants will not become breached. Typical ratios will include:
Interest cover
Cashflow cover
Debt /EBITDA