The ‘Golden Rule’ for financing a new business is: As little as possible, as cheaply as possible. Do not put money into the unnecessary. It is better to start off running your business from the attic without a loan than in a glossy, but unnecessary, high street office with heavy bank borrowings.
On the other hand, do adopt a realistic position on the amount of money that you need to get going. Your financing must be sufficient to carry the business for a reasonable period before it reaches some kind of balance, where money coming in equals money going out. In addition to capital investment in plant, equipment and premises, your financing may have to supply most of the working capital until sales begin to generate sufficient income to give you an adequate cash flow.
You have two options in raising finance:
• Equity – capital invested in the business, usually not repayable.
• Debt – capital lent to the business, usually repayable at a specified date.
For equity, the alternatives are:
• Your own equity – which leads to two questions: How much do you have? How much do you need?
• Other people’s equity – which also leads to two questions: Are you prepared to allow other people to own part of your business? Can your business offer the sort of return that will attract outside investors?
Because equity means giving away part of your business, it’s in your interest to minimise the amount held by outside investors. However, be sensible – it’s better to own 70% (or even 30%) of a thriving and profitable business than 100% of a business going nowhere because it’s starved for funds.
In terms of the equity that you are able to put into the business, you must establish what assets you must retain as a fall-back position, and remove these from the equation. For example, you may not want to mortgage your house to raise finance for your business. Then consider what assets remain in the following terms:
• How easily can they be sold and how much will their sale raise?
• Are they mortgageable assets?
• Will they be acceptable as collateral?
Typical assets include: cash; shares; car; land; house; and boats, second / holiday homes, antiques, jewellery, paintings.
If you are considering mortgaging your family home for the sake of the business, you should be aware that this is a very serious step and professional advice should be obtained. The issues to be considered include:
• Ownership of the property.
• What would happen to the family home and your family should the business fail.
• The approach that the banks and the courts take in such circumstances.
Note that if you mortgage your home, or borrow personally, in order to invest equity into your business and the business fails, you still remain liable to repay the loan. There’s a big difference between this and the situation where the bank lends directly to the business.
For many small businesses, the option of raising equity capital is not a reality. Either the sums they need are too small to interest an investor, or the level of return, while adequate to pay a standard bank loan, is not sufficient to tempt the investor who is exposed to a greater risk. Most equity investors look to invest at least ₠500,000 in a company, arguing that amounts below this do not justify the amount of checking they need to do before making an investment. Thus, perversely perhaps, it is easier to raise ₠5,000,000 than it is to raise ₠50,000.
In most cases – certainly where you require seed capital – you can approach the fund manager directly. A check on the fund’s website to make sure that you meet the fund’s criteria, a phone call to check the name of the person to whom you should send your business plan – then go for it!
Larger, technology-based projects requiring greater and more complex financing can choose whether to go directly to an appropriate fund or to work through a corporate finance house, which has specialist skills in fund-raising.
Whatever your route, remember that it’s not just about money, as the growth of incubators shows. Depending on the strengths of your new business, supports may be as important as cash.
But, despite all the new funds, the best source of small-scale seed capital for most start-ups continues to be family or friends. If you do decide to involve family and friends as investors in your business, make sure both sides know – and agree on the ground rules:
• Their investment is ‘risk capital’ – it may be lost and is not repayable (unless you agree otherwise).
• Equity investment does not automatically give a right to management involvement – even if it’s clear that you cannot cope.
• Their investment may be diluted by other later investors, whose money is needed to continue the development of the business.
Put everything in writing – in a formal shareholders’ agreement, if appropriate, or a simple letter of understanding signed by all parties.
‘Business Angels’, a term adapted from the world of theatre where private investors (‘angels’) are often the source of finance for a new show on New York’s Broadway or in London’s West End, are private investors who take (usually) a minority stake in a business – sometimes with an active management role, too. They’re hard to find and, since they’re usually experienced businesspeople, often hard to convince.
When considering financing your business with debt, consider:
• Fixed or floating.
• Long-term or short-term.
Fixed debt is a loan that is secured on a specific asset, for example, on premises. Floating debt is secured on assets that change regularly, for example, debtors. ‘Secured’ means that, in the event that the loan is not repaid, the lender can appoint a receiver to sell the asset on which the loan is secured in order to recover the amount due. Thus, giving security for a loan is not something to be done lightly.
Long-term for most lenders means five to seven years; short-term means one year or less.
Because you have to pay interest on debt, you should try to manage with as little as possible. However, few businesses get off the ground without putting some form of debt on the balance sheet. The issues are usually:
• What is the cheapest form of debt?
• What is the correct balance between debt and equity?
• How can you sensibly reduce the amount of borrowing required?
• To what extent must borrowing be backed by personal assets?