Types of finance

29 April 2005
Types of finance

Debt finance

Banks are still the most common form of finance for a business and are often the first stop for most small businesses. This is because every business will need a bank account, and it will therefore have a relationship with a bank.

The banks are always looking to lend money to businesses that they consider worth the risk. You must remember that banks aren't venture capitalists. Therefore they're not providing risk capital, and expect to get their funds back at the end of the term.

If they perceive that the risk of repayment not being met is too great, they won't want to lend to you. Debt finance limits the amount of equity that the owners have to invest in the business, but the costs can be high.

Bank overdraft

The quickest and easiest debt to arrange is a bank overdraft. This is a useful facility for smoothing out short-term cash-flow difficulties, but it's not for long-term financing of the business.
Overdrafts are generally repayable on short-notice terms and therefore don't provide long-term stability to the business.

The interest charge is normally a fixed percentage above base rate and will be an expensive option.

Business loans

Banks will also provide business loans more appropriate for longer-term finance needs, such as the purchase of a business premises.

Loans can usually be tailored to suit the particular asset being purchased or the business need. The term can be fixed along with the borrowing rate.

One of the main stumbling blocks for new businesses is the security and guarantees required by the bank before they will lend any money. If you cannot provide sufficient security for the bank's purposes you may be able to apply for help under the Small Firms Loan Guarantee Scheme.

This was set up to help small businesses unable to provide the security required by the bank for a standard loan.

The loan is still made by the bank, but the missing security is provided by the scheme. The lending decision is still down to the bank, but they will liaise with the Department of Trade and Industry (DTI), which manages the scheme on behalf of the applicant.

The limit for such loans is £100,000 for businesses less than two years old with a maximum term of 10 years. For businesses that have been trading for more than two years the maximum loan is £250,000.

Under this scheme the DTI will guarantee the bank 70% of the loan, or 85% where the business has been trading for more than two years.

This means that the bank is still at risk over the balance of any loan, so it will have to be happy with the risk to grant the loan.

Advantages: Your business is not diluted. Disadvantages: This is an expensive option and security is always required.

Asset Financing - Leasing

Specific asset financing through leasing is a useful financial tool when trying to raise finance for a business. The lender effectively lends the business the funds for a specific piece of equipment.
Their security is the actual piece of equipment or asset and technically the leasing company owns the assets that have been leased.

The new business then pays a regular instalment to the leasing company over an agreed period. This form of financing is usually used for start-up businesses to limit the amount of finance initially needed.

Effectively the business will be paying for the equipment over the coming months out of future profits, rather than at the start.

Advantages: The cost of equipment can be spread over many years. Disadvantages: You do not own the asset and are subject to a long-term contract.

Equity Capital

The main advantage of equity capital is that, in contrast to debt, the money doesn't have to be repaid, and there's no interest to be paid. The money invested via equity is risk capital and there's no guarantee that investors will get their money back.

However, the money you need to raise from outside investors means you're diluting the amount of the business you own for yourself.

Your own money

In an ideal world you'll have sufficient funds readily available to inject the required amount of money into the new business and own 100% of it yourself.

Good for: All businesses, as they will need some sort of financial commitment from the entrepreneur. Bad for: The entrepreneur - your funds are at risk if the venture doesn't succeed.

Advantages: You keep ownership of 100% of the business. Disadvantages: Higher personal risks, and you may have difficulty in raising all the capital required.

Other people's money

Very often the founders of a business don't have enough of their own money to provide all the equity capital and they will often ask members of their family or friends to invest in the new business. In some instances those involved will just be lending the money to you to invest in the business as if it were your money in the first place.

Alternatively, those investing directly would actually like to own a stake in your new business and share in its success or failure. The amount of shares they are allocated will depend on the amount of money they are investing and the value attached to the shares.

Good for: Businesses with a good chance of success. Bad for: High-risk ventures - you don't want to lose your friends' money.

Advantages: The project is funded by "friendly" investors. Disadvantages: Could compromise your relationship with family and friends.

Business angels

Business angels are private, high-net-worth individuals looking for opportunities to invest their funds, as well as adding helpful experience in a field where they may have succeeded in the past.

As with family and friends, they will expect a stake in the company in exchange for their money. Business angels will invest only if they like your business plan and, more particularly, the team that hopes to make it happen. You can benefit from the experience of someone who has seen the problems before, but the downside is the amount of equity that you have to give up to secure the investment.

The best way to find a business angel is to make contact with the Business Angel Network in your area. Check out Best Match (www.bestmatch.co.uk) for the National Business Angels Network Gateway (NBAN).

Good for: High-growth businesses with a good chance of success. Bad for: Lifestyle businesses. The business angel investor will be looking to grow his or her investment and won't want the business to stand still.

Advantages: The investors provide the finance to progress your project. Disadvantages: You have to surrender an equity share in the business in order to gain the finance.

Venture capital

Venture capital can be equity and/or loan capital provided by a specialist venture capitalist firm. This type of finance will usually be suitable for a new start-up with an expected high growth rate.

This is because venture capitalists will be looking for a high return on their investment and the underlying business will need to grow rapidly to achieve this. Venture capitalists will also want an exit route in place to ensure that they will be able to realise their investment.

The best way to approach a venture capitalist is through a professional adviser. You will need a fully developed business plan for the next five years before you make your approach.

Good for: Businesses with a strong future growth plan. Bad for: Businesses with low growth, poor profits and few prospects.
Advantages: The funding is unsecured, so may present fewer risks. Disadvantages: This method dilutes your business and removing control from your hands.

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