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The complete guide to business funding

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Finding the right source of funding is key to the success of every start-up. Learning all about funding, as well as the tips when seeking out a business loan, is vital on the road to growth.

Turning an idea into a business and growing an operation requires money. To help kick-start, sustain, or expand the business, entrepreneurs look to the usual sources of funding including family members, angel investors, crowdfunding, loans and grants.

Suffice to say, the routes to funding are many and there isn’t a right or wrong approach. It is all down to how you manage the process. If you manage it well, your business will receive a big boost. But if it is mishandled, funding can lead to a destructive cycle of debt.

At Tax Agility, our small business accountants work with many entrepreneurs across London helping them with financial matters. In this article, we aim to discuss different types of funding and how to go about acquiring it.

The three types of funding

Most people are aware of the two basic routes to getting money: either through trading away ownership of your company, known as equity; or through borrowing money, known as debt. A hybrid of debt and equity financing called mezzanine financing is the third option. Mezzanine financing is often used in commercial real estate purchase and it allows the lenders to convert unpaid debts to an equity interest in the company in case of default. As the first step of funding is in deciding which route you want to take, let us take a step back and discuss each option properly.

Debt

A simple online search on ‘small business financing’ will reveal many sites offering small business loans, with most of them showing images of cheerful and seemingly successful models as if to say debts (borrowings) are good for you and if you take on a loan, you can look as brilliant as the models.

Debts can spur growth if they are used right; but make no mistake, acquiring a small business loan is actually incurring debts that you have to repay the loan plus interest within a specific time period without fail. If you are on the road to profitability, paying off the loan may seem easy, but when you are hit with a series of cash-flow gaps or going through a low period with declining sales, paying off the loan can be a real struggle.

Another reality is that many lenders do not want to lend you the money on the basis of a great idea. They want to see substantial track records and/or business assets which can be used as collateral. In other words, they want some form of security that you can pay back the loan.

Having said that, financing your business through incurring debt does have its benefits and they include:

  • Unlike equity, you retain ownership of your business.
  • Loans are widely available; and because it is rather competitive, there are lenders who will consider small business loans without collateral.
  • The interest rates can be low, especially if you seek out government-backed schemes.
  • Interest paid on business loans is a deductible expense.

Equity

When lenders ask for a percentage of ownership in exchange for the money your business requires, it is equity financing. The lenders involved could be financial institutions or public investors, as well as angel investors who usually come in the early stage to help profitable small businesses in their efforts to grow.

The advantages of equity financing are:

  • Your investors have a shared interest in your growth. This can be particularly beneficial if the investors have connections, knowledge and experience in your industry and are well-placed to help facilitate this growth.
  • There is no need to make any ongoing repayment. This is attractive to start-ups that are not making a profit yet and/or are struggling with their cash flow.

However, the benefits have to be balanced with the primary disadvantage of equity funding: a loss of control. While certain investors may be rather hands-off and trust your abilities and judgements, others can ask a lot of the companies that they have invested in. They may even want to exert control over decisions – in some cases everyday decisions – and this is where conflicts arise. Needless to say, finding equity lenders who align with your goals and vision is key here.

Mezzanine

Mezzanine funding is a creative blend of debt and equity and how it is structured depends entirely on the terms of the agreement and how the business events unfold. Traditionally, mezzanine is used for complex and large-scale commercial deals but recently, it has started to appear on SMEs’ radar as a funding option. How mezzanine financing works is it allows lenders to convert unpaid debt to an equity interest in the company in case of default.

Mezzanine funding is best illustrated with a simplified example here: assuming your business needs £100,000 to increase production in the next 12 months. The lender, a specialist mezzanine investor, lends you the money against a stake in the company’s ownership. Due to a delay in raw material and a decline in sales, you cannot pay back £50,000 of the £100,000 loan. In this instance, the lender can convert the unpaid £50,000 debt into shares and become co-owners.

Top tips for seeking a business loan

As chartered accountants, we are asked frequently by business owners about different types of funding and the best way to pursue it. The answers to these questions actually lie in two documents that are within your disposal: your business plan and the company accounts if your operation has been going on for a while.

Your business plan is your roadmap for business success. It helps you put aside your emotion and make a realistic evaluation of your idea and list out all the elements needed to turn the idea into a reality. It covers everything from market analysis to financial projections. However, please do not assume that it must be a rigid 200-page document which becomes obsolete the minute you finish writing it. Rather, your business plan is a document that asks hard questions and covers different scenarios. Most importantly, it allows you to be realistic and adapt when necessary.

If you have been trading for a while, then your company accounts are equally important. Containing a balance sheet, a profit and loss account and directors’ report, they represent how your company is managed and the strength of your financial position at present. While cash flow forecast isn’t part of your company accounts, its importance cannot be undermined because most lenders would want to see it. If you would like to know more about cash-flow, follow the link to this article “Five ways to improve your company’s cash-flow”.

In essence, before submitting any funding application, it is best to go through your business plan, company accounts and cash-flow forecast. You should also ask yourself all the questions that a potential investor would ask, including:

  • How much do you need?
  • How will the additional money help your business in more ways than one?
  • How much will it cost your business?
  • If it is a debt, how long will it take you to pay it back?
  • If it is equity, how long until the investor will see a return on their investment?
  • How will the business adapt if the business does not go according to plan?

Acquiring the funds for your business

In this section, we would like to discuss the sources you can go to acquire funding for your start-ups or small business.

Start-up loans

Knowing that most start-ups will struggle to get a business loan from a traditional bank, the UK government has set up the Start Up Loans Company to provide easy access to loans of £500 to £25,000 for budding entrepreneurs. The loans have a fixed low 6% interest per annum, plus it comes with free mentoring and exclusive offers to help kick-start your venture. You can find out more at www.startuploans.co.uk.

Bank loans

If your company and yourself have a good credit score and you can demonstrate profitability and growth, then it is likely that your bank may approve your loan application. At present, HSBC offers small business loans from £1,000 to £25,000 with 7.4% interest per annum – there is even a tool on their website allowing you to check your eligibility.

Peer-to-peer lending

The concept of peer-to-peer lending first appeared in 2005 with the idea of matching lenders with borrowers. One of the largest platforms today is Funding Circle, which is said to have helped 72,000 small businesses globally in obtaining unsecured loans. To make it easy for both lenders and borrowers, these peer-to-peer companies perform credit assessment and manage the repayment process. It is not all rosy however, as the collapse of Lendy in May 2019 saw thousands of investors losing a significant chunk of their investments.

Angel investors

Angel investors are individuals with wealth and connections who will invest in your business and they may also give advice pertaining to how your business is managed. In exchange, they usually want a percentage of your company. The one question most entrepreneurs have with angel investors is where they should begin looking for one – the answer is online. Newable, previously known as the London Business Angels, is a good place to start. Other sites that connect angel investors with entrepreneurs include Cambridge Angels, Seedrs and AngelList, to name but a few.

Venture capital

While angels are individuals, venture capital refers to companies made up of professional investors who look for companies with fast growth. Almost exclusively equity funding, venture capital deals with large sums of money, usually a substantial investment that can set the company involved on a path to initial public offering, hoping that when the shares hit the public market, they will make much more than what they have put in.

Crowdfunding

Many people assume that crowdfunding and peer-to-peer lending are the same but they are different in reality. Crowdfunding sites like kickstarter allow individuals to contribute to a project (which can be a creative film or a new generation product) and may or may not receive a reward in return.

Grants

In the UK, grants provided by the government and/or local councils can assume many forms – they can range from broadband subsidy (up to £350) to research in agri-tech (up to £50,000) in a specific geographic area.

Love money

The term ‘love money’ refers to money borrowed from friends or family members to start or grow a business venture. It is highly common among entrepreneurs because the lenders do not usually ask for collateral, do not often include interest, plus they are more likely to provide you with far more flexibility when it comes to repayment. Keep in mind, however, that this form of funding is not without its risk. Taking money from friends and family can lead to rifts, resentment and even the complete destruction of relationships, so tread carefully.

Self-funding

Self-funding is hardly mentioned but at Tax Agility, we know from experience that the first person many entrepreneurs look for help is actually themselves. Driven by passion, entrepreneurs make use of personal savings, liquidate their assets, and some even max out their credit cards (incurring debts) to turn their passion into a business and work relentlessly to sustain it.

While the self-funding effort is admirable, it does pose a high personal risk. Also, it is worth noting that personal funds are usually finite, so it is wise to have a back-up plan and know when and how to source for additional funding is useful.

Get solid business advice from Tax Agility

In order to find the right type of funding, and to prepare your business for growth, you need sound business advice first. At Tax Agility, our chartered accountants help small businesses across London with more than just company accounts, tax advice and payroll. We believe that if you grow, we will grow too, which is why we are with our clients every step of the way in their journey towards success.

If you are ready to grow and expand your business, our management consulting services may be able to assist. The areas we cover include:

  • Preparation of annual business plans, forecasts and projections.
  • Management accounting and delivery of regular overview information.
  • Review of credit control and cash management procedures.
  • Attendance at key business meetings.
  • Creation of strategic plans for business acquisitions and disposals.
  • Advice regarding capital structure and business valuations.

To get in touch and see how we can assist in safeguarding your short and long-term financial health of your business interests, call us on 020 8108 0090 or fill in our online form.

This article was first published in 2018 and was updated on 28/08/2019.

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This blog is a general summary. It should not replace professional advice tailored to your specific circumstance.