Cash as they say is king so it is important to ensure that your business has a ready supply of money when it needs it.
If you scan the business papers you’ll see any number of different companies promising ready cash for businesses, so much so that it becomes very confusing.
So how should you finance your business and what are the up and downsides of different types of financing?
Read on and we will look at;
● Why you need to finance your business
● What is equity?
● What is debt finance?
● What is grant financing?
● Different types of debt financing
● How you should choose
Why you need to finance your business
So you may be wondering why we need to finance a business at all.
Surely, you may argue, a business is started by its founders and as it earns profit it ploughs that back into the business to finance growth?
The ‘organic’ method of financing as it is called is as old as the hills but nobody would argue that it is a good way to grow rapidly! In fact, it is the slowest way to grow your business and for many companies, it is totally unsuitable.
Some businesses, especially innovative startups need to develop a product or service before they can start trading and this takes cash.
Other companies which may be trading, choose to invest in a new project which again takes cash that they may not have to hand.
Hence the need for financing.
What is equity?
Equity is the process of buying a part or all of a company through shares.
When founders start a business they will ‘subscribe’ for the original equity by putting in money in return for a share. The higher proportion of the shares they buy the more of the company they own.
Later on, the owners can sell either unsold shares to external investors or invent a new class of shares to sell for the purpose of raising money.
These shares can have different rights such as the right to vote at board and general meetings and the right to share in the profit or sale of the business.
This is a really cheap way of financing a new startup that hasn’t started trading as no profit means no dividend (or share of the profit) for the investors.
Equity financing has the downside that you are of course giving away part of the profit, the value or the control of the company.
What is debt finance?
Debt finance is the introduction of capital by taking on a liability. In other words, if someone lends you money then you owe them money.
This may sound obvious but it marks a fundamental change from equity funding. The company doesn’t owe shareholders anything as they are the company.
Typically the loan finance will be repayable either in instalments or at some point in the future.
Naturally, there is a price to be paid for debt financing in the form of interest which is arguably the biggest drawback of debt finance.
The natural institution to think of when we think of debt financing are the high street banks but as we will see later, this is just the tip of a very large iceberg.
What is grant financing?
Grant financing is where a government department, an NGO or other organisation provides funds, often to support a specific project.
Essentially this is a gift and requires no repayment and has no rights to the value or control of the company.
But this shouldn’t be thought of as ‘free money’ as a grant will usually come with some form of use restriction.
A grant could be used to support medical research for example. The company would have to carry out the research into specific areas and may well have to report on the project to the funders.
Grant finance is uncertain and can be difficult to obtain in the right amounts. Often it will purely be ‘matched funding’ in that the company has to provide a proportion of the project costs and importantly, many funders won’t make a contribution to running the central and shared function of the business.
Different types of debt financing
The most obvious type of debt finance is a simple term loan. An amount of cash is advanced and the company pays back a bit of the capital and some interest each month. It is easy and understandable and there are plenty of products like this around.
One of the most common types of debt finance is lease finance. In this case, the borrower gets an asset (think cars or photocopiers) to use and pays a rental during the term, at the end of the term they get the option to buy the asset at a reduced value.
Some forms of debt are interest-only and paid back at a predetermined point in the future. Interest-only mortgages are a good example of this. The borrower gets to use and own the asset and the mortgage is then repaid at the end of the term or when the house is sold.
Commercially, some forms of debt (development finance for instance) allow the borrower to not make any interest payments but roll them up into a final payment when the project is complete.
A final form of debt finance is flexible finance. This is a finance ‘facilty’ that allows the borrower to draw down cash as and when they need it.
The most common forms of these would be overdrafts and credit card products but there are commercial products that essentially do the same thing but in a bigger way. Flexible finance has much-increased costs, partially down to the fact that it is so convenient for the borrower.
The biggest downside to debt finance is the interest paid. On personal debt finance, this can be a problem as it is just another cost but for businesses the equation is different.
Imagine a project that costs £100,000 that a business can’t afford to do. The company uses debt finance to fund it at a rate of 10% pa or £10,000.
You could think of the £10,000 as an increased cost but if the project returns say 17.5% net profit then you are actually better off.
So whilst debt finance can look expensive at the front end when you do the maths it actually makes sense, especially when the company couldn’t otherwise have carried out the project without it.
How you should choose
The starting point is equity. If you are able to finance the company in its entirety yourself then you should. Sadly not many of us are in that position.
So you need to decide how much of the control of the company, any profits you make and the eventual sale value of the company you are prepared to give up in return for the money to start up and run the business.
Venture capitalists and private equity are the usual sources but many large charities will also take a stake in innovative companies that make a contribution to their area of interest.
If you are looking at debt then you need to think about the characteristics of the thing you are using it for.
For example, if you are buying a photocopier then a product that lasts for the usable life of the unit makes sense. A lease is a usual option but hire purchase or a term loan are also suitable.
For long-term assets like buildings and land, long-term secured debt is the best bet. It has a lower interest rate and you can pay back the loan bit by bit.
If you have a future income stream that is pretty certain then you can use specialist finance.
Two examples here. Firstly think of a company that is developing an industrial estate. They know that they will be able to sell the whole development upon completion so they could take out finance for a term that matches the build time.
The second example is the Rocking Horse finance offer. We advance money based on your R&D tax credit claim. Unfortunately, HMRC is experiencing increased delays which means that innovative companies often have to stop work whilst they are waiting for the credits to arrive.
Rocking Horse will advance cash immediately based on the value of your claim which you then pay back when HMRC sends you the cash.
In summary: match your financing to its use
So as we can see ‘financing’ isn’t just debt. It can comprise equity, debt and grant funding and for most businesses, it will actually be a mixture.
So don’t view company financing as an ‘either/or’ conundrum.
Instead, match the type of funding to the use you will make of it. Long-term funding for long-term projects and short-term for shorter ones.