Money is one of the biggest hurdles when setting up a business and sometimes a helping hand is needed to fund scaling-up costs or to keep a business afloat.
The most traditional way for businesses to bridge gaps in funding has been to take a business loan. They enable small firms to fund their day to day operations or further growth.
But getting a loan can be a daunting experience because there are so many different products and providers, as well as confusing jargon.
We’ve come up with a guide to explain what to consider before applying for a bank loan, including whether you should take a short or long-term loan and what other funding options are available.
Startup sagas: Launching a business is hard work so securing external funding can be a weight off small business owners’ shoulders
Check if you’re eligible
The first step is working out whether you’re eligible for a business loan.
Each lender will have specific requirements on the turnover of businesses applying and the health of the business will also be taken into account.
Most will ask that your business is officially registered in the UK, the owner is over the age of 18 and it has been actively trading for a minimum of six months.
You will need to decide how much you want to borrow and work out how long you need it for.
Decide what kind of loan you need
Once you know you’re eligible, you should work out how much money you need, what you can afford to repay and how long you need the money for.
A short-term loan might be best if you need a quick cash injection to alleviate cash flow constraints or to buy products or equipment.
The main advantage of short-term loans is that they are repaid quickly, often within a year. This limits the amount of time in which interest can build up, meaning the borrower will often pay less interest overall.
They also usually have faster application processes – but the rate of interest will be significantly higher than if you opted to repay the loan over a medium or long-term period.
Medium and long-term loans typically allow you to borrow to help grow the business, meaning they are spread over a long period and monthly instalments are lower.
A medium to long-term loan might be more appropriate for those looking to set up a business or expand their existing business.
Medium term loans can be paid in monthly instalments over one to five years, while long-terms can range from anywhere between five and 30 years. Short term loans are generally repaid in between three months and a year.
It is also worth noting that it is more difficult to be approved for a long-term loan because lenders need to have assurances you will be able to repay it.
It is worth calculating the monthly loan repayments before applying so you know you can afford to pay it back.
Secured or unsecured?
Some loans are secured by an asset that you own, typically your home – so if you fail to keep up on repayments, you could lose your house.
You can borrow more money with a secured loan, but it is largely dependent on the equity available in the asset the loan is secured against.
Most secured loans come with upfront charges to cover administration, and can be slow to obtain because of things like property valuations and legal checks.
The other option is to take out an unsecured loan. This doesn’t require an asset to secure, but greater scrutiny is applied to your personal credit history.
Get your finances in order
Once you have worked out what kind of loan and how much you want to borrow you’ll need to make sure your finances are in order.
Consolidating debts might help. This is when you combine multiple debts into one single debt which can make it more manageable to pay back.
Lenders will review your business accounts so make sure you have filed fresh accounts before applying for the loan.
You will also have to show a detailed profit and loss statement and a balance sheet.
It is worth having all of the documents to hand before you apply, including legal documents, business and personal tax returns, and financial statements.
You will also need to provide a clear explanation of what the funds are going to be used for.
What are the other funding options?
You may have gone through all of these steps only to discover your bank has rejected your application.
Given the economic backdrop and rising costs, banks have started to tighten their stress testing on new borrowers.
Recent research by Altenburg says tests that previously assumed a two per cent year increase in a firm’s cost base, are now assuming five per cent or higher.
It makes the already tough environment for small businesses even more difficult – but there are other options.
The most common short-term facility for small businesses is an overdraft, but these can be expensive so be sure to check interest rates.
You can also usually borrow more with a business credit card than a personal one. Some banks will allow you to spend interest-free for a set period of time, but once the 0 per cent offer ends the interest rate is likely to spike.
>> Read our guide to the best bank accounts for small business and compare fees, interest and overdrafts.
Stress test: Banks have tightened their eligibility criteria for new business borrowers, sousing an overdraft or applying for a Government-back start-up loan might make more sense
You can apply for a Government-backed start up loan of £500 to £25,000 to start to grow your business, and you will also receive 12 months of free mentoring.
Unlike a business loan, however, this is an unsecured personal loan. The loans charge a fixed interest rate of six per cent per year and you can repay over a period of one to five years. The average loan amount is £7,200.
Crowdfunding might be another option to raise finance. There are plenty of platforms that allow companies to ask individuals for small amounts of money.
You will need to have a target figure, pitch the details of your business to your would-be investors and then raise the money.
You can also raise money via equity – when people invest for a stake in return – or through peer-to-peer lending, where money is lent at a set interest rate.
Former Dragons’ Den star Piers Linney told This Is Money: ‘If you can make equity finance work, you’re then thinking about building a business that you sell or buy investors out.
‘If you’re in this place there are lots of new platforms there… new angel investment networks. But investors are also taking a hit in their own portfolios so you might find the supply of finance might drop off, it’s going to be a difficult period.’
‘The advice has to be understand your financing options. Make sure you really understand them… you haven’t just gone to one high street bank and that’s it you’ve gone home. There are lots of options.’