There is an old saying that there is never a shortage of people offering you money when you don’t need it. It is a vicious circle: you need to have a sound business to attract money – but you need money to build a sound business. Breaking that circle is possible if you can convince people that you are likely to have such a business.

This guide explores the main types of finance available and what investors and lenders look for before they advance money.

Types of finance

There are many different types of finance available, depending on whether you want short or long-term funds and for what purpose. Raising cash for day-to-day needs (working capital) is quite different from raising money for a long-term capital project – say, for buying new machinery or property. It is a big mistake to confuse the two and financiers will want to be sure their money is invested in the way you say it will.

Sources of cash include:

• Credit from suppliers.
• Overdraft.
• Loans.
• Leasing or contract hire.
• Factoring.
• Equity.
• Grants.

All these balance risk and reward – the greater the risk, the greater the return required.

Taking credit from suppliers

Credit is, in effect, borrowing from your suppliers. It can take many forms, varying from industry to industry, but includes the common practice of suppliers giving you time to pay them.

Payment terms tend to be standard throughout most sectors, with large or long-standing customers having some advantage in generally being able to negotiate better terms.

Credit is something that may be convenient in cashflow terms, but you should not consider any money released as capital. For example, it is generally not a good idea to use this money to buy a new car or carry out property improvements. This is because you have simply negotiated a delayed payment to your suppliers. Your suppliers will still have to be paid – as will HM Revenue & Customs for the VAT on the sales if you are VAT-registered. Hopefully, you will sell most of the goods before you actually have to pay for them, so enabling you to use the cash generated from the sales to pay for the goods.

Overdrafts

Many small businesses use a bank overdraft. Overdrafts are flexible and are often the best way to cover short-term requirements for the day-to-day running of a business if, for example, there’s a delay between selling goods and paying for them. It’s most likely that your bank account will sometimes be in credit and sometimes be overdrawn. If your account remains overdrawn for a period of time, an overdraft is probably not the best finance option for your business. There may be other alternatives that can be discussed with your bank.

Loans

Loans are the traditional source of finance for small businesses and are usually used to finance assets and to meet other longer-term capital needs. You know how much you have to pay, for how long. You can, to a certain extent, negotiate the terms and interest to suit your business.

Loans are usually arranged through a bank. There are also other sources of loan, and specialist consultants willing to arrange them. However, unless you have particular experience of the financial sector yourself, the safest route is to go through a bank. If your bank turns down your request for a loan, it may be that it has spotted something you have not, or simply that you’ve failed to make your case convincingly.

The Small Firms Loan Guarantee Scheme, a Government backed initiative, may be available to those businesses who don’t meet the normal lending criteria.

If family and friends lend you money, it is essential to have a formal agreement on paper so that everyone knows where they stand.

Leasing

Leasing or contract hire are simple ways to fund the purchase of capital items like machine tools, cars or computers. Several types of arrangement are possible, each with their own tax advantages.

Factoring

Factoring releases cash to boost your business cashflow. Essentially, factoring advances cash against your outstanding invoices – up to 90 per cent as soon as you raise an invoice. When the debt is collected, the factor pays you the balance, less a small charge.

Factoring simply offers you a way to release cash tied up in your debts. This is a good option if your business needs additional working capital.

An alternative to factoring is invoice discounting. The main difference from factoring is that you collect the money, so your customers are not always aware that you have borrowed money against their debt.

Equity

One way to raise extra capital is to sell shares in your venture to workers, family, friends, the public or professional investors. In a business, the principals, partners or shareholders own the business. After tax and interest is paid, all the profit is theirs. However, if there is no profit, they have nothing. They also share the risk.

Ideally, the managers of a business should have a substantial equity stake in it, so that they have a vested interest in whether it succeeds or fails. It also reassures the other investors if they are willing to put their own money in.

Other shareholders may include ‘silent partners’ or ‘arms-length’ investment funds. However, these can be very vigilant, expecting a regular return on their investment, and quite capable of using their voting rights when that return is not forthcoming.

Private investors, or business angels as they are commonly known, also invest money in return for equity. Some want the kudos of being involved in the business without taking an active role; others will want a more active role, investing their expertise as well as their money. It is rare but not unknown that sometimes this may extend even so far as becoming an employee. All, however, will all look for a return on their investment within three to five years.

Venture capitalists are often prepared to give potential high-fliers significant backing in return for equity. So they will only invest in businesses with a solid business plan and, ideally, a good track record. This usually means one that has traded for three years, and which is turning over at least £1m.

Grants

There are a variety of grants on offer from Europe, Westminster, the Scottish Parliament and Welsh Assembly and local authorities. Exactly what is available varies from area to area, and can depend on how you organise your business, and when in the fiscal year you apply.

There are specialist consultants who can advise you, as well as business advisers at your local Business Link or national equivalent. However, the best advice is to befriend someone in the system itself – for example get someone who works for one of the grant providers to take you under their wing. They can probably lead you to other grant providers. Once one public authority is backing you, others feel more comfortable about doing the same.

Most grant providers look for two things:

• Growth – i.e. the grant will lead to additional economic activity and provide an opportunity for something you could not achieve without the grant.
• Viability – i.e. the additional economic activity is viable and self-sustaining.

There are three issues to consider when chasing grants:

• They are a complex area and you can waste days achieving nothing.
• It can be expensive in terms of professional fees to meet some grant requirements.
• You may not be allowed to spend any money on the project for which you are seeking a grant until you receive it. Therefore, you could be left in limbo for months.

On the other hand, there are websites that can help you source grants, and business advisers from Business Links who can help you raise them.

What all lenders and investors look for

Most types of finance depend on your business having:

• A good track record (if an existing business).
• Good management.
• A good business idea in a properly researched, well thought-out and well presented business plan.
• Strong financial controls.
• Personal commitment.
• Security.

Note that security, while important, is not as important as legend suggests. It relates to what happens if things go wrong – but financiers will only invest in the first place if they believe things will go right. What you hear from financiers time and again is: ‘We invest in people’: they are looking for a strong management team with the skills to succeed.

Track record

A solid, well-established business, with steady sales and profits, and a good balance sheet, will have little difficulty in raising appropriate funding. However, most people are not in that happy position, particularly new businesses.

Good management

If your business has no track record, investors will look at the person or people running it. In particular, they will look for:

• Experience.
• Expertise in their particular specialisms.
• A balance of skills.
• The ability to work together.

Business plan

Before anything else, your basic business idea must be sound – without that, nothing works. However, good business ideas are common. Those that become successful businesses need a viable business plan.

There is no set format for such a plan but a good one must have the following:

• A clear purpose.
• Specific objectives that further that purpose.
• A workable strategy to achieve those objectives.
• Evidence of market research.
• Realistic forecasts based on detailed calculations.
• Milestones for the future – so you can see if you are achieving your goals and can take corrective action if necessary.

Obviously, investors are looking for a good return but they are deeply suspicious of miracles. Nothing destroys the credibility of a business plan faster than over-optimistic forecasts. Caution is the mark of experience.

Financial controls

Too many potentially good businesses fail because they have cashflow problems and lack good financial controls. So investors are wary.

Existing businesses must have systems in place to prevent this sort of thing. But what can new businesses do to prove their financial discipline? 

• They can show awareness of the issue in the business plan and in any interviews.
• They can show what systems they will put in place to address the issue.
• They can get good financial advisers on board from the start.

An experienced accountant is a big asset from the start and it is reassuring to investors to have one with a good reputation. However, actions speak louder than reputation. If you have an accountant, get them to check the forecasts in your business plan. They may know of sources of income and expenditure you have not considered. Have them check your calculations too. Talk to them about financial controls – what books to keep, what software to use, the possibility of management accounting and occasional internal audits. Then tell your investors what you did.

There are other sources of financial expertise you would do well to exploit. Your bank has a wealth of experience as well as money, so don’t be afraid to use it.

Personal commitment

It is often not enough simply to offer security. Investors will expect you to put your own money into your business. After all, if you have no confidence in it, why should they have any? This need not be a large percentage of the total capital, but you must show that you have something to lose and are totally committed to the business.

Security

Security is a final fallback position, so the other factors are more important. However, investors always consider the worst-case scenario. In the event of failure, they may get part of their money back from two sources:

• Any remaining assets of the business.
• Your personal assets.

The assets of a failed business rarely amount to much. Employees and the taxman are paid before lenders, and lenders before shareholders, who usually get nothing. The resale value of unused stock, plant and machinery is usually far below book value, which is far below what you paid for them.

If the business is a limited company, although there are legal exceptions, the shareholders’ liability is confined to the value of their shareholding. So, lenders usually ask for some form of personal guarantee from the person or people who set up the company. If such a guarantee is given, or if the business is not a limited company, your personal assets may be used to pay off business debts.

Always think carefully and take professional advice before giving such a guarantee. A guarantee may be required by lenders – again, not so much for its monetary value, which may be a fraction of the business debts, but as a proof of your commitment to the business.

The government’s Small Firms Loan Guarantee Scheme, administered by the banks, is there to assist new or existing businesses that have a viable business plan but lack the necessary personal or business assets to secure normal borrowing. In this case the Government guarantees the lending bank against default by the borrower.

Approaching investors

Before you approach anyone to lend you money or invest in you, work out a strategy and stick to it:

• Make sure the type of finance is appropriate for what you are buying. For example, don’t use an overdraft to buy a car unless you plan to sell it very soon. Decide precisely what you want and how much you are prepared to give up/pay before you meet potential investors – they will have a good idea of what they want.
• Be prepared to walk away if the deal is not right for you.

Your best starting-point is to approach those who know you personally. Ask your own bank first. Then approach people who have been recommended by friends and colleagues.

If you have no alternative but to start trying at random, get some independent advice first – talk to an accountant or your local Business Link. If you are looking for serious money, for example in the City, you will need a professional adviser who knows their way around.

When you meet these investors, keep these points in mind:

• Don’t be daunted.
• Remember they need you as much as you need them.
• Listen to what they say – they may have good advice.
• Don’t try to oversell your idea – they have heard hype before.
• Don’t undersell yourself either – don’t grab any deal you’re offered. If your idea is a good one, others may offer you a better deal.

It may take time – a lot of time – and lots of preparation to raise finance, but if you have a sound business idea, sooner or later you should find that someone will be willing to back you.

British Business Angels Association

Liz Carrington
5th Floor
52-54 Southwark Street
London SE1 1UN

T: 0207 089 2305
email: liz@bbaa.org.uk
W: www.bbaa.org.uk

British Venture Capital Association

3 Clements Inn
London
WC2A 2AZ

T: 020 7025 2950
F: 0207 025 2951
W: www.bvca.co.uk