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Funding a business

Funding a business

Most business plans are produced for a specific reason and the most common by far is to raise finance. At a fundamental level, there are only two ways to fund a business: either to borrow the money (debt finance) or to raise the money by selling shares (equity finance). Most businesses are funded by a mix of the two.

Debt finance

When a company borrows money, it usually promises to repay the loan in full by a specific date and in the interim to make regular monthly payments. These regular monthly payments are usually a mix of capital repayments and interest on the remaining balance of the loan. Near the start of the loan term, these payments are relatively interest heavy and capital repayment light. As the loans nears the end of its term, the remaining balance of the loan is relatively small and consequently, the monthly payments are relatively interest light and capital repayment heavy.

The sources of debt finance include:

  • Entrepreneur
  • Family and friends
  • Banks
  • Peer-to-peer crowdfunding lenders
  • Working capital reduction
  • Factoring
  • Asset finance

Entrepreneur – When a business requires additional finance, and this includes at start-up, the entrepreneur, and or other owners of the company, may choose to lend to the company rather than seek external investment. This is because the decision making process is relatively quick and simple and does not require any third party involvement nor security nor personal guarantees. It is often more advantageous for the owners to put additional monies into a company as a loan rather than equity. This is because loans can be repaid whenever the company’s finances permit, whereas equity can only be released by selling shares or by closing the company. When making a loan, the entrepreneur and other owners can determine the terms of the loan such as the repayment date, the interest rate and whether the loan is on a repayment or interest only basis. Loans can also be interest free for an initial period or for the full term.

Family and friends – When a business requires additional finance, the entrepreneur may try and raise the funds needed from within his or her network of family or friends. There is also a third F affectionately known as fools. The three F’s lend on a similar basis as the entrepreneur but may choose to be more demanding with the terms.

Banks – Banks have traditionally been a major source of finance for business. However, in recent years, the appetite of big banks to lend to businesses has reduced significantly in the aftermath of the Lehman Brothers collapse. The lending drought has left many companies short of funds with small businesses, deemed high risk, being particularly hard hit. When banks lend there are usually two types of business loans: unsecured and secured. An unsecured loan is one where the lender relies on the borrower’s promise to pay it back. Due to the increased risk involved, the size of the loan tends to be smaller and the interest rate higher than for secured loans. In contrast, secured loans are those where the borrower pledges some physical asset that is owned either by the business (i.e. a plot of land, building or piece of equipment) or by the owners of the business (i.e. their homes). In the event that the business runs short of cash, the assets that secured the business loan can be sold to repay the loan. When granting a business loan, banks may also require personal guarantees whereby the owners are personally obligated to repay the loan in full in event of the company failing.

Peer-to-peer crowdfunding lenders – Peer-to-peer crowdfunding lending is still in its infancy and has only emerged in the aftermath of the credit crunch as an innovative response to the banks being effectively closed for business to small companies. With peer-to-peer lending, a lender agrees to fund a small part of the required loan and the company secures the finance it seeks by virtue of there being lots of small willing lenders. The attraction to lenders, many of whom are private individuals, is that they obtain a significantly higher rate of interest than traditional bank and building society savings accounts offer and that their money is being put to productive use to create wealth and jobs. For the company, it secures the funds it might not otherwise have secured and on competitive fixed terms. Funding Circle and ThinCats both have peer-to-peer crowdfunding platforms and both evaluate all prospective borrowers before granting access to their pools of lenders. To be eligible, prospective borrowers have to have been trading for at least two years and be profitable.

Working capital reduction – another way to raise finance, and one that is often overlooked is to reduce the amount of working capital in a business. This can be achieved by:

  • Changing the trading terms with both suppliers and customers. In simplicity, this means taking longer to pay suppliers (i.e. borrow from them for longer) and requiring customers to pay sooner (i.e. allow them to borrow from your company for less time). The latter is easier to affect than the former. Such measures release working capital which improves cash flow and reduces the need to raise finance.
  • Reducing the amount of stock, both materials and finished goods, will also release working capital and improve cash flow.

Factoring – Factoring is when a company sells an accounts receivable invoice to a third party, called a factor, at a discount. In ‘advance’ factoring, the factor provides the invoice seller a cash ‘advance’, typically 70-85% of the invoice value, with the balance being paid net of the factor’s fee upon payment of the invoice by the customer. Factoring, which in principal is another form of borrowing, releases working capital and improves cash flow albeit at the cost of eroding profitability.

Asset finance – Asset finance is a form of commercial hire purchase. It occurs when a specialist asset finance company purchases a capital asset on behalf of a company and then leases it to the company for a period of time. At the end of the lease period, there is usually an option for the company to purchase the asset from the asset finance company for a nominal sum and thus obtain ownership of the asset. The advantage of leasing is that the company gets the use of an asset it needs without having to raise the funds to purchase the asset. The full cost of the lease in any year can also be offset against corporation tax.

Equity finance

Equity finance is a way of raising venture capital from investors in exchange for a share of a company. There are four main sources of equity finance:

  • Entrepreneur
  • Family and friends
  • Business angels (and venture capital and private equity funds)
  • Retained earnings

Entrepreneur – the first source of finance is the entrepreneur and a company can be formed with as little as £1 share capital. If the entrepreneur is constrained by the amount of capital he or she can put into a business, whether equity or debt or a mix, then the entrepreneur will need to seek outside investors and consequently have to place a value on the worth of the company and the shares to be offered in exchange for funding.

Family and friends – When seeking additional funding, the three F’s are often the second port of call after the entrepreneur. Amateur investors will often be less demanding than professionals and thus can be a source of relatively cheap venture capital finance for an entrepreneur.

Business angels – Business angels are high net worth individuals, who invest in high potential private unquoted companies. Unlike banks and lenders where the principal concern is whether they will repaid, a business angel is interested in capital growth and critically whether the entrepreneur is investible and can deliver the capital gain sought. Business angels are sharp, think Dragon’s Den, so do not be surprised if you fail to secure finance if either you or your business plan are not up to scratch. If a business angel is interested in investing, he or she will try and negotiate a deal that balances his or her desire to have a higher rather than lower share of the business with the need to keep the entrepreneur highly motivated to deliver. Business angels may invest individually, as part of a syndicate or on via a peer-to-peer crowdfunding platform such as Crowdcube. A company is also a much more attractive investment opportunity if it qualifies for either the Government’s Enterprise Investment Scheme (EIS) or Seed Enterprise Investment Scheme (SEIS). Learn more about the business angel investment process.

Retained Earnings – Once a company is established and making profit, retained earnings often provide the main source of funds for a business to invest in its future growth. Retained earnings are owned by the shareholders and thus, are effectively equivalent to the shareholders putting additional equity funding into the company by virtue of them sacrificing dividends which might otherwise be paid from the earnings retained.

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