A start-up business faces some particular problems in raising finance when compared with an already established business, in that as the business does not yet exist or is in its very early stages it does not have the following.

• A track record of trading with which to demonstrate its viability and its ability to meet its forecasts, which obviously adds a degree of uncertainty to any investor’s or lender’s consideration of putting money into the business.
• Significant business assets to act as security for loans.
• Reserves retained in the business from prior years’ profits that can provide a cushion when things get tight.

They also tend to have a requirement to invest cash in the early stages of setting up; arranging premises, hiring staff and taking products or services to market, before they can hope to start to see some cash coming back through achieving sales. There is an American phrase ‘burn rate’, which describes the speed at which a business uses up its available cash.

These characteristics mean that while start-ups tend to use the same types of sources of finance as more established businesses, as covered in Section B, these tend to be in a different order of priority which runs thus.

• You as the business owner, in a mix of both cash and unpaid time (sometimes known as sweat equity).
• From within the business itself, by way of bootstrapping or running it in such a way as to maximise the cash generated and retained within the business in order for the business to support its own growth.
• Before relying on external funders for grants, equity or loans.

It should be stressed that each of these areas is covered in more detail in Section B and this chapter therefore simply gives an overview of the issues involved.

When you are preparing your business plan and its cashflow forecast, you should at first leave out any injection of finance as the important thing to start with is to establish how much is required. Only once you have a view on this, should you then start to think about how you’re going to fund it.

One tip, however, is that while lenders will always be looking for you to put in as much of your own cash as possible, both to demonstrate your commitment to the business and to reduce the amount of money you need to borrow from them (and therefore their risk), you should always try to keep something in reserve. This is because if your business ever gets into difficulty, in extremis you may decide to pay in these reserve funds to see you through, where a third-party funder such as a bank, which doesn’t have such an emotional stake in the outcome or a financial incentive in terms of the value of the business, may not want to advance additional funds.

YOU AS THE BUSINESS OWNER

Many businesses are funded in the first instance by the owner’s own cash.

The advantage of this approach is that if you are providing all of the equity funding, you will retain full control and ownership of your business. The disadvantages can be that:

• you may not have sufficient resources to fund the business properly to the level required; and that
• your personal assets (and personal financial health) are now mortgaged to the success of the business.

Nevertheless for many new businesses, raising your own money to go into the business may be the only approach available and this will involve:

• using your savings;
• selling off assets to raise cash;
• raising personal loans or borrowing on credit cards; or
• if you’re a homeowner, borrowing against the equity in your property.

While you will obviously not have to prepare a pitch in order to sell yourself the idea of investing in your business in the way that you will have to if you are seeking money from other people, it is still always a good idea to prepare a formal business plan. This should always include a cashflow forecast (see Chapter 4) to help you think through how much money the business is going to need and where you’re going to raise this from. There is an old saying in the insolvency profession to the effect that there is no point putting enough fuel in the plane to fly halfway across the Atlantic. If by preparing a business plan including a cashflow, it becomes obvious that you cannot arrange sufficient funds from your own and the business’s resources to make it through to a sustainable trading position, then you need either to find another investor at the outset, or rethink or abandon your existing plans.

In practice, many small business owners start off by funding much of the business’s initial expenditure from their own resources, bearing expenses like rent, stationery or advertising from their own funds because until the business has achieved a successful level of trading, it simply doesn’t have the funds to do so. Once the business is up and running the owner then has the choice as to whether these expenses should be repaid, or the cash left in the business by way of a director’s loan, or treated as an equity investment. This is something that you might want to talk to your accountant about as it may have an impact on your tax position.

Personal loans

As you can see from the frequent adverts in the press or the junk mail that pours through your letterbox, most people who own a home and who have a reasonable credit history will be able to obtain an unsecured loan of up to £25,000 (which is a limit imposed under consumer credit legislation) over ten to 15 years. As unsecured loans these tend to be expensive when compared with loans secured against your property such as a mortgage or second charge. However, they do tend to be quick to organise and can provide a valuable resource for business start-ups.

Credit cards

Similarly, most people who have a reasonable credit rating will also receive a large number of offers of credit cards. As is well known, interest rates on credit cards are extremely high in comparison with most other forms of borrowing; however, some small businesses are taking advantage of the competition in this marketplace whereby many of the offers of new cards have an introductory period of up to six months at 0% interest, including on balance transfers.

For those who are sufficiently organised and brave, these can used to provide a source of finance at 0% whereby a personal credit card is used to meet business expenditure. The minimum payments are then made on a regular basis and the balance is transferred to a new card with another 0% balance transfer rate at the end of each introductory period.

The risk is obviously that at some point you will need to either repay this borrowing to clear the card, or you may end up with funds borrowed at a very high rate, so it is not a strategy that I would recommend.

Borrowing against personal property

Most individuals’ major store of personal capital is the equity in their house and therefore when looking to raise business capital, borrowing against this is usually the only realistic option.

It’s also true that cash raised against the security of residential property can be amongst the cheapest sources of financing available, as it is raised at domestic mortgage rates. If you simply want to arrange a top-up loan by borrowing against your house without disturbing your existing mortgage, using what is called a second charge (because the lender will take a second charge on the property behind your mortgage lender), there are a number of web sites which will allow you to apply for such money direct (try www.creativehomeloan.co.uk).

If you need to seek a full remortgage this is an area that is now highly regulated and you will need to take professional advice from an independent financial adviser. Contact Creative Business Finance (see Useful Contacts p 249) for referrals to one of the appropriately qualified advisers with which they work. Fleximortgages, which allow you to draw cash down against your property (and repay it again without penalty) can be a particularly useful source of flexible funding for business owners.

In any event, you must always remember that, as it says in the small print, your home is at risk if you do not keep up the payments on a mortgage or other loan secured on it.

BOOTSTRAPPING

Once your business has started, the way that you trade it has an enormous impact on the amount of cash it may or may not require. The practice of running a business in such a way that it generates the maximum amounts of cash internally, and both retains this and uses it as efficiently as possible, is known as bootstrapping, from the expression to pull yourself up by your own bootstraps. The techniques for doing so are covered in Section A, but essentially this is a matter of the following.

• Squeezing money out of the working capital (or to look at it another way, making whatever cash you do have go as far as possible in funding trading) by actively managing to:
  • minimise the investment in current assets (stock and debtors); and
  • maximise the finance available from its normal sources of trade credit
• where use of techniques such as consignment stocking can in effect help both sides of the equation.
• Retaining as much as possible of the profits from trading in the business, which is a matter of restricting the dividends paid out to shareholders (dividend policy) or cash drawn by the partners or owner.

EXTERNAL FUNDING

There is a wide range of external sources of finance that you can look at to start your business (each of which is covered in detail in Section B).

Grants

Grants are defined by the DTI as a ‘sum of money given to an individual or business for a specific project or purpose’, where as long as you keep to any conditions attached to the grant you will not have to repay it as you would with a loan, nor will you have to give up any shares in your business, as you would with an equity investor.

There are a large number of grant schemes across the country, particularly in depressed or deprived areas, designed to help support business start-ups. However, many of these only operate in a specific local area, or like the Prince’s Trust are open to people of certain ages, so the first hurdle is finding out what grants are available for you and your business.

Your local Business Link should be able to advise on what is available in your region, while www.j4b.co.uk has a searchable database.

Equity

Equity is money put into your business by investors in return for a share of its ownership and profits.

Before going any further, however, a warning is required. To look at raising equity funding you are going to need to approach investors. But as soon as you send out a business plan or contact people to discuss the possibility of investing in your business, this is defined as a Financial Promotion under the Financial Services and Markets Act (FSMA). The rules under the FSMA are essentially designed to protect investors from being enticed into investing their cash into fraudulent or excessively risky schemes. So unless your approach falls under one of a number of exemptions set out in the Financial Promotions Order (FPO), it will need to be issued by an authorised person, which is generally someone regulated by the Financial Services Authority (FSA). If you fail to do so, not only might you be committing a criminal offence in issuing a financial promotion, but the other party may be able to walk away from any agreement entered into. You should therefore always take legal advice before attempting to raise equity from other people for your business.

Equity can come from a range of informal sources, sometimes sneeringly referred to by financial professionals as the three Fs of family, friends and fools. However, they should really know better, as this type of funding has been vital for the start-up of thousands of successful businesses over hundreds of years.

Through your personal network you may have direct access to people who will be interested in providing cash, without incurring the significant costs of other routes. However, your relationship with these people can then be a problem for the business, so you should always draw up a clear shareholder agreement spelling out their interest in the business and the overall arrangement, to avoid as far as possible any later disputes.

Business angels

Business angels are usually successful business people who have made money in business and are interested in investing in small businesses, typically sums of up to £100,000, both as a way of making money and of continuing to be involved in business.

They are therefore usually interested in investing in small businesses, normally in their local area and in an industry in which they have some knowledge, with potential for high growth businesses where by taking equity they can hope to obtain a high return on their investment. To access business angels finance you will normally need to either find a local financial adviser with links to local angels, or approach one of the networks to which many belong (see the British Business Angels Association as a starting point www.bbaa.org).

Business angels therefore bring not only cash but usually significant business experience and often a good network of business contacts. The downside for the entrepreneur can be that they will often seek to be actively involved in the direction of the business, which can lead to conflict, so it is important to see how hands-on they want to be and how you feel about this.

Venture capitalists

Venture capitalists (VCs) are businesses that exist to raise funds from institutional investors such as pension funds (or for bank related VCs, their parent bank), which they are then looking to invest to provide them a higher return than they can achieve from other sources.

VCs of all types will therefore be looking to:

• invest in unquoted companies with high growth potential and ambitious, experienced management;
• management who are willing to commit a material amount of their own money into the venture;
• companies that are prepared to sell a realistic stake in the business for the funding required and the risk the VC is taking;
• where the VC can expect to be able to sell their investment on within say three to seven years, which will mean the:
  • sale of the shares back to the company
  • sale of the company; or
  • a flotation; and
• obtain a return on their investment by way of a capital gain on their exit of say over 20% to 30% a year.

This means that before considering venture capital (or indeed business angel) investment your business needs to be an entrepreneurial one that is looking for a high rate of growth, rather than a lifestyle business which gives you a decent standard of living, but which is unlikely to provide the financial returns to make it worth an outside investor risking their money in the business.

A VC will not generally become involved in the day-to-day operations of your business as the management of the business will remain your responsibility, whereas business angels will often actively seek a role.

Other than some smaller regional funds that specialise in smaller amounts of seed or start-up capital, most venture capitalists are also looking for large investments to justify their time and costs in undertaking a transaction. The minimum level of deal that a VC will be interested in will obviously differ from house to house, but for most mainstream VCs this is likely to be in excess of say £2m. Since business angel finance can generally only deliver funds of up to a few hundreds of thousands of pounds, this presents a difficulty for businesses seeking from say £500,000 to £2m in investment, known as the equity gap.

In order to try to bridge this equity gap the government, with European support, has introduced Regional Venture Capital Funds (RVCs) which are managed by professional fund managers, can advance up to £250,000 and will often work in concert with business angels. There are a number of other initiatives as discussed in Chapter 12.

Depending on which industry you are in, you can also find that larger companies on the lookout for emerging products and talent have set up internal funds to act as quasi VCs in order to invest in smaller innovative businesses. Since these activities are always industry related, the players involved are generally reasonably well known and a study of your trade press may be sufficient to identify companies that are operating in this way.

Spin-offs from research

Some of the leading universities have recognised the potential of businesses being spun out from the research work they do and are therefore seeking to provide support to these businesses to get off the ground. During the dot com boom this approach was taken one step further when a number of private businesses were set up, described as incubators, where potential entrepreneurs with a viable idea could be provided with funding to help set up in business together with other managerial and facilities support as appropriate. Since the demise of the dot com boom much less is heard about this type of approach.

Listing

Finally, in the UK, the idea of listing is usually associated with the main market of the London Stock Exchange where the country’s main publicly known businesses are traded and is thus very much associated with big business. However, listing can also be of relevance to small and medium-sized businesses as a real alternative to raising venture capital.

In addition to the main market there are also two stock markets in operation in the UK today, both regulated by the FSA, on which new businesses can be listed to raise capital from investors.

• Ofex, which is an independent exchange where shares in about 150 listed companies are sold mainly to private investors. It offers a route for small companies that need to raise in the order of £lm to £10m and so can provide a way around the equity gap, although the costs of doing so tend to be in the order of £150,000.
• Alternative Investment Market (AIM), which is part of the London Stock Exchange (LSE) and is also designed for small companies including start-ups where no trading record is required. As a result almost 30% of AIM’s listed businesses have a market value of less than £5m, but with stricter requirements including the production of a full prospectus, the professional costs of listing on AIM are higher than those for Ofex.

Debt

Debt is money that has been lent to a business.

The most familiar type of debt is formal lending by a financial institution set up to advance funds to a business such as banks, building societies and a range of businesses known as Asset Based lenders (ABLs). These institutions offer a range of financing services such as overdrafts, mortgages, leasing, hire purchase, sale and leaseback, trade finance, factoring, and invoice discounting.

However, it can come from other sources such as:

• directors, or family loans into the business; or
• credit provided normally by a third party as part of the business’s transactions which is the equivalent to a loan. Examples of these would include trade credit, sums due to the Crown by way of VAT or PAYE/NI and vendor finance where the seller of a business allows the buyer time to pay for some or all of the purchase price over a period of time.

When it comes to formal lending such as from a bank, start-ups have a particular problem as most bank lending is based on two legs.

• Confidence in the business’s ability to meet its forecast repayments, whereas a start-up has little or no track record on which a lender can make a judgement as to its ability to achieve its projections, and therefore its ability to manage repayments, and banks tend to be reluctant to provide overdraft facilities. One way around this is for the business to borrow instead from asset based lenders such as factors or invoice discounters where the funding available is related directly to the business’s assets. With factoring, for example, as the business and therefore its debtor book grows, so the funding available from the lender will also grow.
• The assets available as security to enable repayment of any borrowings in the event of default where start-ups tend to have few assets to offer as security. To address the problem of start-ups with a viable business plan requiring a loan, but which do not have the security required, the DTI operates a scheme with a number of participating lenders called the Small Firms Loan Guarantee (SFLG) whereby the government will provide the lender with a guarantee against default by the borrower. To qualify for this scheme your business must be less than five years old and have a turnover of less than £5.6m. Under the SFLG, the government provides the lender with a guarantee for 75% of the loan amount in respect of loans of up to £250,000 and terms of up to ten years, which can be used for most purposes although there are some business sectors which are not eligible. The cost to the borrower of this guarantee is a payment to the DTI of a premium of 2% of the outstanding loan, in addition obviously to the lender’s own charges and interest.

In summary then, the question whether your business’s cash requirements can be met by borrowing, and if so from which source, or will it require an equity investment will generally come down to the question of the available security. Whilst it is a bit crude, the flowchart in Figure 17 provides a rough and ready guide to the likely answer to this question.

Franchises

The purchase of a franchise can solve some of the above problems in that the track record of other franchises can give a lender some comfort as to the viability of your business’s projections.

Additionally, since the franchising organisation has an interest in enabling prospective franchisees to buy and run franchises, many will have set up financing arrangements to enable them to do so.