May 2023
A guide to
non-equity financing
Sponsored by
Produced in partnership with
City Road Communications
May 2023
A guide to
non-equity financing
Sponsored by
Produced in partnership with City Road Communications
Contents
JUMP TO A SECTION THAT INTERESTS YOU
Contents
JUMP TO A SECTION THAT INTERESTS YOU
Introduction
Raising finance is a critical challenge for many small and medium sized enterprises (SMEs).
Whether to overcome short-term cashflow issues or fuel long-term growth, an injection of capital can transform a business’ fortune. As such, knowing the type of finance to go after, and where to get it, is of utmost importance.
There is a vast range of options available to SMEs seeking finance. Broadly, these can be split into two categories: equity and non-equity (debt). Both present a unique set of opportunities and challenges.
Equity financing involves selling a stake in the business – a portion of a company’s equity – in return for capital
Debt financing involves borrowing money and paying it back at a later date, typically with interest.
In this report we will delve deeper into the world of debt financing, providing SMEs with a guide to the most pertinent information they need to know.
We will explore:
• Why an SME would choose debt over equity financing;
• The factors driving up demand for debt finance in the current climate, and what common challenges SMEs face when seeking it;
• What types of debt financing SMEs have to choose from;
• Best practice when applying for debt finance;
• The role of brokers in assisting SMEs seeking capital.
Equity financing involves selling a stake in the business – a portion of a company’s equity – in return for capital
Debt financing involves borrowing money and paying it back at a later date, typically with interest.
In this report we will delve deeper into the world of debt financing, providing SMEs with a guide to the most pertinent information they need to know.
We will explore:
• Why an SME would choose debt over equity financing;
• The factors driving up demand for debt finance in the current climate, and what common challenges SMEs face when seeking it;
• What types of debt financing SMEs have to choose from;
• Best practice when applying for debt finance;
• The role of brokers in assisting SMEs seeking capital.
Why choose non-equity financing?
There are many reasons an SME would opt for debt over equity financing. Most notably, unlike equity, debt financing allows the borrower to maintain control and ownership over their business; they retain decision-making powers without needing to consult with the financier. However, it is important to note that in many instances debt finance will come with restrictions for the borrower – for instance, the ability for the business to take on further debt – while certain company activities, such as making acquisitions, may require approval from the lender.
Unlike with equity investments, when using debt finance, the company has no obligation to share profits with lenders, and when the debt is repaid, the relationship with the financier ends.
Further, from a tax perspective, any interest payments that have to be made on debt finance count as “expenses”, meaning the borrower can offset them against the business’ taxable profits.
The disadvantages of debt financing are that, often irrespective of the business’ performance, repayments must be made. Over the term of a loan, for instance, these repayments can create cashflow issues, and if an SME falls on hard times or economic conditions change for the worse, it might be unable to pay. This can result in a loss of ownership of the company, as well as any intellectual property, rights or other securities and assets (such as a property) that might have been used to secure the debt.
The other drawback of debt financing – like equity financing – is that it can be difficult to source, particularly for SMEs with no or poor credit scores. This is a pertinent issue at present: with demand for debt finance high, there are also significant barriers hindering businesses’ attempts to secure it.
Further, from a tax perspective, any interest payments that have to be made on debt finance count as “expenses”, meaning the borrower can offset them against the business’ taxable profits.
The disadvantages of debt financing are that, often irrespective of the business’ performance, repayments must be made. Over the term of a loan, for instance, these repayments can create cashflow issues, and if an SME falls on hard times or economic conditions change for the worse, it might be unable to pay. This can result in a loss of ownership of the company, as well as any intellectual property, rights or other securities and assets (such as a property) that might have been used to secure the debt.
The other drawback of debt financing – like equity financing – is that it can be difficult to source, particularly for SMEs with no or poor credit scores. This is a pertinent issue at present: with demand for debt finance high, there are also significant barriers hindering businesses’ attempts to secure it.
Pros
• Management control
• Tax-deductibility of interest on repayments
• No profit-sharing
• Relationship with financier ends when
debt is repaid
• Repayments and pressure on cashflow
• Risk of not being able to repay
• Difficult to access without a good credit rating
• Can harm credit rating if debt is not repaid
Pros
• Management control
• Tax-deductibility of interest on repayments
• No profit-sharing
• Relationship with financier ends when
debt is repaid
• Repayments and pressure on cashflow
• Risk of not being able to repay
• Difficult to access without a good credit rating
• Can harm credit rating if debt is not repaid
However, it will often not be a choice between one or the other. Rather, many scaling businesses will seek out both equity and debt finance options during their early years.
Sonya Iovieno
Head of Venture & Growth Banking
SVB UK
Sonya Iovieno, Head of Venture & Growth Banking at SVB UK, explains:
“For an early-stage business (seed, series A, series B), debt should be complementing equity. It is not an either/or, rather it is about reducing execution risk by diversifying sources of capital funding.
“For startups, debt finance acts as an insurance policy and source of comfort, such that, if there are any boulders in the road, the debt provides extra breathing room (cash) before equity starts to run out. It gives management teams time to pivot a business and make changes, in order to hit their next growth milestone.
“Layering in debt also gives founders more time to build the company’s valuation before the next equity round.”
“For startups, debt finance acts as an insurance policy and source of comfort, such that, if there are any boulders in the road, the debt provides extra breathing room (cash) before equity starts to run out. It gives management teams time to pivot a business and make changes, in order to hit their next growth milestone. “Layering in debt also gives founders more time to build the company’s valuation before the next equity round.”
Demand for debt financing
As a collective, the UK’s SME community has faced more obstacles in the past three years than at any point in the last half a century, with several converging economic trends contributing not only to increased demand for debt financing, but also heightened challenges in accessing it.
That high street banks are reportedly becoming more cautious in their SME lending activities is mirrored in the equity finance space.
For instance, an annual survey of 246 UK-based angel investors, conducted by Portfolio Ventures in January 2023, shows that the community of individual financiers has become more judicious with their cash. Some 53% responded that economic conditions have forced them to be more selective in their investments.
Similar trends are being seen among venture capital (VC) firms. According to KPMG’s latest Venture Pulse report, VC investment into UK businesses fell by 30% in 2022.
While private investment into scaling businesses is declining, so too are business valuations. High-profile companies such as payments firm Stripe, Buy Now Pay Later firm Klarna and delivery start-up Instacart all saw their valuations knocked down notably in 2022. More generally, according to analysis by Plimsoll, average business values across the UK economy fell 5% in the 2021/22 financial year, with 62% of companies seeing their value fall in that time.
Sonya Iovieno
Head of Venture & Growth Banking
SVB UK
Iovieno continues: “The landscape for raising capital has changed markedly in the past year – interest rates are elevated and rising, so debt is becoming more expensive. This also means that some debt providers do not have as much availability to lend as they might have done in the past. As a result, the bar is higher in terms of the financial performance required to access debt.
“The good news is that there are far more providers of debt to SMEs than ever before. There is a plethora of banks, debt funds, digital lenders and fintechs all servicing this market. The key to success is to be well-organised and understand your credit profile – how do your KPIs compare to peers, have your accounts and management reporting in order, and be clear about the use of funds and how you are going to repay the debt.”
Factors driving up demand for non-equity finance
• Cashflow issues hampering many SMEs in the current climate → others need capital injection to fuel growth strategies
• Meanwhile, UK business valuations are falling, while angel and VC investment activity is declining → so, equity financing is becoming less attractive or attainable for many SMEs looking to raise capital
Piotr Pisarz
CEO and Founder
Uncapped
Piotr Pisarz, CEO and Founder of Uncapped, echoes this point, adding:
“We’ve seen a significant increase in the demand for lending; however, also a severe deterioration in the quality of applications.
“With interest rates rising, and all lenders tightening their credit criteria, loans have become more expensive and harder to obtain. At the same time, the equity market is practically evaporating, making debt an even cheaper option than equity.”
“We’ve seen a significant increase in the demand for lending; however, also a severe deterioration in the quality of applications.
“With interest rates rising, and all lenders tightening their credit criteria, loans have become more expensive and harder to obtain. At the same time, the equity market is practically evaporating, making debt an even cheaper option than equity.”
Different types of debt financing
Debt financing is a broad term that includes many different types of debt and a wide range of financial products. Understanding the options available is therefore important for SMEs seeking capital.
“If an SME has never raised it before, understanding the landscape, the types of debt and providers can be confusing,” says Iovieno. “The terminology in the debt market is not always consistent. Looking underneath the hood and understanding what is available from which providers is very important.”
Indeed, a survey from mid-2022 revealed that while more than two thirds (70%) of SMEs planned to access external funding in the following 12 months, almost a fifth (17%) were unaware of the finance options available.
This issue has become more pertinent in recent years, as the number of non-equity finance options available to SMEs has increased.
This issue has become more pertinent in recent years, as the number of non-equity finance options available to SMEs has increased.
Marvin Fletcher Rogers
Principal Solutions Consultant
Sage
Marvin Fletcher Rogers, SaaS Industry Principal at Sage, explains:
“Conventional wisdom suggests that economic downturns can create opportunities. As the number of opportunities and frequency of equity funding reduces, greater market demand for debt financing is expected to increase – which presents an opportunity to challenger financial institutions – as businesses seek more flexible sourcing of debt.”
“With interest rates rising, and all lenders tightening their credit criteria, loans have become more expensive and harder to obtain. At the same time, the equity market is practically evaporating, making debt an even cheaper option than equity.”
Iovieno echoes this point: “New providers and new products have emerged from traditional lenders (such as debt funds, banks) as well as new entrants (fintechs, digital lenders). We’ve seen new debt funds launched (often funded by VC equity), and lots of innovation on the credit card and charge card side.”
To that end, here are some of the most common forms of debt financing that SMEs use, with an explanation of how they work and why a business may choose that option:
There is a wide range of business loans available to SMEs. These broadly fall under two categories: secured and unsecured business loans.
A secured business loan requires the provision of an asset to secure financing. For instance, an SME might own its commercial property, against which it secures a loan. Or an individual within the company may use an asset – such as their residential property – as a security for the business loan.
Conversely, an unsecured business loan does not require the business or an individual to offer up an asset to receive the capital; nothing is used as a collateral. These can be harder to source for an SME as they rely on sufficient revenue to prove a loan can be repaid, rather than the value of another asset that the lender could claim if repayments are not made.
Historically a business would turn to a high street bank for a business loan, but today there is an increasing number of alternative and digital lenders offering both secured and unsecured SME loans.
Rather than simply being a category of business loans, Startup Loans refers to a specific initiative.
The Start Up Loans programme is funded by the Department for Business, Energy and Industrial Strategy (BEIS) and is delivered by The Start Up Loans Company (SULCo), a subsidiary of the British Business Bank.
The programme offers loans from £500 to £25,000, at 6% interest. As well as the capital, early-stage business (trading less than three years) receive free mentoring and support.
During its 2021 Spending Review, the government stated that it will provide funding for 33,000 Start Up Loans until 2025.
R&D tax credit loan – sometimes referred to R&D finance – is a newer type of finance that allows businesses which are eligible for HMRC’s R&D tax credit scheme to access a loan secured against the value of their future tax credit.
The type of debt is only suitable for SMEs with sufficient investment in research and development – this is to ensure they will be worthy of an R&D tax credit. They can receive a fast (within weeks) short-term loan from a lender, which is repaid when their tax credit comes through from HMRC.
This form of debt financing is popular among some SMEs because it is accessible for companies that have yet to turn a profit and may have no tangible assets like equipment, receivables to factor, or land to use as collateral. Instead, the tax credit acts as an asset to secure a loan against.
Many scaling companies use crowdfunding to access capital, but equity crowdfunding – where a pool of private investors can purchase a share of a company – is perhaps the better-known model.
Yet debt crowdfunding has also become far more common over the past decade, with SMEs seeking debt finance outside of traditional banking institutions.
Debt crowdfunding is a way for businesses to borrow money from many individuals, usually through an online crowdfunding platform. Falling under the peer-to-peer (P2P) finance umbrella, a collection of individuals will come together to provide the total loan amount desired by an SME – the P2P loan is often for a fixed term and rate, so the business will repay ‘the crowd’ the pre-agreed amount once the loan term is completed.
Invoice financing is when an SME takes out a loan against its unpaid invoices. It is particularly useful for businesses that experience problems with late payments. Indeed, late payments are a common issue among SMEs; they cost small business owners in the UK an estimated £684 million a year, with businesses receiving payments an average of 5.8 days late.
Using invoice financing, an SME can receive full or partial value for their outstanding invoices. The capital is then repaid with interest once the invoices are settled.
In other cases, in what is known as invoice discounting or invoice factoring, an SME can sell their outstanding invoices to a third party for a discounted price. For instance, a small business with £50,000 worth of unpaid invoices might sell these to a factoring company for, say, £40,000. The factoring company will then receive the capital from the unpaid invoices at a later date.
Invoice financing and invoice discounting are most commonly used by manufacturing and wholesale businesses that have large invoices that – if unpaid by their customers – can cause significant cashflow disruption.
Merchant financing provides a cash advance on predicated debit or credit card sales.
This type of unsecured business financing is typically targeted at retailers and consumer-facing businesses, such as a hospitality venue – they receive capital that is repaid, plus a fee, as a daily or weekly percentage of the SME’s sales.
Asset financing is an option that businesses can use to grow by acquiring essential equipment, such as vehicle fleets, fitting out hospitality venues, farm machinery, and even aircrafts. The business pays a regular amount to use the asset over an agreed period, avoiding the full cost of buying outright.
The Recovery Loan Scheme (RLS) is a government-backed initiative designed to support access to finance for UK businesses as they look to invest and grow.
The RLS encourages lenders to loan money to SMEs as the government guarantees 70% of the finance back to the lender, should the SME default on the loan. The scheme, launched in response to the Covid-19 pandemic but since extended, is managed by the British Business Bank, which works through accredited lenders.
Know your options, be prepared
In 2021, a third of SMEs who sought access to debt finance were rejected[i]. Where business loans specifically are concerned, this problem has become more acute in the past year, particularly when seeking finance from traditional banking institutions.
The aforementioned Channel Capital survey of over 500 UK SMEs found that most (54%) believe big banks are too slow in assessing business loan applications, with 47% feeling high street banks are reticent to lend to smaller businesses. Of the SMEs that had applied for a loan in the past five years (between 2017 and 2022), only 51% said they found the process of finding a lender and product ‘easy’ or ‘very easy’.
Brokers – intermediaries involved in sourcing loans for borrowers – have recently echoed this sentiment. In February 2023, when asked if high street banks were becoming more cautious in lending to SMEs, 82% of business finance brokers said they were, with 49% reporting that they had seen more applications rejected in December 2022 compared with the previous month.
The statistics reaffirm the importance of SMEs having a firm handle on all the debt financing options available to them, including solutions provided outside of the high street banking sector. Further, the challenges many businesses have encountered in accessing debt products demonstrates the need to prepare appropriately before beginning any application process.
Marvin Fletcher Rogers
Principal Solutions Consultant
Sage
Sage’s Marvin Fletcher Rogers stresses this point:
“The current macroeconomic environment has created greater due diligence and scrutiny by financers into organisations seeking funding. Therefore, in anticipation, several considerations must be made by scaling firms when looking to secure finance. These include process governance such as automating operations and systems to improve working capital, satisfy the audit and provide management information as quickly as possible.”
“With interest rates rising, and all lenders tightening their credit criteria, loans have become more expensive and harder to obtain. At the same time, the equity market is practically evaporating, making debt an even cheaper option than equity.”
Sonya Iovieno
Head of Venture & Growth Banking
SVB UK
Iovieno from SVB UK adds:
“Much like raising equity, the best time to start engaging with lenders is when you don’t need it. Get to know a few lenders in your space, help them understand your business and make it easy for them to understand your strategic vision.
“Do your research to make sure that you are approaching relevant providers and spend your time on those who are the right fit. Cultivate the relationships with potential lenders as early as possible and be as open as you possibly can with a lender when you engage with them. The more information you share about your business the better facility you will get to suit your business.”
“Do your research to make sure that you are approaching relevant providers and spend your time on those who are the right fit. Cultivate the relationships with potential lenders as early as possible and be as open as you possibly can with a lender when you engage with them. The more information you share about your business the better facility you will get to suit your business.”
What to do before applying for debt finance
So, what can SMEs do to ensure they have the best possible chance of being successful when applying for debt finance?
The obvious starting point for any SMEs considering debt financing is to establish exactly how much they need to borrow and why. As Uncapped’s Pisarz stresses: “The first priority is always determining what you need funding for.”
To that end, several fundamental questions need answering: how much money does the business need; how will it be spent; what will the capital enable the business to do; how can the finance be repaid.
Whether a business loan or debt crowdfunding, invoice discounting or merchant financing, all lenders will want to see detailed, robust answers to those questions.
SMEs might need the capital to hire new staff; invest in R&D; purchase equipment or stock; expanding into a new office; executing a marketing campaign; or a combination of any of the objectives. The business must demonstrate the rationale, as well as a clear financial plan for how much is needed for that specific goal.
In the first instance, creating a business plan or a business case for the debt financing will ensure the leadership team are completely clear on why they need the money. It will also act as a strong supporting document to any debt finance application – indeed, some lenders may wish to see it.
As consumers, most people are aware that their individual credit score plays a crucial role in determining their ability to apply for credit, such as a mortgage or an overdraft. It is less well known that businesses also have a credit profile.
A business credit score measures the creditworthiness of a company. It is based on an SME’s financial history, including loan applications, credit accounts, loan repayment history and supplier payment times.
The relative strength or weakness of an SME’s credit profile may go some way to determine how much they can borrow, and the type of debt finance they can access. For a fee, businesses can use tools like Experian Business or Equifax Business to understand their credit score.
Similarly, some lenders may check the credit scores and profiles of the business’ owners and directors. Red flags thrown up by those personal credit checks could create barriers to SMEs seeking debt finance.
Establishing the business’ credit profile, and taking action to build it up positively, will likely prove important for an SME seeking finance. Such action can include: having all accounts accurately filed up to date; consolidating and repaying debt; improving on personal credit scores; building up a better credit score by taking on and repaying smaller debts, such as a company or personal credit card, or small loans.
Marvin Fletcher Rogers
Principal Solutions Consultant
Sage
Marvin Fletcher Rogers, from Sage, explains that financial reporting tools can also play an important role here:
“Given the current climate and relatively limited opportunities for financing (both debt and equity), it has become more important to demonstrate reliable financial reporting.
“While the industry literature suggests there are still vast opportunities to secure funding, the overall level of diligence and scrutiny has undoubtedly increased as a result of the environment.
“Therefore, investing in applications that provide, real-time, reliable, investor-grade reporting is critical in displaying the value and creditworthiness of the business. This makes it possible for the financing organisation to forecast more confidently and identify the dependability of the organisation to meet the necessary performance obligations.”
Lenders increasingly rely on technology to process debt finance applications and make decisions as to which businesses to lend to.
Indeed, simple requests may be processed electronically, and a system decision will be made based on key criteria such as the asset owned by the business, its credit and trading history, its financial performance, and the industry or market it operates in.
However, given the more complex nature of many non-equity finance deals, many requests will involve a judgement decision by a lending or credit manager. In these cases, funders will consider many of the key questions outlined above:
• The request itself – the amount the business has requested and for what purpose
• The client contribution – how much capital can the business put forward, with 50% of the total request sometimes required for start-ups
• Security – personal guarantees, debentures and legal mortgages over assets or a property are commonplace
• The source of repayment – how the finance will be repaid, such as through trading income, existing invoices, receivable of rental payments, or the sale of an asset
• The people involved – the experience and make-up of the leadership team, namely the owners and directors, and those involved in the day to day running of the business
• Financial performance – the company’s past and current performance, including profitability
• Forecasts – are the forecasts for future earnings realistic, how have they been developed, and who by?
• Business plan – is there a well-researched plan that demonstrates a clear understanding of the market and the business’ growth strategy?
Today, lenders will also often use systems that pick up multiple repeat enquiries. Businesses that do this might find their credit score is affected, and their applications might be rejected outright.
The role of brokers and business planners
Just as with consumer loans and mortgages, intermediaries can play an important role in enabling borrowers to seek out the right finance options for their needs.
In the case of non-equity finance for SMEs, brokers, business planners, accountants and other specialists can help guide the company through the funding process and find appropriate options. They will typically take the time to understand the business’ situation, its financial circumstances, what finance is needed and why – from here, the specialist can advise on relevant products and providers.
SMEs would call upon the help of professionals, such as a broker or business planner, to help with:
- The preparation of an application, business plan and financial forecasts
- Finding suitable lending options
- Collecting the information specific to a lender’s requirements
- Communicating with lenders on the business’ behalf
- Providing guidance on the process and progress being made
Sonya Iovieno
Head of Venture & Growth Banking
SVB UK
SVB UK’s Iovieno says:
“Brokers and advisors play an important part in this market, which can be challenging to navigate for first time founders. Not all companies have the time, or the network, to complete thorough diligence. Advisors with experience with companies in a similar sector at a similar stage, can be well positioned to provide good advice.
“Be aware that many lenders will not engage directly with brokers or pay broker fees, so it is worth asking your broker who they are going to source debt opportunities from.
“Consider your wider network beyond founders and investors. Speak to your accountancy firm, legal advisors, or your bank, to see who they work with, they may be able to make introductions or recommendations to you.”
“Consider your wider network beyond founders and investors. Speak to your accountancy firm, legal advisors, or your bank, to see who they work with, they may be able to make introductions or recommendations to you.”
Case studies
Here are two case studies of SMEs that have secured non-equity finance, including some valuable lessons that other business leaders can learn about going through this process.
Ieso: Tech firm uses debt to provide flexibility and optionality to financing options
Since 2010, Ieso has been transforming how the world understands and treats mental health. Through collective research, deep AI analysis and clinical science, Ieso’s technology is continuously improving recovery rates and making effective therapy accessible to new audiences.
Ieso’s clinical service is used widely across the NHS, while it is also a digital technology partner transforming outcomes at every stage of our partners’ patient care pathway.
However, as it looked to expand globally, it needed to consider its financing options. Nigel Pitchford, the company’s CEO, explains: “Ieso has been operationally profitable for a number of years but with its growth plans and an eye on the international markets we needed to have a flexible finance package in place to call upon funds as and when needed to help finance the business in the most meaningful way.”
SVB UK worked with Ieso to provide a venture debt facility to support growth plans.
“Venture debt has enabled Ieso to add a degree of flexibility and optionality to its financing options,” Pitchford says. “Having the venture debt facility also enables us to choose when to raise further equity and do so only when the company meets key value inflection points. As an operationally profitable business, we are able to service the loan through our income, which means we can really focus investment on our people and technology.”
Current Health: Venture debt for US expansion without diluting ownership
Launched in 2015, Current Health is an enterprise remote care management platform that enables early, preventive treatment to patients in their own home. It helps global health systems and pharmaceutical companies deliver high-quality healthcare at home, leading to better patient outcomes and a lower overall cost of care.
The company’s CEO, Christopher McCann, explains why the company sought debt financing: “At Current Health, our strategy has always been to create best in-class technology that can support novel healthcare models. We want to be the glue that enables safer healthcare at home, which required building a platform that can seamlessly integrate into our customer workflows. Making this vision a reality required sizeable capital funding.
“On top of that we needed further capital to expand our market presence and scale up our offering in the US where there has been increasing interest in technology that can enable value-based care.”
SVB UK worked with Current Health to provide a venture debt facility to support growth plans. “Venture debt has enabled Current Health to invest in our technology, meet our strategic goals and scale up in our key markets like the US,” McCann says.
He adds: “Having the venture debt facility also enables us to keep more ownership of the business by reducing dilution. This means we have extended our runway and can choose when next to raise further equity. It also means we can control the speed of how fast we scale in the US and grow our network of partners in a sustainable way that doesn’t impact patient care or services.”
Thanks to our sponsors
This report was produced in partnership with City Road Communications, a PR and comms agency that specialises in using research and data for the technology, real estate, and financial markets.
As well as building brands for scaling companies, City Road Comms creates engaging, in-depth reports for publishers and their clients.
