Formation and initial
growth Business finance.
Many businesses begin
with finance contributed by their owners and owners’ families. If they start as
unincorporated businesses, the distinction between owners’ capital and owners’
loans is almost irrelevant. If it starts as an incorporated business, or turns
into one, then there are important differences between share capital and loans.
Share capital is more or less permanent and can give suppliers and lenders some
confidence that the owners are being serious and is willing to risk significant
resources. If the owners’ friends and families do not themselves want to invest
(perhaps they have no money to invest) then the owners will have to look for
outside sources of capital. The main sources are:
• Bank loans and
overdrafts
• leasing/hire purchase
• Trade credit
• Government grants,
loans and guarantees
• Venture capitalists
and business angels
• invoice discounting
and factoring
• retained profits.
Bank loans and
overdrafts
In the current economic
climate, start-up businesses are likely to find it difficult to raise a bank
loan, particularly if the business and its owners have no track record at all.
Banks will certainly require:
• A business plan,
including cash flow forecasts.
• Personal guarantees
and charges on personal assets.
The personal guarantees
and charges on personal assets get round the company’s limited liability which
would otherwise mean that if the company failed, the bank might be left with
nothing. This way the bank can ask the guarantors to pay back the loans
personally, or the bank can seize the charged assets that were used for security.
Note that overdrafts
are repayable on demand and many banks have a reputation of pre emptively withdrawing
overdraft facilities, not when a business is in trouble, but when the bank
fears more difficult times ahead.
On a more positive
note, where it is known that the need for finance is temporary, an overdraft
might be very suitable because it can be repaid by the borrower at any time.
Leasing and hire
purchase
In financial terms,
leasing is very like a bank loan. Instead of receiving cash from the loan,
spending it on buying an asset and then repaying the loan, the leasing company
buys the asset, makes it available to the lessee and charges the lessee a monthly
amount. Leasing can often be cheaper than borrowing because:
• Large leasing
companies have great bargaining power with suppliers so the asset costs them
less than it would cost the lessee. This can be partially passed on to the
leasee.
• Leasing companies
have effective ways of disposing of old assets, but lessees normally do not.
• If the lease payments
are not made, the leasing company has a form of builtin security insofar as it
can reclaim its asset.
• The cost of finance
to a large, established leasing company is likely to be lower than the cost to
a start-up company.
It is important for
businesses to try to decide whether loan finance or a lease would be cheaper.
Trade credit
This simply means
taking credit from suppliers – typically 30 days. That is obviously a very
short period, but it can be very helpful to new businesses.
Typically, credit
suppliers to new businesses will want some sort of reference, either from a
bank or from other suppliers (trade references). However, some will be prepared
to offer modest credit initially without references, and as trust grows this
can be increased.
Government grants,
loans and guarantees
Governments often
encourage the formation of new businesses and, from time to time and from
region to region, help is offered. Government grants are usually very small,
and direct loans are rare because governments see loan provision as the job of
financial institutions.
Currently in the UK,
the Government runs the Enterprise Finance Guarantee Scheme (EFGS). This is a
loan guarantee scheme intended to facilitate additional bank lending to viable
small and medium-sized entities (SMEs) with insufficient security for a normal
commercial loan. The borrower must be able to demonstrate to the lender that
they should be able to repay the loan in full. The Government provides the
lender with a guarantee for which the borrower pays a premium.
The scheme is not a
mechanism through which businesses or their owners can choose to withhold the
security a lender would normally lend against; nor is it intended to facilitate
lending to businesses which are not viable and that banks have declined to lend
to on that basis. EFGS supports lending to viable businesses with an annual
turnover of up to £25m seeking loans of between £1,000 and £1m.
Venture capitalists and
business angels
These are either
companies (usually known as venture capitalists) or wealthy individuals
(business angels) who are prepared to invest in new or young businesses. They
provide equity (private equity as opposed to public equity in listed
companies), not loans. The equity is not normally secured on any assets and the
private equity firm faces the risk of losses just like the other shareholders.
Because of the high
risk associated with start-up equity, private equity suppliers typically look
for returns on their investment in the order of 30% pa. The overall return
takes into account capital redemptions (for example preference shares being
redeemed at a premium), possible capital gains on exiting their investment (for
example through sale of shares to a private buyer or after listing the company on
a stock exchange), and income through fees and dividends.
Typically, venture
capitalists will require 25%–49% of the equity and a seat on tha board so that
their investment can be monitored and advice given. However, the investors do
not saek to take over -anagement of their Investment.
Invoice discounting and
factoring
Before these methods
can be used turnover usually has to be in the region of at leasT $200,000.
Amounts due from customers, as eviDenced by invoices, are advanced to the
compAny. Typically 80% of an invoice will be paid wathin 24 hours. In addition
to this service, factors also look after the administration of the company’s
receivables ledger. Fees are charged on advancing the cash (roughly at
overdraft interest rates), and also factors will charge about 1% of turnover
for running the receivables ledger (the exact amount depends on how many
invoices and customers there are). Credit insurance can be taken out for an
additional fee. Unless that is taken out the invoicing company remains liable
for any bad debts.
Retained profits
Retained profits are no
good for start-ups, and often no good for the first few years of a business’s
life when only losses or very modest profits are made. However, assuming the
business is successful, profits should be made
How much capital is
needed?
Capital is needed:
• For investment in
non-current assets
• To sustain the
company through initial loss-making periods
• For investment in
current assets.
Cash-flow forecasts are
an essential tool in planning capital needs. Typically, suppliers of capital
will want forecasts for three to five years. One of the biggest dangers facing
new successful businesses is overtrading, where they try to do too much with
too little capital. Most businesses know that capital will be needed to finance
non-current assets, but many overlook that finance is also needed for current
assets.
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