Raising Finance - an Introduction

Whether you are starting up or looking to expand, how best to raise finance for any business is never a straightforward exercise. Even if a company can finance its growth from cash-flow alone (which is generally unlikely), this is not often the best option.

Growth plans normally require funds to be raised from alternate sources. Investing in new capital equipment or acquiring another business will normally need external help. The same is true when managers are looking to buy-in to a a business or buy-out the existing owners. Rarely will they have sufficient funds themselves and even if they do, some form of equity or debt finance may be more appropriate. So where can this extra funding come from? There are a number of different sources.

• Family and friends
• Existing shareholders and directors funds
• Grants and Soft Loans
• Clearing banks (overdrafts, short & medium term loans)
• Merchant banks (medium/ longer term loans)
• Hire purchase and leasing Factoring and invoice discounting
• Business angels
• Venture capital.

When comparing the alternatives, there is a fundamental distinction to draw - equity versus debt financing. A combination of the two is often fine but the balance must suit the business.

Equity investors take risk. As with the other shareholders they are gambling on the future success of the business. They will benefit by way of sharing the profits of the company and its eventual sale value when it is sold. Some investors though will require preference shares or loan stock.

Debt finance is borrowed money and the banks will therefore require regular payments of interest and capital. In many cases they will also require that the lending is secured against assets of the company and / or the personal assets of the shareholders and/or the directors. the banks can also push the business into administration or bankruptcy if it defaults on its payments.

The balancing act for a business is to avoid excessive high borrowing but without unnecessary dilution of the share capital.

Grants and Soft Loans

Grants are normally given to enable equipment and other assets to be bought, employee training and to generate jobs. Government both central and local, local development agencies and the European Union are major sources of grants. At the same time they will also offer soft loans.

Soft loans are commercial loans but where a third party, for instance the Department of Trade Industry, subsidise or guarantee the loan so that the terms of payment and security required is less than the normal market requirement. Such loans are aimed at new and small businesses that cannot meet the normal lending criteria of the High Street banks.

Bank Overdraft

An overdraft allows a bank customer to overdraw their current account up to an agreed limit. It is to cover fluctuations in short term working capital and is repayable on demand by the bank. Security may be required. Interest is normally variable and linked to the bank base rate.

Loans

Medium and long term loans are for specific purposes such as acquiring another business or shares. The loan will be secured on the company assets with the interest rate being fixed or variable. The Small Firms Loan Guarantee Scheme can provide up to £250,000 of borrowing supported by a government guarantee where all other sources of finance have been exhausted.

Mezzanine Debt

Where there is little or no security left after other debt has been secured, mezzanine finance may be available. This is a loan finance . that reflects the higher risk by way of a substantial increase on the interest rate. The lender may have an option to take equity.

Hire Purchase and Leasing

Hire purchase and leasing provide finance for specific assets such as equipment, machinery and vehicles. A deposit is paid and then regular payments over a period of time typically 3 to 10 years. Ownership of the asset remains with the lessor although this will pass to the hirer when the HP agreement has been paid in full.

Invoice Discounting and Factoring

Cash flow can be improved by raising money against the invoices of the business. Up to 80% of the invoice value can normally be raised in this way. Differences will exist in whether the business continues with looking after its won sales ledger and debtor collection or if this is passed onto the finance company.

Some of these institutions will also lend against stock value and other assets.

Business Angels

Individual investors who are often wealthy individual in their own right may consider an investment in a business in exchange for equity. They will often look to invest in businesses that reflect their own experience and expertise and may take an active role in the business they are helping or act as a sleeping investor with little involvement in the day-to-day activities.

Business Angels may be found through personal contacts but also often belong to a network of similar investors.

Venture Capital

Venture capital is normally sought for start-up situations often where there is a potential for high returns in a short period of time. The VC investor institution will take an equity stake in the business and have keep a very close eye on the business. There are over 100 VC funds in the UK with preferences for specific sectors or geographical areas. Some large companies will also have funds to invest in growing businesses normally in related activities.

Completing the finance-raising

Raising finance is often complex. It is not just a case of selecting the option with the best financial terms.

Other points will have to be considered.

• Whether equity investors take a seat on the board
• Voting rights for equity investors
• Guarantees and indemnities provided by the directors
• Financier's fees and costs
• The cost and process of due diligence.

During the process the whole business plan will be reviewed by the potential investors / lenders including the financial detail of the plan. This may be a formal or informal report, an overview or an extensive review which would include:

• company's management information system
• forecasting methods and their accuracy
• review of latest management accounts
• employee contracts
• pension fund liability
• key customers.

Please Note:

This article is for general guidance only and should not be regarded as constituting legal or business advice or opinion.

Proper legal and/or business advice should be sought and taken in relation to the specific circumstances of each case. This article is not intended to be a substitute for obtaining specific legal and/or business advice from an appropriate professional.

Author: Jon Heath, The CMC Partnership
Date: February 2007

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