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As part of any business set up a formal business plan is needed. This will need to include various financial projections such as a profit and loss forecast and a cashflow forecast to determine how much financing you need.
The areas that require funding should be split into two types: short term capital requirements and long term capital requirements. This split will help to identify which source of finance is suitable for which area. Having done this, you now need to consider the various options available to you which will depend in part on the nature of your business and your time frame for raising the finance.
The other main issue in obtaining finance is to consider the security that you can offer. Most lenders will require security in one form or another. This may be a loan secured on your house for instance or maybe funding advanced for a specific business asset where the loan is secured on that asset. Many new businesses suffer from a lack of cash funds and an inability to provide security for loans. Professional advice is therefore essential to ensure that all available options have been identified and explored. To set up with the wrong level or type of funding could be extremely harmful to the chances of a new business surviving. The most common funding options are:
| Your own capital |
Using your own money is one of the most common ways to fund a business. Your money could be used for both long term needs and for short term working capital. There is little red tape but the financial risk is yours alone. If the business fails you will have lost everything you put in |
| Friends and family |
Friends and family may be prepared to fund your business. This is also a good way of obtaining finance quickly and cheaply. However, it is important that a written agreement is in place to ensure that the terms of the loans are known to avoid any disputes in the future which can be harmful to any family. The family member may also want a say in how the business is run which may not suit the proprietor and can again lead to disputes. Where the business is in the form of a limited company, certain individuals can claim tax relief for their investment when it is taken in the form of shares. There are various criteria for people who qualify but basically they must not be connected to the company such as being a close relative of the shareholders. Tax relief is granted under the Enterprise Investment Scheme |
| Overdraft finance |
Banks are the most common source of external finance. Many businesses need overdraft finance from time to time to finance temporary cash shortages. Whilst you only pay interest on the amount that you are overdrawn each day, exceeding your overdraft limit is costly. A risk is that the bank could, in principle, demand repayment in full at any time which could threaten the continuance of your business. In addition a bank lender would normally require regular information from you regarding the progress of the business, such as quarterly or monthly accounts. The bank would also normally require security on the overdraft. This may be a personal guarantee from the proprietor - for instance the overdraft might be secured on your house |
| Loan finance |
Loan finance is suitable where the finance need is longer-term. Loans are usually for a fixed period and repayments are agreed in advance and are currently relatively cheap due to low interest rates. As with overdrafts, security will normally be needed. Again it is common to fix this using a private residence or using a business asset purchased with the loan, say a factory or shop. Obviously the big disadvantage is that if the business fails the security will be called in and this may mean losing any asset used as security. However this will only be used as a last resort by the bank and there will be plenty of time to rectify the situation if things take a turn for the worse |
| Factoring/Invoice discounting |
These are both forms of flexible loans, which advance money to a company based on the invoices that it sends out. There are two major advantages of factoring compared to overdrafts or other loans. Firstly, factoring/discounting is flexible in that the amount a company can borrow grows with sales. Secondly, no other assets are needed to secure the funding. The down side is that the charges made by the factoring/discounting company are quite high when compared to interest rates. It is also fair to say that from a traditional point of view, a company that uses this sort of finance is seen as being 'in trouble' which can damage its reputation. As the terms and conditions of each agreement can vary widely it is important that an agreement is negotiated to suit your business |
| Grants |
Most businesses ignore the funds available from grants for good reason - information is hard to find and different grant schemes are launched and then disappear with daunting speed. The conditions imposed on grant finance are also extremely complicated and quite often mean that grants are either not available or are too costly and time consuming to apply for. However, the benefits of grant-funding to help a business grow and develop can be significant. Directors' Briefing FI 22 - Getting a grant for your business - provides a useful guide to the kind of grants available to small and medium-sized businesses together with the criteria a project must meet to qualify for a grant, and the potential benefits and pitfalls involved in applying |
| Small Firm's Loan Guarantee Scheme |
Run by the Small Business Service (SBS), this scheme is for people who have tried and failed to get a conventional loan because they are unable to provide the necessary security that banks and finance companies expect. The scheme is open for firms with an annual turnover of no more than ?1.5 million and will guarantee 70% (or 85% if a business has been trading for more than two years) of a loan. The scheme covers loans of ?5,000 to ?100,000 (?250,000 if a business has been trading for more than two years) over periods of two to 10 years.
In exchange, the borrower pays the SBS a premium of 1.5% per year for the outstanding amount of the loan. The premium is reduced to 0.5% if the loan is taken out at a fixed rate of interest. Loans are available for most types of businesses and purposes, but there are some exclusions and restrictions and companies should check their eligibility before applying. The Business Link website (www.businesslink.org) contains more information on this and also has a list of lenders that participate in this scheme. This will normally include all of the main high street banks and lenders |
| Leasing |
Asset finance or leasing is a way of obtaining equipment, machinery or other assets without having to pay the full amount upfront. There are various different structures that can be used and the attraction of each one will vary according to your requirements and, perhaps, according to tax changes made by the government. Depending on the type of agreement, the asset may become the property of the business or it may go back to the suppliers and a new asset leased. This flexibility is useful especially where technology becomes out of date quickly or loses value such as computers or cars |
| Business Angels |
Where a business is seeking to raise financing of between £10,000 and £250,000, investment by a business angel is likely to be the best avenue. Banks will normally require security whilst venture capital firms tend to be interested in assessing the viability of the business and obtaining a return on their investment when it is up and running. Private investors who invest directly in private companies in return for an equity stake and perhaps take a seat on the company's board are frequently known as "business angels". Business angels are entrepreneurial individuals who provide capital in return for a proportion of the shares of the business. Typically, business angels want hands-on involvement and will only be interested in a business if it offers high returns as well as an exit route. This may not be in the best interests of the proprietor who may not wish to dilute his/her control of the business. However the business angels expertise in business matters can provide very valuable experience which could outweigh this disadvantage
A guide to business angel introduction agencies can be found at the British Venture Capital Association(BVCA) website (www.bvca.co.uk).
The National Business Angels Network (www.bestmatch.co.uk)is a national organisation committed to helping businesses obtain equity finance and assist private investors in their search for investment opportunities. The Network achieves introductions between private investors (Business Angels) and businesses seeking finance. |
| Venture Capitalists |
Venture capital firms provide unsecured financing in return for a proportion of the shares of a business. As they take a higher risk than banks do, they expect to receive higher returns. Most venture capital firms will want to realise their profits, probably within three to seven years, and therefore will need an exit route.
There are constraints imposed by involving venture capital firms:
- agreed payments of capital, interest and dividends
- specific legally binding 'covenants'
- probably a representative on your board
- provision of information and regular consultations
- the cost of your own professional advice and probably the professional costs of the venture capital firm.
As with business angels, the introduction of venture capital has its advantages and disadvantages. The source of finance will bring with it a dilution in control and business aims/objectives being imposed.
Potential investors can be identified through the directory published by the British Venture Capital Association (www.bvca.co.uk). It is best to approach a potential investor through a professional adviser. Accountants and solicitors will also have roles to play.
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