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Finance for Business – What Are Your Choices?

Very few businesses have funds to develop or expand without some kind of external support so finding the right finance for business is crucial, but it’s important to make the right decision on what funding will help you grow. Many businesses are being held back by a lack of awareness or understanding of the options available, so this blog looks at a wide range of options available to SMEs, from traditional sources such as bank loans through to alternative funding solutions.

Finding the right funding solution

There are many sources of finance to help small and medium-sized businesses to grow. The right solution will depend on several factors:

For those seeking investment, it’s important to have a clear and documented plan. This will likely need to be shared with potential financing sources, to demonstrate that your ideas and plans are viable and will generate returns which will enable you to repay the finance.

What is business finance?

In simple terms, business finance is the money required by a company for carrying out its business activities. Many businesses require significant amounts of fixed and working capital to operate. There are two main categories of finance for business available:

Debt finance

This source of finance involves borrowing money from a lender and agreeing to pay it back in full with interest. This could be a business loan over a period of time. Unlike equity, you don’t have to relinquish any shares or control in the business. Examples of debt finance are bank loans, overdrafts, invoice discounting or asset finance.

Equity finance

This method involves raising capital by selling shares in a business to investors. The value of their shares is dependent on the success of the business, so these investors then have an interest in its growth and profitability. They could bring skills, knowledge, and connections that can assist in the growth of the business. Examples of equity finance are angel finance and venture capital.

Things to be aware of:

What are the sources of financing a business?

There are many sources of finance for businesses looking to raise funds. Here’s an overview of the main ones, with the key features and some of the important factors to consider when deciding which is the right solution for your business.

Personal resources

Many individuals when starting a business will invest their own funds and leverage personal assets such as remortgaging their home. This has the benefit of being personally in their own control, plus it may be the only option available when first starting out.

For more established organisations – or when the business starts to grow – internal sources of money become limiting (for most businesses) and other external sources will need to be used. These could include:

Overdraft

An overdraft facility is flexible and can be very useful as a backup arrangement. It is generally considered a short-term funding arrangement and is usually easy to arrange.

However, it tends to be for smaller amounts and can be an expensive way to borrow, with fees and interest payable. And another important factor is that overdrafts can be subject to recall by the bank. Because it is a form of unsecured lending, overdrafts are usually only available to established businesses.

Bank loan

A bank loan is often one of the first of the various sources of finance that people think of. It’s a well understood and straightforward way to borrow money – usually a lump sum for a set period. Interest is payable on the loan which can be based on fixed or variable interest rates.

There is no impact on business ownership and the funds can be used for any purpose and can be a helpful boost to cash flow. A plus is that bank business loans can often be available to a new business subject to appropriate security or personal guarantees.

Whilst simple to understand, a bank loan is not always flexible and the application process can be time-consuming and complicated.

You’ll need a solid business plan in place and the bank will be looking to evidence that you have a sound and viable business and are going to be able to keep up repayments.

Friends and family

A loan from friends or family can be one of the easiest sources of finance for small businesses, as your friends and family know you and your business and are often willing to help out.

It is frequently used by those starting out in business due to the challenges in finding finance before the business has established a trading history and credit rating. In the right circumstances, this form of loan can be hugely beneficial but isn’t available to everyone.

One thing that is very important is to treat the arrangement formally – as if from a bank – with an agreement and terms laid out to avoid problems or fallings-out further down the line.

Business credit cards

One of the more convenient sources of finance, which is useful for purchases and day to day transactions. It’s particularly useful for this type of expenditure as it can be used by multiple people.

A business credit card is best suited to spending on smaller items over the short term, and generally not appropriate for large investments as it can be an expensive form of borrowing. Whilst there are sometimes 0% promotional deals available, generally, credit card borrowing will incur interest charges and fees. Your business will need a trading history and credit rating to qualify.

Merchant cash advance

This is one of the relatively new forms of financing, also known as a business cash advance, and is based on future sales.

It works by bringing forward future card sales made via a credit card machine and repayments are based on a percentage of monthly transactions. It can be a helpful form of financing for those with regular sales but only suits those selling through credit card terminals, such as retailers. Payback is aligned to revenues and so if sales are strong, the debt will be paid back faster. A merchant cash advance can also be quick and simple to arrange.

Asset finance

This is ideal for financing assets such as vehicles, machinery, or equipment. It’s a form of secured lending, as the asset finance company will have some security in the form of the asset itself.

It helps businesses that need to invest in new assets to spread the cost. Budgeting is easier as the cost is fixed, giving a known monthly payment that eases cash flow.

It allows investment in more expensive items to support business growth, without tying up valuable working capital that can be used elsewhere. Asset finance can be quick to arrange, with applications reviewed swiftly and pay-out within a matter of days; and unlike a bank overdraft, the facility cannot be called in.

Peer-to-peer lending (P2P)

These are alternative sources of financing, where private lenders make loans to small businesses via a lending platform, which produces decent returns to these lenders. Different platforms have different criteria so it’s worth having a look at all the options.

This option is generally more expensive than a bank loan but can be delivered in a matter of days unlike a bank loan. You’ll also need to factor in the up-front cost – a fee is usually charged by the platform, which again are higher than a comparable bank loan.

Invoice finance

A useful source of finance if the business is growing rapidly and needs cash flow. It allows businesses to borrow money against the value of outstanding invoices owed by customers.

There are two types – invoice factoring and invoice discounting.

Invoice factoring

You pass unpaid invoices to a lender in return for a percentage (up to 90%) of the face value depending on the sector the business is based in. They take responsibility for collecting the payments. When the invoice is settled, they will pay you the remaining amount less interest and administration charges. While factoring reduces administration, be aware that you are dependent on the credit-control competence of the factoring company to collect your debt – if they are not strong in this area, you could be borrowing more for longer and be liable for the associated interest costs.

Invoice discounting

In this form of invoice financing, you retain credit-control responsibility in ensuring invoices are paid. The funders lends up to 90% based on the value of these invoices. When the invoices are settled, the money is paid into a trust account and the remaining balance can then be drawn down less any admin and interest charges. Invoice financing is flexible and suits businesses that have a flow of invoices – so you need to be generating revenue and getting paid by customers. It is a form of financing business that will grow as the business grows.

It is a form of secured borrowing, however security is limited to the book debts of your customers and generally a personal guarantee from the directors. It can also be suitable for those needing business finance, but which don’t qualify for traditional business loans. It only works for businesses who have business customers as invoice finance is not available for consumer invoices. However, there is still a need to have a reasonable customer base to be accepted for invoice finance.

It can also be used for seasonal or one of sales to help support additional demands on a business.

Export trade and supplier finance

For businesses that trade abroad, trade finance helps mitigate risks such as delays in payment or defaulting customers.

If you are importing materials, suppliers will need to be paid in advance before shipping and so export finance can fill that gap between importing goods and materials and delivering the product to the end client.

Angel finance

This type of funding is typically provided by wealthy individuals or retired, successful business people. Angel investors will sometimes club together to form syndicates or angel investment networks.

An angel investor is often an experienced professional who can provide expertise and advice as well as financial support. For some businesses, this may make this source of finance invaluable.

A big difference to the other forms of finance covered so far is that you will need to give up some business equity in return for the financial investment. And, whilst there aren’t repayments to be made, the investor may choose to impose some restrictions on how the money is used.

Crowdfunding

This is a relatively recent way to source finance. Funding is accessed by pitching your business idea and offering some incentives to investors in return. It works based on asking a large number of people to invest a small amount of money. It can be a good way to raise funds for a new venture but will need a convincing proposition to get people to join in. The crowdfunding platform will charge a fee.

The downside is that there is no guarantee that the project will be funded. Crowdfunding is generally used by product or tech-based organisations and requires the ability to strongly market the business to generate enough interest. It can be very useful for start-ups and product launches.

There are several different types of crowdfunding:

Venture capital

Businesses that tend to be of interest to venture capital funds are those with substantial growth potential. This is unlikely to be an option for most smaller businesses and venture capitalists will rarely invest in start-ups – but it is a possibility if the business is in an attractive niche or shows high earnings potential.

You will need to evidence a capability to scale up, and that there has been clear success to date. There can be significant pressure on the business to deliver high returns to the venture capitalist. Like angel finance, venture capitalists can also bring expertise to the business and help guide strategy

Private equity

Again, private equity investors are interested in companies with high potential for growth over the medium to long term and this can involve funding MBOs.

Private equity investors are usually looking to improve the performance of a business via:

Investors will expect evidence of solid management. They will bring additional non-financial support in the form of strategic insights and guidance. The typical lifecycle of private equity investment is five to seven years, after which investors would seek to exit, having grown the value of the business.

Growth capital

This is a form of private equity investment for companies looking to finance changes within the business. An advantage is that it involves no change of ownership or loss of control. Growth capital works well for more mature organisations that are profitable but not able to raise adequate cash to fund investments and expansion.

Funding comes from a combination of equity and debt sources – it is a form of debt but with the characteristics of equity.

It’s a suitable source of finance for businesses that may already have borrowings, but that want to fund a transformational change, such as new product developments, expansion into new markets, or make strategic acquisitions. It’s also an appropriate source of finance for high-growth businesses.

Growth capital funding can also be used to restructure the balance sheet to reduce interest-bearing debt, which then results in improvements in working capital.

Note though that a growth capital loan is secured with ownership/equity in the company if the loan is not paid back on time and in full.

Mezzanine finance

Mezzanine funding or mezzanine loans do not fall into the category of either a pure debt or pure equity. It is a very high risk and high reward tool that fills the gap between senior debt and equity. A company uses this type of funding to raise money for specific purposes, rather than for more general financing. A mezzanine fund pools the capital of the investors, after which it can be used for varying purposes such as recapitalisation, acquisition, development finance or management buyout.

Mezzanine finance is usually treated as equity in the balance sheet. It is subordinate to senior debt but senior to common equity when it comes to the priority of payments.

Mezzanine funds differ from private equity in that the latter aims to take a stake in the company they invest in. Mezzanine investors, on the other hand, get regular interest payments. However, the loan may come with an option to convert into equity at a later date.

Incubators

An incubator is an organisation engaged in the business of fostering early-stage companies through their different developmental phases until the fledgling companies have sufficient resources to function on their own.

These are often funded by the public sector or academic institutions and can provide co-working space. An incubator firm typically helps nurture businesses from an early-stage idea.

Services provided by incubators can include:

Incubators either charge a fee for their services or take an equity stake in the start-up. The period of incubation can last from a few months to several years. The quality of the incubator is essential so be sure to check out their reputation and track record.

Government schemes & business grants

In the UK there are government support grants and subsidies available to help support entrepreneurs, providing a range of loans and grants to small and growing businesses. They support start-ups and can help with an initial cash injection, although this is unlikely to be a substantial amount. Grants are not repayable, but they can be very competitive and difficult to secure and the criteria can be strict, e.g. targeting young people or specific sectors of the economy. However, you will keep ownership of your business.

Summary

Here at Pegasus Funding, we’re experts in helping to plan and raise finance for a wide range of businesses. We work closely with you in planning the type of finance best suited to your needs, the terms involved and the type of security required for the finance. Contact us today for an informal chat and let us help drive your business forward.

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