Author: Jim Riley Last updated: Sunday 23 September, 2012
When a company is growing rapidly, for example when contemplating
investment in capital equipment or an acquisition, its current financial
may be inadequate. Few growing companies are able to finance their expansion
plans from cash flow alone. They will therefore need to consider raising
from other external sources.In addition, managers
who are looking to buy-in to a business ("management buy-in" or
"MBI") or buy-out (management buy-out" or "MBO")
a business from its owners, may not have the resources to acquire the company.
They will need to raise finance to achieve their objectives.
There are a number of potential sources of finance to
meet the needs of a growing business or to finance an MBI or MBO:
- Existing shareholders and directors funds
- Family and friends
- Business angels
- Clearing banks (overdrafts, short or medium term loans)
- Factoring and invoice discounting
- Hire purchase and leasing
- Merchant banks (medium to longer term loans)
- Venture capital
A key consideration in choosing the source of new business
finance is to strike a balance between equity and debt to ensure the funding
structure suits the business.
The main differences between borrowed money (debt) and
equity are that bankers request interest payments and capital repayments,
and the borrowed money is usually secured on business assets or the personal
assets of shareholders and/or directors. A bank also has the power to
a business into administration or bankruptcy if it defaults on debt interest
or repayments or its prospects decline.
In contrast, equity investors take the risk of failure
like other shareholders, whilst they will benefit through participation in
increasing levels of profits and on the eventual sale of their stake.However in most circumstances venture capitalists will
also require more complex investments (such as preference shares or loan stock)
in additional to their equity stake.
The overall objective in raising finance for a company
is to avoid exposing the business to excessive high borrowings, but without
unnecessarily diluting the share capital. This will ensure that the financial
risk of the company is kept at an optimal level.
Once a need to raise finance has been identified it is
then necessary to prepare a business plan. If management intend to turn around
a business or start a new phase of growth, a business plan is an important
tool to articulate their ideas while convincing investors and other people
to support it. The business plan should be updated regularly to assist in
There are many potential contents of a business plan.
The European Venture Capital Association suggest the following:
- Profiles of company founders directors and other key
- Statistics relating to sales and markets;
- Names of potential customers and anticipated demand;
- Names of, information about and assessment of competitors;
- Financial information required to support specific projects (for example,
major capital investment or new product development);
- Research and development information;
- Production process and sources of supply;
- Information on requirements for factory and plant;
- Magazine and newspaper articles about the business and industry;
- Regulations and laws that could affect the business product and process
(patents, copyrights, trademarks).
The challenge for management in preparing a business plan
is to communicate their ideas clearly and succinctly. The very process of
researching and writing the business plan should help clarify ideas and identify
gaps in management information about their business, competitors and the market.
Types of Finance - Introduction
A brief description of the key features of the main sources
of business finance is provided below.
Venture capital is a general term to describe a range of ordinary
and preference shares where the investing institution acquires a share in
the business. Venture capital is intended for higher risks such as start up
situations and development capital for more mature investments. Replacement
capital brings in an institution in place of one of the original shareholders
of a business who wishes to realise their personal equity before the other
shareholders. There are over 100 different venture capital funds in the UK
and some have geographical or industry preferences. There are also certain
large industrial companies which have funds available to invest in growing
businesses and this 'corporate venturing' is an additional source of equity
Grants and Soft Loans
Government, local authorities, local development agencies and
the European Union are the major sources of grants and soft loans. Grants
are normally made to facilitate the purchase of assets and either the generation
of jobs or the training of employees. Soft loans are normally subsidised
a third party so that the terms of interest and security levels are less
than the market rate. There are over 350 initiatives from the Department
and Industry alone so it is a matter of identifying which sources will be
appropriate in each case.
Invoice Discounting and Invoice
Finance can be raised against debts due from customers via invoice
discounting or invoice factoring, thus improving cash flow. Debtors are used
as the prime security for the lender and the borrower may obtain up to about
80 per cent of approved debts. In addition, a number of these sources of finance
will now lend against stock and other assets and may be more suitable then
bank lending. Invoice discounting is normally confidential (the customer is
not aware that their payments are essentially insured) whereas factoring extends
the simple discounting principle by also dealing with the administration of
the sales ledger and debtor collection.
Hire Purchase and Leasing
Hire purchase agreements and leasing provide finance for the
acquisition of specific assets such as cars, equipment and machinery involving
a deposit and repayments over, typically, three to ten years. Technically,
ownership of the asset remains with the lessor whereas title to the goods
is eventually transferred to the hirer in a hire purchase agreement.
Medium term loans (up to seven years) and long term loans (including
commercial mortgages) are provided for specific purposes such as acquiring
an asset, business or shares. The loan is normally secured on the asset or
assets and the interest rate may be variable or fixed. 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.
This is a loan finance where there is little or no security
left after the senior debt has been secured. To reflect the higher risk of
mezzanine funds, the lender will charge a rate of interest of perhaps four
to eight per cent over bank base rate, may take an option to acquire some
equity and may require repayment over a shorter term.
An overdraft is an agreed sum by which a customer can overdraw
their current account. It is normally secured on current assets, repayable
on demand and used for short term working capital fluctuations. The interest
cost is normally variable and linked to bank base rate.
Completing the finance-raising
Raising finance is often a complex process. Business management
need to assess several alternatives and then negotiate terms which are acceptable
to the finance provider. The main negotiating points are often as follows:
- Whether equity investors take a seat on the board
- Votes ascribed to equity investors
- Level of warranties and indemnities provided by the directors
- Financier's fees and costs
- Who bears costs of due diligence.
During the finance-raising process, accountants are often
called to review the financial aspects of the plan. Their report may be formal
or informal, an overview or an extensive review of the company's management
information system, forecasting methods and their accuracy, review of latest
management accounts including working capital, pension funding and employee
contracts etc. This due diligence process is used to highlight any fundamental
problems that may exist.
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