When you start up in business you will need finance. Should you use your own money, borrow from family and friends, or go straight to the bank? What about invoice financing and factoring? Do you want a business angel? Understand the different forms of borrowing and choose the best financial option for your business.
How much do you need?
To work this out you need a business plan. The business plan will help you work out your financial needs, including the initial start up costs and running expense. You can draw up a budget that shows your forecast sales, expenditure and – absolutely vital – your cash position for each month.
Consider possible peaks and troughs in the business (perhaps seasonal) and remember that many start-ups spend more than they earn in the first couple of years. Customers may not pay you immediately but you still have to pay all your bills to keep trading. Make sure you have a contingency fund in case things go wrong. Try to have at least enough capital to cover projected expenses for at least six months – the nature of your particular business may mean you need more.
Types of finance
Most new businesses use a mixture of finance – savings, borrowing from friends or family, personal loans and bank borrowing. Overdrafts and fixed term loans are popular. New start-ups can also apply for grants and interest free loans and bigger businesses with good prospects might attract an outside investor, like a business angel. Raising money from shareholders may also be an option. If you are short of cash at the outset you can consider leasing and hire purchase for vehicles and equipment, rather than buying. If your business has lots of unpaid invoices you may want to consider invoice financing. All methods of finance bring their own advantages and disadvantages and you should take advice before making a decision.
Using your own money
You will have to invest some of your own money if you want to interest a bank in giving you a loan. If you don’t have savings you might have to get a mortgage, sell possessions or assets, or use money from friends and family. If you are relying on family and friends they should only invest amounts they can afford to lose and understand the risks. Have agreements put in writing.
Generally, using unsecured loans or credit card borrowing for business start- ups is unwise and may end up crippling your business before it has a chance to get going.
Bank finance – loan or overdraft?
It is increasingly difficult to borrow from banks – even with a good track record. Since the credit crunch began, banks have been trying to increase deposits and are not keen to lend. Rates are high and banks are nervous about losing yet more money. So you will have to be a good risk before a bank will part with any cash. Before lending, a bank will want to see a credible business plan, evidence of a successful track record in business (this is often the chicken and egg situation for start-ups – how can you establish a good track record without borrowing money to start?). You will have to offer security for any money lent (either business assets or personal guarantee) and you will have to show commitment by investing your own money as well. Increasingly banks expect you to invest larger percentages of your own money before they will commit. If they will commit at all.
Overdrafts
These are very useful for financing temporary or fluctuating cash shortages and are generally a flexible way of funding day to day requirements. Interest is paid only on the amount you are overdrawn each day. But they have higher interest rates than loans, and exceeding your overdraft limit is costly. In theory, the bank could demand repayment any time – even 24 hours notice.
Loans
Loans are often the best way to finance a longer term business needs. They are usually fixed for one to ten years (although mortgages and some other loans may be for as long as 25 years). Repayments are agreed in advance so at least you can match the term of a loan to your requirements and can budget for repayments. On the downside there is no flexibility – if you are not using the funds you will still pay interest. You may also have to offer security.
Costs
Costs can vary widely. Both overdrafts and loans are set at a margin over the bank base rate (which itself fluctuates). You will probably pay an arrangement fee to set up the loan or overdraft, usually about 1.25% of the total amount requirement. Sometimes you may have to pay a renewal fee if an overdraft facility is extended and you may also have to pay costs arranging security.
Banks will look at your business assets, but you will not get more than 80% of the value of the business property (and realistically quite a lot less). Any equipment will only be valued at resale price – usually its price at auction. Banks may lend up to 60% of the value of your trade debtors, but will not be interested in old debts or small debts which are difficult to collect. Any other loans, factoring services or leasing arrangements will also reduce the amount of security you can offer the bank and therefore the amount they will lend.
Finance from outside investors
Shareholders
You could issue ordinary shares (standard shares with no special rights or restrictions) to investors in return for money. Unlike loans and overdrafts you do not normally have to make payments to investors until the business can afford them. In addition shareholders might bring in additional expertise, and will share the decline if your business fails. In addition if you increase the capital invested in the business it might be easier to borrow from the bank.
On the downside your share of the business and its profits will be lower. You might lose some control if investors want to be involved in how you manage the company. Investors may want the business structured in a way that makes it easier to sell their shares in future.
Business angels
Wealthy individuals will typically invest £10,000 or more and may also offer business expertise. But you are unlikely to interest outside investors unless you can show a strong track record and credible business plan. Investment will come at a price – they will expect high potential returns to compensate for the risks they are taking on.
To find an investor you may have to use a broker who will charge approximately £50-£400 in fees, plus a percentage of any money rose.
Business Angels Association website www.bbaa.org.uk
Other venture capital
Government backed venture capital funds will invest up to £500,000 in English companies. Check with your local regional development agency for details. Banks may also be interested.
British Venture Capitalist Association British Venture Capital Association website www.bvca.co.uk
Grants
Grants and government support may be available. You can get subsidised or no interest loans or cash. Often support schemes provide lots of free advice you might otherwise have to pay for.
But there may be stiff competition, you will have to meet specific criteria and usually have to provide funds yourself. Grant applications can be time consuming, but there is money out there for grabs. See Duport’s grant section.
Small firms loan guarantee scheme
Businesses which would not normally qualify for a loan can get help.
Additional sources of finance
There are small amounts of money – micro finance or micro credit – can be available, usually only for businesses setting up in a disadvantaged area or sector normally not helped by mainstream lenders.
Community development finance institutions (CDFIs) and peer group lenders
These are organisations set up to support specific groups of individuals and businesses. Including:
- Prowess – UK associations of businesses and individuals that specifically support women in business www.prowess.org.uk
- Asian Business Development Network (ABDN) – ethnic minority enterprise network which assists Asian and minority businesses by creating access to opportunities and sharing best practice www.abdn.org.uk
- The Black Business Initiative (BBI) aims to support the black and minority business community www.bbigroup.org
Leasing
This can be a good way of financing a vehicle and you have the option of fixing costs as part of the agreement. Instead of buying you can lease – usually for a fixed period of three to five years. Payments are spread out over the period helping cash flow. You get full tax relief on lease payments, except for cars costing more than £12,000.
Hire purchase
Used for equipment. You buy the equipment but payments of capital and interest are spread over a fixed period (usually 3–5 years). You can claim capital allowances on the equipment and the interest payments receive full tax relief.
Factoring
Factoring can free up the cash tied up in unpaid invoices. Factoring firms normally give up to 80% of the value of each sales invoice within 24 hours. The firm then collects outstanding payments on your behalf from your customers. Factoring is particularly useful for fast growing businesses or those that have very high value invoices but have to wait 30–90 days for customer payment.
Invoice financing
This provides you with finance against invoices that customers have not yet paid. You can receive up to 85% of the face value of each invoice immediately and the balance (less charges) when the invoice is paid by the customer. Unlike factoring, you have to chase up the invoices yourself.
Stock finance
Cash is raised against the value of stock held by a manufacturing company.
Security for borrowings
For any type of borrowing you will need to show you can afford to pay it back and that you can offer security to ensure the loan is repaid if things go wrong. Security can take different forms. You might be able to offer:
- a personal guarantee from an individual (be aware that if the guarantee is called on and has been supported by a legal charge over your personal assets, these assets, including your house, can be at risk)
- a guarantee from a third party. This person will be liable for the debt if you default. Sole traders (and partners) are already personally liable for all business debts and directors of limited companies may have to provide personal guarantees in case the company fails
- Small Firms Loan Guarantee for start-ups and young businesses that have been trading for fewer than five years. Run by the Small Business Service this can be used to guarantee loans of up to £250,000 (turnover must be under £5.6 million), but you have to pay a premium of 2% a year on the outstanding balance as well as the repayment terms and interest rates set by the bank or institution you borrow from, and you may have to take out insurance.
