20 FAQs people ask about financing a business.
- When should approach lenders for money to start a business?
- Should we raise all the start up funding we need at once or just enough to get started and then come back when we have six or 12 months' trading experience?
- Should I accept business finance from relatives as a loan, or as equity capital?
- Should we give friends and relative investing in the business normal shares, or special/preference shares?
- What's the difference between a term loan and an overdraft when financing my business?
- What happens if I cannot keep up the instalments on a term loan?
- What issues should I look out for in an equipment finance, lease or purchase agreement?
- What is a personal guarantee on my business borrowing?
- Should my spouse see a separate solicitor about securing a business loan on our house?
- Do I have to give the bank a personal guarantee for overdraft facilities?
- What is a fixed charge?
- What is a floating charge?
- What are our options if we need to raise more business finance?
- How should we finance expansion of our production facilities?
- The bank has a fixed and floating charge over our assets, which far exceed the value of the loan but will not lend us more. What can we do?
- Can we offer employees the chance to invest in the company or the opportunity to take shares instead of pay? Are there any tax advantages?
- A bigger company is interested in helping fund our expansion. How can we protect our interests while exploring the opportunity?
- We have been approached by a bigger company with an offer of funds, but we are worried about a take over. What precautions can we take?
- What is corporate venturing?
- What is an exit strategy, and when should we start thinking about it?
1. When should we approach lenders for money to start a business?
It is reasonable to assume that the majority of potential investors (as distinct from friends or family) will be looking to take their money out after three, or at most five years; so you need to produce detailed cash flow and profit and loss projections for the first three years, and outline figures for the next two years. Of course, you may get the figures wrong, particularly if you are offering a new product or service, but potential investors need a starting point in assessing your proposition, and that is what your projections for the first three years will provide.
Get the package looked over by at least one experienced, professional advisor (an accountant or solicitor), to establish the weaknesses in your case, if any. If you leave it to your potential investors to expose any unrealistic assumptions, you will simply ruin your chances of winning their confidence.
2. Should we raise all the start up funding we need at once, or just enough to get started and then come back when we have six or 12 months' trading experience?
Raise all the money you need, plus a cushion - depending on what sort of business it is, 10-25% of the total. If you attempt to go back to your bank (or to investors) too soon, they are likely to assume that you have run through the original funding more rapidly than was projected, and have not begun to generate income to sustain the business. None of this is going to encourage them to make more cash available.
3. Should I accept business funding from relatives as a loan, or as equity capital?
It depends - on how much you want to raise, how long you need it for, and how good your relationship is with your relatives. If you take the money as a loan, you incur interest and repayment obligations which - initially at least - could be very substantial in relation to your income. However, unless the lenders have negotiated special terms on the loan relating to the management of the business and its financial performance, or the funding is secured on the assets of the business, they will have no rights to influence the way the business is run, providing the payments can be made.
Loan debt may cost less to service, in the long run, than dividend payments on shares, and interest payments can normally be set off against profits for tax purposes. But you will eventually have to find the money to repay the loan, whereas 'ordinary' share capital is not normally repayable. For your relatives to take shares (ie 'equity') rather than lending money, your business will have to be incorporated, which in itself has tax implications. In buying the shares they acquire a stake in the ownership of the company, and therefore - depending on what proportion of the shares they get - rights to influence its management.
You may have to get a shareholders' agreement drawn up to record any special understandings about how the business will be run, when the shares can be sold and so on. While they hold shares, they will be entitled to any dividends declared on them. Unless you stipulate that under certain circumstances you will be entitled to buy back their shares, you may have difficulty in persuading them to sell at all, or to sell to you (see 4).
If your business fails, relatives who have lent you money may be entitled to recover some of it from the proceeds when the assets are sold off, like other creditors. Relatives who have taken shares in the company are unlikely to recover anything.
4. Should we give firends and relatives investing in the business normal shares, or special/preference shares?
Companies usually have a share capital made up of 'ordinary' shares - though it may be very low. For example, a private company is allowed to operate with only one share in issue. The ordinary shares are normally the ones that carry voting rights (through which the company is controlled), and rights to receive dividends if the company makes profits.
It is perfectly possible to create other types of share, which may have different rights to dividends or votes. For example, preference shares may carry little or no voting rights, but receive the first 'slice' of profits by way of dividend (with the ordinary shares getting anything left over). If your relatives have little interest in active decision making for the company but would like to know that their investment will see a return before yours does, giving them preference shares may work well. Shares can also be made 'convertible' (which means they can be changed into a different type of share, such as ordinary shares, in specified conditions), or 'redeemable' (where the company has to come up with money to return the value of the share to the investor in certain circumstances).
Choosing types of equity is like selecting from a restaurant menu. What is right for you will depend on your appetite, and that of your relatives, for risk, returns and a say in the running of the business.
5. What's the difference between a term loan and an overdraft when financing my business?
A term loan is the loan of a fixed sum over a fixed period of time, with regular payments of interest and repayments of capital. Both the interest payments and the capital repayments may be postponed over a given period - for example, the first year of the loan - but once they begin they have to be maintained. Providing that the payments are maintained, the bank is legally committed to letting the loan run for the full period - it cannot be called in early.
An overdraft is a much more flexible arrangement on both sides. You will be given an overdraft limit on your business account and may borrow up to that limit at any time while it remains in force. However, the bank is entitled to withdraw your overdraft facilities without notice, which means that you could find yourself required to refund these borrowings on demand.
Banks tend to think of term loans as a method of financing specific investments, whereas overdrafts are intended to cover fluctuations in working capital.
6. What happens if I cannot keep up the instalments on a term loan?
As soon as you see yourself heading into difficulty, speak to your bank and give a coherent explanation of how the problems have arisen.
Strictly speaking, if you are in breach of your agreement to make specified payments at specified times, the bank will be entitled to ask for its money back. If, however, you take action early and show that this is a one-off breach, the bank is more likely to be understanding. It may merely change the repayment conditions or amend (increase) the rate of interest.
If you continue to breach the loan conditions, or try to hide the problems from the bank, it will be much more likely to demand repayment of the loan, and if you are unable to make such repayment, to call in its security (see 13 and 14).
7. What issues should I look out for in an equipment finance, lease or purchase agreement?
Before you sign any agreement, you need to know:
- How long will the agreement run? How many instalments will you be committed to paying?
- Are all the instalments the same size, or - for example - are you paying less initially but a large payment (a 'balloon payment') at the end of the term?
- What does the instalment payment cover, exactly? For example, does it cover servicing, or consumables?
- Who has responsibility for insuring the equipment? If you, is the cost of insurance included in your payments, or do you have to arrange that separately?
- Is there a usage (eg 'cost per copy') charge, and if so, what exactly is it? Will it be based on your actual or your estimated use? (Be careful: it is easy to be landed with a very expensive contract because of confusion over usage charges.)
- If the payments cover the use of consumables (for example, toner for photocopiers), exactly what consumables will be delivered, and when? What are the delivery charges, if any?
- Who has responsibility for keeping the equipment secure?
- What happens if it does not work properly?
- What happens at the end of the agreement? Does the equipment belong to you? If not, can you extend the agreement, and if so, is this at a reduced rate? Alternatively, do you have to give notice to end the deal?
- What is the tax position? (If you are buying the equipment, you should be able to claim capital allowances; if you are leasing it, you should be able to set the lease payments against your taxable profits.)
- What is the position on VAT?
- Do you have to show your financial liability on your balance sheet?
- What happens if you cannot keep up the payments?
8. What is a personal guarantee on my business borrowing?
The bank is effectively asking you to provide security for your business borrowings by committing yourself to repay them - if necessary from the sale of your personal assets, whatever they may be (your house, car, investments, or valuables such as jewellery, pictures, antiques and so on).
Providing that you can service the business loan out of the business profits, there is no reason why the bank should ever have to call upon the personal guarantee. However, most personal guarantees are “on demand” which means that if your business fails to make a payment, the lender may be able to make a claim on your personal assets as soon as the due date for payment has passed. Similarly, if your business does less well than you expect, you (or your creditors) decide to pull the plug on it, and there is insufficient cash to repay your liabilities to the bank, you will be called upon to personally pay any remaining liabilities (subject to any cap or restriction set out in the personal guarantee).
9. Should my spouse see a separate solicitor about securing a business loan on our house?
Yes, it is normal practice. The bank will want to protect its rights to recover the loans against the possibility that - if the house has to be sold to repay the debt - your spouse (or anyone else with a right to live in your house) will claim that they are being penalised by an agreement to which they were not a party, or to which they were a party, but without understanding the full implications of the deal.
Such claims have been made in the past, and judges have been extremely reluctant to force spouses (or other residents), whom they see as having been 'duped', to move out so the house can be sold.
So banks now aim to obtain written evidence that all other parties with an interest in the property have not merely consented to the deal, but also received independent legal advice on its implications before they did so. If your spouse refuses to see a separate solicitor, then - depending on the circumstances - it is quite possible that the bank will not be prepared to make the loan.
10. Do I have to give the bank a personal guarantee for overdraft facilities?
Again, the answer will depend on the circumstances. If yours is a very new or rather shaky business, and you want borrowing facilities which are substantial in relation to the amount of money coming in, you will almost certainly have to provide some form of security, although not necessarily a personal guarantee.
If your business is established, and the funding you need is small in relation to the amount coming in, then it is reasonable for you to argue that any form of personal security is unnecessary. Not all banks will agree, so you may have to shop around.
In any case, consider whether you can resolve the problem by other means - for example, improving your debt collection procedures - before you approach the bank at all.
11. What is a fixed charge?
A fixed charge is a form of security under which a specific item of property or an asset such as a piece of machinery is used as security for the loan. If you fail to repay the loan in accordance with the terms under which it has been granted, the asset in question is forfeit.
It is effectively the same, from the lender's point of view, as the mortgage on your home - and just as with your home, you cannot sell the assets subject to a fixed charge without getting the charge released or lifted by the lender.
12. What is a floating charge?
A floating charge is a form of security under which all the assets (or a particular class of assets) of the business, other than those which are subject to a mortgage or fixed charge, are used as security for the loan.
The great advantage of the floating charge is that you can sell or use the assets - such as your stocks - as if they are free of any charge, at least until the lender tells you otherwise.
If you fail to repay the loan in accordance with the terms under which it was granted, the lender can activate certain remedies, such as:
- converting the security to a fixed charge (thus stopping you from selling the assets)
- appointing a receiver or administrator to run the business
- seizing and selling any - or all - of the assets to pay off the loan
13. What are our options if we need to raise more business finance?
Depending on the extent to which you have committed business and personal assets as security, they could be limited. It probably makes sense to start off by talking to your bank manager, who may be willing to offer further finance if you have a clear plan to turn things round, the figures are obviously moving in the right direction and/or there is security available.
If the figures are moving too slowly to make sense - or even worse, moving in the wrong direction - then you will have to make some hard decisions. You may be able to find an investor from amongst your friends or relations, but it is extremely unlikely that you will be able to find other outside sources of finance.
If you are still committed to keeping the business going, you will certainly have to slash your overheads and tighten up on your credit controls. You might be able to scale back with a view to building up more gradually, finding another source of income to finance your outgoings in the meantime. Alternatively, you might consider realising your assets, paying off your loans to reduce your outgoings, and devoting yourself to building up the business from a lower personal base.
14. How should we finance expansion of our production facilities?
Your first port of call should be your bank manager, who will probably be interested in suggesting a deal, particularly if you need to expand your production facilities because your business is doing well.
However, with a three-year record and a history of growth and profits, you may have reached the stage at which you can also explore other possibilities:
- Consider whether a lender specialising in equipment finance could offer a better solution (see 7).
- If you have a strong cash flow, consider raising finance through an invoice discounting facility, which typically releases more of the value of your invoices to you than overdraft lending.
- Consider whether the best way to expand might be some form of combination with a business in the same sector, whether by a merger, a take-over or perhaps a joint venture.
15. The bank has a fixed and floating charge over our assets, which far exceed the value of the loan but will not lend us more. What can we do?
You might need to put out feelers to other lenders - which can often be best done through brokers, or your solicitor or accountant. That way the strengths of the business can be emphasized, initially on a no-names basis, and you can get a feel for which finance providers are in the market for your type of business, and what their terms might involve.
The more effort you put into developing a clear, professional presentation of your business, its current financial position and its prospects, the more seriously you will be taken by other lenders.
Sometimes the fact that another lender is willing to finance the business is all it takes to bring a bank around - on the basis that it is better to accommodate a customer than to lose one.
16. Can we offer employees the chance to invest in the company or take shares instead of pay? Are there any tax advantages?
Yes, providing that your business has corporate status, and you can agree some way of valuing your shares. If you want to attract or retain good managers, but you cannot afford to pay them what they are worth on the open market, you could try topping up their pay with an offer of share options - which give the right now to buy shares at a given price in the future. If the shares increase in value in the meantime - as they will, if yours is a successful business - anyone who holds share options stands to do well out of the deal. There are various HM Revenue and Customs (HMRC) approved schemes, with benefits (limited by quite complex rules) for those who use them.
If there are only a few individuals involved, one possibility is the Enterprise Management Incentive (EMI) scheme, under which you can offer options on shares with a current value of up to £250,000. Your business must have gross assets of less than £30m; you must not have more than £3m in share options outstanding at any one time; and there are rules about the type of business and the number of hours that the favoured employees work; but overall this is a flexible scheme and comparatively uncluttered with bureaucratic requirements. The beneficiaries do not have to pay tax on the grant or exercise of their options but might have to pay capital gains tax when the shares are eventually sold.
If you want to offer share incentives more widely, you might want to go for a Company Share Option Plan (CSOP). Under a CSOP you can offer options on shares worth up to £30,000 to as many employees as you like - there is no overall limit on how much you can have outstanding. Again, beneficiaries do not have to pay tax on the grant or exercise of their options, though they might have to pay capital gains tax when the shares are sold.
If you would like employees to put some money into the company you could consider introducing a Share Incentive Plan or SIP (also known as an All-Employee Share Option Plan, or AESOP). Employees can buy up to £1,800-worth of shares each year, and you can reward their commitment by offering up to two 'matching' shares for every one bought. You can also offer 'free' shares worth up to £3,600 per employee. To establish a SIP, however, you need to set up a trust to hold employees' shares, and this, plus the palaver of getting HMRC approval, makes it a cumbersome route, at least for comparatively small companies.
17. A bigger company is interested in helping fund our expansion. How can we protect our interests while exploring the opportunity?
First see your solicitor and get a legally binding confidentiality or non-disclosure agreement put in place. That way, you can continue discussions without worrying about giving away commercially sensitive material, although this protection is only watertight if the other company is also based in the UK. If it is a foreign entity, suing for breach of the agreement is likely to be complex and expensive.
Secondly, ask your bank (or use a credit reference agency such as Coface UK, Dun & Bradstreet or Experian) to do some checks on the larger company. Do they have a reputation for sharp tactics? Have they been sued in recent times for similar reasons?
If your doubts persist, look elsewhere for your investment partner. 'Marry in haste, repent at leisure' is true in the world of business, too.
18. We have been approached by a bigger company with an offer of funds, but we are worried about a take over. What precautions can we take?
This is the sort of situation in which it might make sense to use different types (or 'classes') of shares, and to draw up a shareholders' agreement (see 4).
In this way you can protect or entrench your rights as shareholders and your position as directors of the company. You can also lay down rules as to how the strategy of the company will be developed, and perhaps also as to what arrangements each side wants to put in place for an eventual 'exit route' (see 20).
However, it is only worth going down that path if you have quite a high degree of confidence in the good faith of the other, larger party. If you have serious doubts, do not embark on a relationship, no matter how much protection you think your arrangements should give you.
19. What is corporate venturing?
This is a potentially attractive arrangement under which one company (generally a bigger one) can make a limited investment in another (generally a smaller one), to the advantage of both parties. It works best where, for instance, the companies are involved in complementary but not competing businesses: as for example, a pet food manufacturer and the manufacturer of a new and revolutionary mousetrap. The bigger business puts some money in and — depending on the deal struck — may also offer help with marketing, purchasing, R&D, etc.
The bigger business gets exposure to a field in which it is not currently involved, plus the benefits that come from investing in small companies: fast growth, fast reactions, innovative solutions etc. The smaller business gets, at the least, some cash. The tax advantages potentially available to the bigger company are designed to encourage it to invest. In particular, it can claim 20% tax relief on the cost of the investment, provided that it is held for at least three years, and it can set its losses (if any) off against profits, if the smaller company turns out to be a dud.
Each side has to comply with various rules. In particular, the big company must limit its investment to no more than 30% of the shares of the smaller company; the smaller company must be unquoted and independent, and 20% of its shares must already be owned by outside investors (ie not employees, directors or their relatives); and the small company must have assets worth no more than £7m before the deal, or £8m after it (unless the shares were issued before 6 April 2006, when the limits were £15m and £16m).
For smaller companies with ambitions, this could be a good way of organising both financial and non-financial support. Take advice, if you think this could be the right next step for your business.
20. What is an exit strategy, and when should we start thinking about it?
Your exit strategy is your current plan for bringing your connection with your business to an end.
You might be thinking of selling up eventually to one of your larger rivals, passing your business on to a family member, preparing your management team for a management buy out (MBO) or floating on the Stock Market, and wish to take steps to groom your business with that in mind. If you are thinking about it before you have even got your business off the ground, however, don't bother. Building up a small business is not a soft option, and if you have an ulterior motive there will be easier ways of achieving it.