31 Oct Alternative Forms of Business Finance in Nigeria
Businesses often fail due to a lack of funding for growth in areas of operations, business equipment, marketing etc. Financing a business is often difficult for business owners as there are varying options available to capitalize or finance a company, each having its own nuances and technicalities.
Before taking a decision on the type of business finance to venture into, there are several factors to be considered by the business including inter alia, its ability to enter into finance transactions, cash flow requirement in terms of liquidity, taxation and flexibility or rigidity of the type of financing.
Equity and/or Debt Financing (which we discussed in a previous article) are the two most common and contemporary forms of financing in Nigeria however this article seeks to examine other methods of financing which are feasible for Nigerian businesses.
Some of these other forms of funding include:
- Mezzanine Financing;
- Lease Financing;
- Invoice Financing;
- Hire Purchase/Conditional Sale;
- Stocking Finance;
Mezzanine Financing can be typically described as an amalgamation of equity and debt finance. It gives the lender the right to convert to an equity interest in case of a default by the business (borrower) after all the senior lenders have been paid.
Mezzanine financing is often offered to businesses who have a proven track record in its industry, propensity for high profitability, a viable product and workable expansion plans. An advantage of such financing is that minimal collateral is required from the borrower. It is treated as equity on the company’s balance sheet.
Unlike other forms of finance, interest rates in respect of Mezzanine financing are typically very high.
Some of the other characteristics of mezzanine financing include:
- In terms of priority of repayment, these loans are subordinate to senior debt (as mentioned above) but senior to common equity;
- Mezzanine loans demand a higher yield than senior debt and are often unsecured;
- Part of the loan on a mezzanine loan is fixed which makes this type of security less dilutive than equity;
- Providers of the mezzanine capital are often long-term investors in the business.
A disadvantage to owners of businesses when securing mezzanine financing is that they sacrifice an element of control due to loss of equity. In addition, the longer the mezzanine financing subsists, the more interest will be paid by the business.
Lease Financing is one of the most essential sources for medium to long term financing. A lease finance is a type of lease whereby a finance company (lessor) who acquires the asset is the legal owner of same for the period of the lease however the lessee has operating control over the asset. In addition to the foregoing, the lessee also has a substantial share in the economic risks and returns in the event of a change in valuation of the asset.
In return for use of the asset, the lessee will make periodic payments to the lessor (finance company). The periodical payment made by the lessee to the lessor is known as lease rental.
Essentially, under lease financing, the lessee is given the right to use the asset but the ownership lies with the lessor and at the end of the lease contract, the asset is returned to the lessor or an option is given to the lessee either to purchase the asset or to renew the lease agreement.
Depending on the transfer of risk and rewards to the lessee, the period of lease and the number of parties to the transaction, lease financing can be classified into two categories.
- Finance lease;
- Operating lease.
Finance lease is the lease where the lessor transfers substantially all the risks and rewards of ownership of assets to the lessee for lease rentals. In other words, it puts the lessee in the same condition as it would have been if it had purchased the asset.
On the other hand, Operating lease is where the risks and rewards incidental to the ownership of asset are not transferred by the lessor to the lessee. The term of such lease is much less than the economic life of the asset and thus the total investment of the lessor is not recovered through lease rental during the primary period of lease. Furthermore, in the case of an operating lease, the lessor usually provides advice to the lessee for repair, maintenance and technical know-how of the leased asset and that is why this type of lease is also known as service lease.
A few of the advantages of this form of financing from the perspective of the lessee include:
- Use of Capital Goods:a business will not have to dispense a lot of capital acquiring an asset but it can use an asset by paying small monthly or yearly rentals.
- Tax Benefits: a company is able to enjoy the tax advantage on lease payments as lease payments can be deducted as a business expense.
- Cheaper: leasing is a source of financing which is cheaper than almost all other sources of financing.
- Technical Know-How: in this sort of arrangement, the lessee would receive some technical assistance and support from the lessor.
- Ownership: after expiration of the lease agreement, the lessor offers the lessee the optionof purchasing the leased asset – by paying a nominal amount.
Invoice Financing/Receivables Financing
Invoice financing is a method in which businesses borrow money against amounts owed to it by its customers. It aids the business improve cash flow, pay employees and suppliers and reinvest in other areas of the company. Invoices act as collateral for invoice financing andthe lender also limits its exposure by not disbursing 100% of the invoice amount to the company.
There are two forms of invoice financing namely: (i) Invoice Discounting; and (ii) Invoice Factoring.
This is where the lender advances the business up to 70% – 90% of the invoice value and will release the remaining amount minus a small fee once the business is paid by the customer. Invoice discounting comes with a recourse or non-recourse action. In terms of recourse, the business will be required to pay back any amount advanced on invoices of the customer defaults on payment. Non-recourse is the option that passes the risk of default to the lender.
Invoice factoring is where businesses are required to “sell” the whole of its debtor book for a predefined time period (e.g. between 1-2 years) to the lender who may then pay the company 70% to 85% up front of what the invoices are ultimately worth. Assuming the lender receives full payment for the invoices, it will then remit the remaining 15% to 30% of the invoice amounts to the business, and the business will pay interest and/or fees for the service.
Hire Purchase/Conditional Sale
This is an agreement to buy an asset by making payments over a period of time. It is an arrangement whereby a buyer makes regular installments while enjoying the use of a commodity. The buyer does not own the goods involved until the last instalment is paid to the owner. This method of finance is mostly used for obtaining consumer commodities such as vehicles, vessels, aircrafts, inter alia.
Hire Purchase may also be referred to as a lease purchase but the circumstances are different. In a lease purchase, the hirer pays a reduced rental fee with a balloon payment (lump sum) at the end of the lease, which is usually higher than the rental price. The hirer also has the options to buy, refinance or simply return the commodity involved unlike in Hire Purchase where there is only an option to buy.
A conditional sale is very similar to a hire purchase transaction, the difference being the buyer/hirer’s right of termination. Upon termination of the contract of conditional sale by the purchaser, he must pay the full price to mitigate the vendor’s loss. This is to put the owner in a position as if the sale had been concluded, whereas, the hirer has the right to terminate the hire purchase contract without incurring penalties.
This is also referred to as wholesale finance. This finance method is provided almost exclusively to companies who need to maintain adequate supplies of stock to be able to satisfy orders promptly and to also attract custom by display. The capital required to maintain a reasonable level of stock is such that only a few dealership companies have the cash flow to provide it from their own resources and most dealerships are reluctant in extending credit to distributors. It is usually extended by financing houses or manufacturers themselves.
Stock financing enables a company to effectively manage its circulating capital and to improve cash flow at a reasonably lower interest rate. It is important to note that not all stocking finance is provided on a secured basis, that is, collateral may not be necessary.
Berkeley Legal advises on a wide spectrum of business financing options to enable our clients make informed business decisions.
The information provided in this article is for general informational purposes only and does not constitute legal advice. If you require specific legal advice on any of the matters covered in this article please contact firstname.lastname@example.org