Chapter 8   Sources
Chapter 8   of finance
Chapter 8

The chances are that unless you win the National Lottery, inherit a fortune, marry a rich widow or toy boy or find a sugar daddy, that you will sooner or later have to raise some short-term or long-term finance for your business. The most obvious source of funding for most owner-managers is from the local high street bank, but this is not necessarily the cheapest or best way of financing a particular borrowing requirement.

The purpose of this chapter is to examine some of the potential sources of finance that are available for new and expanding businesses, and to examine their relative uses, advantages and disadvantages. For the NVQ candidate, Element 4.2 ‘Identify how the business will be funded’ requires the candidate to demonstrate that various funding options have been examined and appropriate choices made, and that these can be fully justified.

In many cases this will involve considering not just the finance required for the initial start-up phase of the business to cover the period until the firm achieve regular profitable trading. It is just as important to consider and identify the available options for the next stage, when the firm starts to expand, possibly at a rate which is faster than receipts from profits can support. The effective planning of finance at this stage is critical to avoid over-trading, where the business is growing beyond the level which can be supported by its own working capital. This is one of the most common causes of business failure, when growth outstrips working capital and results in a cash flow crisis and inability to pay suppliers, wages etc. on time. In this situation, profits might be excellent, but the firm is still technically insolvent and, therefore, trading illegally. Some firms manage to hang on and trade out of this situation but, for the majority, the only sensible remedy is to raise finance to increase working capital to a level that will support the expansion.

Factors which influence suitable sources of finance

The most appropriate form of borrowing will be determined by a number of factors:

•   The purpose for which the funds are required, e.g. whether it is to increase working capital, or to acquire a vehicle or an item of capital equipment. For the former, a medium-term loan would be suitable, whereas for vehicles or plant and equipment, leasing or hire purchase might be better.

•   The size of the borrowing requirement. Most bankers will only lend against security. A personal guarantee may be adequate for a few thousand pounds, but for a more substantial sum the loan will need to be secured by a legal charge on property. Borrowing small sums can also be quite expensive in that interest rates tend to fall as the size of loan increases and, with small loans, the initial set up fees form a larger proportion of the total cost.

•   The anticipated repayment period. Short-term borrowing tends to incur higher rates of interest, whilst the rate usually falls when spread over a longer period. Some forms of finance, such as commercial mortgages, also have maximum repayment periods or repayment periods that are linked to the size of the borrowing, as in the case of car loans.

•   The affordability of repayments. The crucial question when assessing funding options is ‘Can the business afford to make the required regular payments from its current or expected levels of profit?’ If not, we must question the viability of the business: ‘Is it really worth carrying on?’ If so, we must question the necessity of the borrowing: ‘Do I really need a new car, or will the current one last another year?’ Then, we need to examine the alternative funding options: ‘Can I find another lender who will consider lower repayments spread over a longer period?’

•   The availability of security or collateral. As bankers will rarely lend against the full equity value of property (50 per cent is a more realistic figure for some high street banks), the availability of the loan may be limited by the equity or residual value of the property against which it will be secured. If the net value of your home is £50 000, then you may only be able to borrow £25 000 to £30 000 against it.

Funding options for small and medium-sized businesses

These are some of the commonly used options most regularly used by smaller organizations to raise finance.

Equity or capital

This is basically the value of the resources that are introduced into the business by its owners or investors. These resources do not have to be in cash form only, as they can include just about anything of value that will be of positive use to the business, including saleable stock, vehicles, computer equipment, land and buildings, office equipment, plant and machinery etc. In the case of sole traders and partnerships, the value of these resources is assigned to a capital account for each of the proprietors. In a limited company the resources become the property of the company, against which shares are issued. The investors cannot withdraw their capital investment but, if the company wishes and if it can afford to do so, then the company can redeem or buy back the shares from the investors.

Unsecured loans

Unless you have a long-standing and proven track record, obtaining an unsecured business loan from a bank, for anything but a small sum, is a virtual impossibility. Many small businesses are started with unsecured loans from friends or family, as this can be a very low-cost and flexible way of getting started. However, it is very much in the interests of both lenders and borrowers to in some way formalize the loan arrangements in writing, even if only by means of a covering letter signed by both parties. This would, for example, show details of the lender and borrower, the sum involved and the purpose of the loan, the date borrowed and the date when repayment is due and details of interest payable (or not payable). Even a simple signed document would protect the lender in the case of default by the borrower. Similarly, if say the lender died, then the deceased's estate could not demand immediate repayment of the loan prior to the agreed date.

Overdrafts

Overdrafts are essentially a short-term form of borrowing, designed to cover temporary periods when cash flow may be poor, or during seasonal troughs such as those experienced in the coastal holiday trade. These are usually only granted for up to one year, and approval and reapproval incurs an arrangement fee charged by the lender. Interest rates are quite high, but interest is only charged when the overdraft facility is in use. The important thing to remember, is that if you find that you need a permanent overdraft, then you do not need an overdraft at all. What you really need is a longer-term loan.

Loan guarantee schemes

These schemes were introduced by the government in the early 1980s to encourage banks to lend to new and small firms whose proprietors could not offer any conventional security. The idea was that the government, in return for a percentage charge, would guarantee up to 80 per cent of the value of the loan. The banks, in return for a higher rate of loan interest, would stand the risk of the other 20 per cent. Loan guarantees can still be found, but the scheme as a whole was viewed as an abysmal failure. Apart from the high cost of interest and fees, banks simply do not like to risk lending even as little as 20 per cent for a new business on an unsecured basis, and so were only willing to advance money to established firms with a proven track record. Homeowner applicants were told that as they had potential security, the loan guarantee scheme was inappropriate. Applicants with no assets were asked why the bank should risk backing them when they had nothing at risk themselves.

Short- and medium-term bank loans

These typically involve repayments over two to five years, but sometimes up to seven years. For sums in excess of £5000, security would almost certainly be required in the form of a charge against private or company property, or of a fixed and floating charge over the book debts and assets of the business. For short-term loans for sums below £5000, a personal guarantee of payment in the event of default would probably be acceptable, as long as it was given by one or more persons with tangible assets (e.g. homeowners). Interest would typically be fixed at between 2 per cent and 5 per cent over the base rate prevailing at the time the loan was taken out. The precise rate of interest may be influenced by the type of security offered, in that better security may attract a lower rate of interest. Arrangement fees are also charged on new loans.

Long-term loans from banks

High street banks will make long term loans to businesses, typically over five to ten years on a secured basis. Beyond that period, the loan is more likely to be treated as a mortgage, being secured by a specific fixed asset belonging to the business or one of its proprietors. Again, arrangement fees are charged and there may be some solicitor's costs incurred in setting up legal charges on property.

Share capital from private investors – ordinary shares

Private limited companies cannot offer their shares for sale to the general public, as only those companies listed and quoted on the Stock Exchange or the Alternative Investment Market can do that. However, private limited companies can still sell shares privately to individual investors or to other companies. These transactions normally involve the purchase of a fixed number of ordinary shares for an agreed sum that then belongs to the company. Ordinary shares confer voting rights on the owner, and dividends are paid annually from company profits, usually in the form of so many pence per share.

Share capital from private investors – preference shares

These are sold in the same way as ordinary shares, but are fundamentally different in that ownership of them confers no voting rights and there is normally an option for the issuing company to buy them back (redeem them) after a fixed period of time. In lieu of those rights, preferential shareholders receive guaranteed dividends, which are fixed or have a minimum payment level and which are paid even when no dividends are paid to holders of ordinary shares. If no dividend is paid one year, then the next time that one is declared, the preferential shareholders will receive recompense for any past unpaid dividend. In the event of liquidation, holders of preference shares have priority over ordinary shareholders if any residual funds are available for distribution.

Debentures

Debentures are a special type of fixed-term loan, often guaranteed by a charge on the assets of the business and sometimes linked to an option to convert into share capital. They differ from conventional loans in that during the lifetime of the loan, only interest is paid, as the capital sum does not fall due for repayment until the period of the loan expires, when it must be repaid in full. Interest rates are agreed at the start of the term, either at a fixed level, or linked to commercial lending rates with a minimum specified level. Debentures will often be arranged between one company and another, or by financial institutions, particularly to assist with expansion of a business.

Mortgage debentures

As the name suggests, these are debentures that are mortgaged to a specific fixed asset of the company, e.g. a piece of land or a building. Otherwise they work in the same way as a debenture.

Grants

Grants to assist in the setting up of a new business are quite scarce, although for those who are under twenty-five, it is worth applying to the Prince's Youth Trust which makes grants available to unemployed young people who wish to start up on their own. Some relocation grants are available for businesses starting up or moving to development areas, particularly in remote rural areas. Local authorities in urban redevelopment areas often have access to European Social Fund monies, which are sometimes issued in grant form to assist small firms, and local councils or chambers of commerce can often advise on the availability of these, as they will differ from area to area. Grants to subsidise training for employees can also be obtained from some local authority economic development units, and from most Training and Enterprise Councils, Business Links or Enterprise Agencies, which are shortly to be redesignated under a new title. Up to 50 per cent of the cost of training can currently be obtained by firms working towards Investors in People status.

Commercial mortgages

A person who is buying their own home will normally take out a mortgage with a bank or building society typically over twenty-five to thirty years. A commercial mortgage arranged through a bank, insurance company or financial institution is basically the same, but would normally be repaid over ten to fifteen years. Commercial mortgages for licensed premises can also be obtained from some of the regional and national breweries, linked to a contract to buy their products.

Venture capital

Venture capital organizations are specialist companies that invest in new businesses and unquoted companies to help them expand and grow. Investments can take the form of loans or minority shareholdings, but the majority of these companies will only advance sums exceeding £500 000 so their main area of interest is in expansion rather than business start-up. They are generally looking for investments offering potentially high returns (20–40 per cent of capital investment) from dividends and capital growth to justify the investment risks that they take. They frequently seek boardroom representation, will require regular and detailed reports and information, and will often expect the business in which they have invested to buy out their share after a specified period of time. On the positive side, venture capital companies can provide the levels of investment which might otherwise only be obtainable via the Stock Exchange, but without the massive cost of achieving Stock Exchange listing. They also impose structure and regulation of company affairs. On the negative side, they can restrict the owners’ ability to make decisions, their expectations are high and the owner loses a good deal of strategic control over the business. The owner will also be liable for legal and accountancy charges to facilitate the capital injection.

Hire purchase

This is usually used to buy a fixed asset such as a vehicle or piece of plant or machinery. Under a hire purchase agreement, the business would typically pay 20 per cent of the cost of the asset plus the full VAT sum up front, with the hire purchase company financing the balance. The VAT is claimed back at the next quarter, and fixed monthly payments are then made over a specific period of time, perhaps three to five years, at the end of which the asset belongs to the business. In case of default on monthly payments, the hire purchase company, which still technically owns the asset until the final payment is made, can recover and sell the asset. If the business has already paid at least two-thirds of the money due, then recovery will require a court order. Hire purchase is useful to a business that wants to show the fixed asset on its balance sheet, however, being a capital purchase, capital allowance taxation rules apply.

Leasing or contract hire

In the case of hire purchase, the asset eventually becomes the property of the business, but with lease hire or contract hire this transfer of ownership does not occur. The business simply makes regular monthly payments to the leasing company over the duration of the contract, and has the use of the asset during that time. Leasing is cheaper to set up, usually requiring an initial deposit of only three months’ payments, with VAT being charged on each payment. Leasing is good for cash flow, and is tax-effective as all payments count as a business expense, but as ownership of the asset never changes hands, it cannot be included in the company balance sheet.

Factoring or invoice discounting

Factoring involves the management of the firm's sales ledger by an outside organization, typically a bank. First, all company customers are given a very tight and careful credit check and, when approved, the factoring company guarantees to pay the business a fixed percentage (e.g. up to 80 per cent) of the value of every invoice within fourteen days of the issue of the invoice. The balance, less a factoring charge, is paid once the debt has been settled. The system is excellent for cash flow, but factoring companies are very strict and can be heavy-handed in dealing with customers, which may result in the loss of trade. There is also usually a minimum turnover requirement of £250 000, so the system is hardly suitable for new or start-up businesses. Invoice discounting works in a similar way, but the sales ledger is controlled by the company itself, with advances of up to 80 per cent being made against specific invoices. The company repays the advance when the debt is collected, and interest is paid at between 2 per cent and 5 per cent over normal commercial rates.

Further funding options more suited to larger organizations

These are mentioned in passing, just to draw the reader's attention to the fact that they exist, as they would certainly not be relevant to most small firms. Taking those firms at the top end of the government's definition of ‘small and medium-sized enterprises’ which employ between 100 and 250 staff, some of those would be more likely to consider using the following options. However, for the 87 per cent of firms in the UK which only employ less than twenty staff, they are largely inappropriate.

Commercial bonds

These are way out of the league of small firms, as commercial bonds usually are issued by large blue-chip companies. The company issues (sells) a negotiable bond with a guaranteed redemption value of perhaps £10 0000 payable in five or ten years’ time. The initial selling price is less than the face value but, as time progresses towards the redemption date, the value will increase. Dealings in the bonds take place on the Stock Exchange.

Bills of exchange

Usually with a value of at least £100 000, these are a bit like post-dated cheques, but they are only payable when certain conditions have been met, e.g. the goods to which the bill of exchange relates have been delivered. However, they can be discounted to finance early payment, or money can be borrowed against them, subject to the reputation and status of the issuing company.

Stock Exchange or Alternative Investment Market flotation

This can be a very expensive process, and is generally regarded as not being justified unless the floating company intends to raise at least £5 million. The company has to prove that it can meet certain accounting, operational and capitalization standards in order to find a merchant bank willing to underwrite the floatation (i.e. to buy up all of the surplus shares if no one else wants to buy them). Once listed, its shares can be sold to the public, and the capital raised can be used for expansion.

Convertible loan stock

This takes the form of an option to buy shares in a company, which is issued against loans from financial institutions or investment companies. The issuing company receives a loan usually at a low interest rate, with no capital repayments until the settlement date and with the interest being paid out of pre-tax earnings, so this amounts to a very cheap form of finance. The lending company, as well as receiving interest on the loan, has an option at the end of the loan period. If the borrowing company's shares have performed poorly, the loan can be repaid in full and the share option returned. Alternatively, if the shares have increased in value in the meantime, the lending company can exercise its right to buy them at the original price in lieu of repayment of the loan, (i.e. ‘convert’ the loan into shares) and sell them for a capital profit.

Capital reserves

Well-established and profitable companies will often look to use their reserves and investments, accrued from the profits of earlier years, as a source of finance to pay for expansion of new developments. For the average small business this option is just a dream for the future. Start-up businesses have the problem of raising the money to start the company before they can make the profits to create the reserves.

Long-term loans from financial institutions

It is often said that it is easier for a business to borrow £10 million than £10 000. Most of the merchant banks and financial institutions have little inclination to be involved in setting up long-term loans for less than £250 000, as the time and effort involved does not justify the potential profit. This is no problem for larger organizations, but it does leave small firms very much at the behest of the high street banks. Long-term loans are invariably secured, if not by property or assets, then by stocks or shares or by a debenture. Interest and capital repayments are made monthly or quarterly, with interest rates set at prearranged levels. Arranging the loans invariably incurs legal costs, and larger loans can take several months to negotiate and set up.