Sources of funding
There are many sources of funding for a business. If we assume that the business is in a private limited company, which is the most common entity in which to run a business, the most usual are:
1. Funding from the Company’s shareholders and/or directors– All private limited companies will have some funding from its shareholders and/or directors. Every private limited company will have issued shares to its shareholders. The amount paid for those shares are part of that Company’s share capital. This may not be much and initially may be only £1. Shareholders and Directors may also choose to make loans to the Company. Sometimes this is to fund a particular situation and sometimes it is effectively more permanent funding. They may charge interest or may not. The reason you might put money in as a loan rather than for shares tends to be it is easier to repay loans than it is to realise value in shares.
2. Loan Funding from Banks/Financial Institutions– Most companies have some funding from banks or other financial institutions. This might just be credit facilities on your normal banking activities (e.g debt that might arise on credit cards or BACS facilities or letters of credit) or it could be more formal overdrafts (essentially repayable whenever the bank or other financial institution asks for it) or loans (which will be repayable on the basis agreed with the bank or other financial institution). These loans tend to come with the need for security from the Company and possibly from its shareholders and/or directors.
3. Equity Funding from Banks/Financial Institutions– You may seek funding from banks or other financial institutions in exchange for shares in the Company. There are many different ways to do this but typically the risk on this type of funding is higher so the bank or other financial institutions will want a higher return and will tend to take a mix of preference shares with an agreed return and ordinary shares so they share in any exit event of the Company. This type of funding also tends to have loan funding as well.
4. Funding from Business Angels– This tends to be early stage funding and is therefore very high risk. This tends to be a mix of shares in a similar way to banks or other financial institutions and loans.
What is right for you?
The type of funding is key. You will want to pay the least you can for the funding you want to obtain but being realistic you have to consider how much risk any loan or equity provider is taking and when they can be repaid. Key considerations are:
1. What security can you offer?
If you have assets and debts that you can give security over this lessens the risk and in turn should lessen what you have to pay for the funding. Please bear in mind that the assets and debts will be assessed so that their value if you did not pay could be taken into account. Debt from blue chip companies (i.e. a nationally or internationally recognized, well-established, and financially sound company that is publicly traded) such as Coca Cola or government will be valued more highly from a risk perspective than debts from local customers no matter how well they tend to pay. You may be prepared to give personal guarantees or even security on your personal property which again would lessen risk to a lender but obviously increase risk for you.
2. How much have the Company’s shareholders and directors lent or otherwise invested in the Company?
The better the balance sheet for a Company looks the better from a lender perspective. You may find a lender wants you to agree that you cannot take your money out until the lender has been repaid and this is something to consider.
3. How much of your Company are you prepared to offer?
We have all seen Dragon’s Den where people value their Companies highly and have those valuations shot down. Realistically an equity investment is high risk and the percentage required may be higher than you are prepared to give. A lender may also want a seat on the board or an observer at board meetings. This can be a blessing if you get on with the person and they bring relevant experience but can also be a burden if you have different views in how the Company should be run. You are likely to have little control over the identity of the person and they are likely to change over time.
They may also want leaver provisions in the Company’s articles of association so that if you cease to be employed by the Company you have to sell your shares. How much for is a matter for negotiation.
An equity investor is likely to want an exit in 3 to 5 years.
4. What do your projections say?
Expect a lender to look closely at your projections in any business plan. They will expect them to be realistic and that you believe they are achievable based on the information available to you. They will then stress test them. They will want to make sure you can pay them back and deliver a return. They will not expect to be taking all the risk so they will want a margin for error. Expect a bank to want at least twice as much in security terms for what you may wish to borrow for lending. Equity investment will depend on their view of your business and the market it operates in.
What’s the answer?
There will be a different answer for each Company. If you have a good feel for your business you will look for your funding in good time. Last minute desperation is a great way to get a bad deal or no deal at all. You will probably want to appoint a corporate finance adviser to look for funding with you. Lenders do not always want the same types of businesses. Some of them may have had bad experiences with companies in your sector. A corporate finance adviser should have a good feel for which lenders are looking for what types of business at the time. Always look at it from a lenders perspective and consider their risk profile. If you have a good track record with your existing funder they are likely to be a good first port of call if only to give you a feel of what you can get at what cost. If you have a deal then it is likely to be easier to get an alternative at a better cost.