Institutional lending should be treated with caution, whilst recognising that debt is an essential part of the funding mix for most businesses. Approached correctly, lending can be flexible, responsive, and in some cases cheaper for a society in the long run. Institutional lending to societies generally takes three forms; secured longer-term capital finance for fixed assets, shorter-term finance for working capital, and bridging loans. Other forms of debt finance, such as overdrafts, factoring and corporate credit cards, are not considered here.
Secured longer-term capital loans, for terms of five years or more, are typically used to finance the purchase of fixed assets, where community share capital and the resale value of the fixed assets are seen to reduce the risk of the lender. Lenders may be willing to lend up to 80% of the total capital required by a society, especially for a fixed asset such as property that is unlikely to depreciate quickly in value. Payment of interest and repayment of capital for secured loans takes priority over any payment to shareholder members, or to unsecured creditors such as suppliers. The payment of loan interest will reduce the amount of surplus available for community benefit, share interest and withdrawal. Loans may also be more expensive than community shares. High proportions of secured debt in the overall capital financing package will increase the effect of these drawbacks for a society.
Shorter-term loans, for up to five years, are usually made to provide working capital, enabling a society to purchase stock, or meet staffing costs in the early start-up phase of a society's operation. This form of lending provides a safety net for societies that have unpredictable or large fluctuations in their cash flow requirements, or simply lack cash when they start. Such loans should be restricted to an amount the society can realistically repay from cashflow within the lifetime of the loan.
Some institutions may be prepared to provide bridging finance. Such finance can help societies that need to act quickly to secure the purchase of fixed assets, or where they might be involved in a competitive bid for the assets, and do not want to publish a community share offer providing full details of their capital plans. Alternatively, finance may be needed to fill a temporary cashflow deficit caused, for instance, by VAT payments or delays grant funding. Bridging loans are so called because they bridge a gap in finance, so are usually very short term, and comparatively expensive. In the context of community shares, bridging loans are usually replaced by the proceeds of a successful community share offer. The society needs to be confident that the problem is only temporary, or that it will be able to raise sufficient community share capital to replace, or reduce, the bridging loan to a viable level.
All forms of debt finance will usually be subject to legal agreements which may contain covenants that restrict the freedom of the society. The two most common covenants are to establish security over a society’s assets, and to require directors to seek permission from the institutional lender before entering into any further debt finance agreements.
Societies should be cautious of accepting loans for more than 50% of their total capital requirements. For loans of between 25% and 50% of their total capital requirements, caution should also be exercised if the cost of the loan is significantly above the maximum interest rate payable on community shares, and or where the lender requires full capital repayment in less than five years. In such circumstances a society’s members and prospective members should be fully informed about how the loans might affect their financial interests.
Debt finance can be highly effective in addressing any shortfalls in funding raised through a community share offer. Section 4.5.4 recommends that societies making a time-bound offer set three fundraising targets; a minimum, an optimum, and a maximum amount. Debt finance can be used to fill the gap between the amount raised and either the optimum or maximum fundraising target. However, this can only be done if the lender agrees to adjust their loan to fill any shortfall from the targets. Some institutional investors may want to charge a higher fee for making such an arrangement, to ensure that their costs are covered.
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