Financing A New Business

BUSINESS: The Ultimate Resource™ July 2006 Upgrade 46

GOOD SMALL BUSINESS ACTIONLIST Financing a New Business GETTING STARTED New businesses need finance to cover the cost of equipment and expenses before sales generate enough cash to make the operation self-supporting. This actionlist describes the main ways of financing your business (equity finance, loan finance, and grants). It explains how to work out the amount of finance you need, and what proportion of debt to equity is advisable.

FAQS What is a business angel? A business angel is someone who is willing to invest money in a business. The amount available from angels is usually much less than from venture capitalists, but they are often willing to take bigger risks. What is equity finance? Equity, or shareholder capital, is the money introduced into a business by the owners. If it is a company, then the equity is introduced in exchange for shares. Investors expect a share of the business’s profit. In the case of limited companies, this takes the form of dividends. The person starting a business will normally introduce equity capital, but it can also be raised from external investors, including business angels and venture capitalists. Investors will be looking for an annual dividend, which often can be quite small, and a good return when they sell their shares. Equity is best suited, therefore, to businesses that expect to grow quickly. What is loan finance? Loan finance is money that is borrowed from a finance company, such as a bank. Loans are repaid over a period of time, at either fixed or variable rates of interest. The lender will usually require security against a business or personal asset. Terms can vary in length from one year to 25 years, and will usually be determined by the asset that is being financed. The interest rate will reflect the lender’s perception of the risk in providing the loan. Loan finance can be provided in different ways. An overdraft is money that a business can borrow from a bank up to an agreed limit. It provides a business with short-term finance, effectively by running a negative balance on the bank account. This is a particularly good way of funding short-term requirements, such as providing working capital during the course of each month. © A & C Black Publishers Ltd 2006

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Term loans are funds borrowed for a fixed term. Usually, such loans are repayable in equal instalments over the term of the loan, although sometimes they can be repaid in a lump sum at the end of the term. Term loans are more attractive than overdrafts for longterm borrowing because repayments are fixed and the cost is usually less. However, lenders are increasingly writing into the small print that term loans are repayable on demand. If the loan has been used to finance capital assets, this could cause problems. Creditor finance is an excellent way of ‘borrowing’ money, effectively at no cost. Typically, suppliers may give 30 to 60 days’ credit for their goods or services before payment is due. If you can sell your product or service and get paid before paying your creditors, then it will generate cash into the business. Your business may have to establish a trading record before credit is given, and it can be withdrawn at any time. Debtor finance is particularly useful if your business is growing rapidly and is providing credit accounts to its customers. Instead of waiting for your own customers to pay your invoices within a 30– or 60-day period, you can use the services of a third party invoice discounting or factoring firm. Factoring can be an expensive way of speeding up cash flow, but it may reduce administration costs since the factor normally takes on the role of invoice clerk. Grants are usually ‘one off’ payments providing a percentage of the costs towards a specific purpose, usually for capital expenditure, but sometimes for a specific activity such as taking part in an exhibition or trade fair. Amounts vary depending on the scheme. A grant may be available from the government, the European Union, the local authority, or a related organisation. Grants are usually treated as income to the business and, as such, are shown on the profit and loss account. There are several sources of grant aid worth investigating when starting in business, and whenever you are buying equipment. Capital asset finance can often be done through ‘off-balance-sheet’ finance. There are different ways of doing this. Financial leasing allows you to finance the use of an asset rather than owning it. The equipment remains the property of the leasing company; the business has the legal right to use the equipment for the period of the lease, provided that the lease payments are up to date. In a lease purchase arrangement, you have an option to purchase the equipment at the end of the lease period. Through hire purchase, you pay regular instalments to a third party, normally a finance house, to purchase ownership of plant and machinery from a supplier. The finance house will own the equipment throughout the period of the agreement, until the last instalment has been paid.

MAKING IT HAPPEN Work out how much capital you need The working capital of a business is its current assets (typically stock, cash at the bank, and debtors) minus its current liabilities (typically trade creditors, other creditors such as PAYE and VAT, and your bank overdraft). This information is summarised on the balance sheet, although this only gives a snapshot of the working capital requirements at a specific moment in time. Generally, this is the finance required for the short-term running of the business.

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The amount of working capital needed will vary during the course of the year and even during the course of a month. You need to allow for the maximum likely working capital requirement. Consideration needs to be given to the variation that can occur within each month. As a rule of thumb, it makes sense to aim for minimum working capital of a month’s average sales multiplied by the number of months it takes to collect payment. If you want to be more accurate, then use the following procedure: 1. Determine the average number of weeks that the raw material is in stock. 2. Deduct from this figure the credit period from suppliers, in weeks. 3. Then add the average number of weeks to produce goods or service, the average number of weeks finished goods are in stock, and the average time customers take to pay. 4. Take the total, and divide it by 52 (the number of weeks in the year). Multiply the result by your estimated sales for the year. The answer will give you a figure for the maximum working capital required. It would be more accurate to use the cost of sales (direct and fixed), rather than the full selling price, but the above calculation is close enough. If your business is growing, then you need to use the budgeted sales figures, and it is advisable to calculate your working capital needs on a regular basis. Understand gearing and interest cover Gearing is the proportion of debt to total capital in the business. The more debt there is relative to equity, the higher the gearing. Introducing more equity, or retaining more of the profits, can reduce the gearing ratio. Most banks look for a gearing of no more than 50%; in other words, your debt should be no more than half of the total capital. Once you have built up a track record with your bank, you should be able to attract medium-term loans (three- to seven-year loans) to cover the cost of plant and equipment. Established companies may be able to raise long-term debt as a debenture or convertible loan stock, which normally receives a fixed rate of interest and is repayable in full at the end of the term. Long-term debt is usually included with the capital on the balance sheet. The banks will also be more comfortable with a higher gearing, though they still do not like to see it too high. Lease and hire purchase companies will not have as great a concern about gearing as the banks. They will, however, be interested in your cash flow and whether you can afford the repayments. If you expect to grow quickly and do not have enough of your own money to provide the necessary finance, then you may need to look for equity early on. Banks will be reluctant to keep on providing additional working capital as that simply increases the gearing and increases their risk. Growing too quickly is often known as ‘over-trading’ and is a major cause of business failure. The banks will also want to reassure themselves that you can afford the interest on the loan. So they will look for profits that are at least three or four times the expected interest charge.

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COMMON MISTAKES Not thinking ahead Regularly calculate the total level of funding required for the next year, and split the funding into fixed asset requirements and working capital requirements. Think carefully about the term, the cost, the suitability, the timescale, and any security required. Remember that cost should not be the sole criterion. Keep your lenders informed of your financial position, giving ample warning if you are likely to need to increase your overdraft, for example. Not changing with the times In times of recession, keep as much of your debt as possible as fixed medium-term loans, and keep your overdraft requirement to the minimum. In times of expansion, when finance is more readily available, it may be more cost effective to use an overdraft.

THE BEST SOURCES OF HELP British Venture Capital Association: www.bvca.co.uk Factors and Discounters Association: www.factors.org.uk The Prince’s Trust: www.princes-trust.org.uk

© A & C Black Publishers Ltd 2006