The majority of small business finance is raised from a bank. Use your bank for advice and guidance, they want to see you succeed.

In this chapter, four things that really matter:

• ˜ Understanding how an overdraft works
• ˜ Considering long-term funding
• ˜ Comparing the true costs of borrowing
• ˜ Offering security for the debt

Your bank should be the first port of call when you are looking for start-up finance. Banks operate a wide variety of special lending schemes for the start-up business. In some cases, this will also be combined with ‘free’ banking for an initial term, usually ranging from 12 to 18 months.

Quite apart from the financial side, your bank can also offer advice and guidance on a wide range of business concerns. These can include insurance and pension advice, through to help with taxation and other such legalities of running a business.

In most cases the business advice is offered free of charge so you should make the most of it. Banks want their business customers to succeed and you should really treat them as a partner. Talk to your bank on a regular basis and keep them informed. If for any reason your business is running into problems then seek their help at an early stage. Do not leave it so late that nothing can be done.

Is this you?

I just need an overdraft for all my funding, it keeps things simpler that way. • I don’t want to borrow long-term, I should make enough in the short-term to pay off all the funding. • I don’t understand why the bank is charging me twice for the same finance, are they overcharging me? • I can’t offer any security, will that stop me raising money?

Understanding how an overdraft works

An overdraft is there to provide short-term working capital. Remember those key words – short-term. Overdrafts are available effectively to bridge the gap between money that is due from your customers and money that you need to pay to your suppliers. An overdraft should never be used to fund the purchase of assets unless full repayment is to be made in the short-term.

Unfortunately this critical rule is often ignored by business owners. It is vitally important that you obtain the right type of funding for your business.

• ˜ Long-term funding for long-term investments such as the purchase of fixed assets.
• ˜ Short-term funding for short-term requirements such as money due from debtors.

A bank overdraft works in a very simple way. An overall limit on the overdraft amount on your account is agreed between you and the bank. You are then free to draw money up to that amount, which is then repaid when you receive funds from your customers. In banking terms it is defined as an ‘in and out’ facility. Funds flow in and out on a regular basis to fund your working capital requirement.

Working capital

Working capital within a business is the amount of money that is held in short-term assets such as debtors and stock against the amount owed to short-term liabilities such as trade creditors. In an ideal situation, your account should swing on a regular basis from being overdrawn to being back in credit. This would mean that your short-term assets are being quickly converted into cash which is paid into the account.

This demonstrates the requirement to keep tight control of your working capital. You must always have sufficient funds to meet your liabilities as they fall due. The overdraft is there to help you in this respect but you must also retain tight control over the facility. It is essential that you do not exceed the overdraft limit without the bank’s permission. Quite apart from the penalty interest that will be imposed, in some cases equating to over 30% per annum, the bank may refuse to pay cheques or other items such as direct debits.

Once this happens you have effectively lost control. No longer are you able to use the overdraft freely to pay your creditors. It is now the bank that is deciding what will be paid. You can be sure that their interest and charges will come out first.*

Considering long-term funding

In plain and simple terms, long-term finance is provided by a bank in the form of a loan. The name of the loan may differ between the banks but it will take one of two forms:

• ˜ Fixed rate loan
• ˜ Variable rate loan

A fixed rate loan means that the interest rate is fixed when the loan is granted and remains the same throughout the term of the loan. A variable rate loan is where the interest is linked either to the base lending rate or other ‘managed’ rate that the bank may have.

The simple difference between the two is that the repayments for a fixed rate loan will remain the same, whereas the variable rate loan repayments may increase or decrease. This means that in budgeting terms the fixed rate loan can offer an advantage. At least you know exactly how much you will repay each month.*

Fixed or variable rate?

Choosing between a fixed rate loan and a variable rate loan can be difficult. For obvious reasons it is unwise to lock yourself into a high interest loan. By the same token, when rates are low it can be unwise to take a variable rate loan. The decision rests on which way you think interest rates are going to move.

Whichever you choose, the loan will

generally be for a minimum of £1000, with some schemes having a maximum amount that can be borrowed and other schemes being unlimited. Repayment terms will depend upon the purpose of the loan. For example, a loan to purchase a vehicle will probably be repayable over three to five years.

Loans for the purchase of substantial fixed assets, for example land and buildings, could be available on repayment terms of up to 20 or 30 years. It is essential that you link the repayment terms to the potential life of the asset that you are purchasing. You will not, for example, be able to gain finance to purchase computer equipment if you offer to repay the loan over 20 years.

Comparing the true costs of borrowing

When you borrow money from a bank you can expect to pay a cost. This cost will come in two ways:

• ˜ interest charges
• ˜ arrangement fees.

We have already looked at the two different kinds of interest rate i.e. fixed rate or variable rate. These can apply on both an overdraft and a loan.

Interest is normally calculated on a daily basis. In the case of an overdraft this means that you are only paying interest when the account is actually overdrawn. Depending on your bank, the interest is then charged to the account on a monthly or quarterly basis. What this means, of course, is that if the account is overdrawn, or not sufficiently in credit in order to pay the interest, you will then pay interest upon the interest. This will affect the Annual Percentage Rate or APR that the bank will have quoted upon granting the borrowing.

Before we look at the APR concept you need to understand the imposition of arrangement fees. When the bank grants the overdraft or loan facility they will charge an arrangement fee to ‘set up’ the facility. In some cases this is charged on a sliding scale and in others it is calculated as a straight percentage of the total amount borrowed, say one or two per cent.

This means that if your bank agrees a loan account with a fixed interest rate of 10% and an arrangement fee of 2% you are actually paying 12%. In the case of a one-year loan this would also equate to the APR. For a loan repayable over five years, however, the APR would reduce to 10.4% because the arrangement fee is a one-off payment. This means that the cost is also spread out over the five-year term.

The important point to remember is that interest rates and arrangement fees are not always set in stone. The bank will have guidelines as to what should be charged but they are negotiable. They will also vary from bank to bank.*

Now that competition between banks and other finance providers has become so intense you should not accept the first offer. You will be trying to achieve value for money

and cost efficiency within your business and you should treat the provision of finance in the same way. What you should avoid doing is playing one funder off against another. Once the bank has discussed your proposition with you and agreed an interest rate and arrangement fee, it is unlikely that they will renegotiate.*

Offering security for the debt

Depending upon the amount that you are looking to borrow, you may be asked for security. This can take the form of intangible or tangible security. Intangible security usually takes the form of a guarantee by a third party to pay your debt should you default. It may be that the bank will also require some form of tangible security to back up this guarantee. Tangible security involves a charge over assets that you may own, for example:

• ˜ your house
• ˜ an endowment life policy
• ˜ stocks and shares.

If the bank does ask you for security and you are unwilling to provide it, despite having it available, you will need to give some very good reasons. The bank will be willing to take a risk to a certain extent, but the business is yours and you should be willing to support it. Remember the importance of commitment.

If you intend to trade as a limited company there is one other form of security that the bank may require. This is a mortgage debenture which effectively charges all of the company’s assets to the bank. These will include land and buildings, stock and debtors. Of further importance to the bank is that the debenture will give them additional rights under the various Insolvency Acts, including the ability to appoint a receiver.*

Small Firms Loan Guarantee Scheme

Even if you do not have any tangible security to offer there are other options. We have already looked at the prospect of family support and the possibility of them offering security for your debt. A further option open

to the bank is the use of the Small Firms Loan Guarantee Scheme or SFLGS.

The SFLGS is a joint venture between the Department of Trade and Industry and the major high-street banks. It is available to businesses with viable business propositions but a lack of security or business track record, or both. Under the scheme the government provides a guarantee for a percentage of the total debt ranging from 70% to 85% depending on location. In return for this support a premium is paid to the government of between 1% and 2.5% per annum on the amount guaranteed. Various terms and conditions apply to the scheme and you should approach your bank for full details.

If you are able to offer security for the borrowing this should affect the perceived risk by the bank. This will also affect the interest rate to be charged. It is difficult to give precise advice on the reduction that you can expect but it should be at least 1.5% per annum.

Summary points

• * Match the type of finance to the purpose – long-term finance for long-term investment and short-term finance for short-term working capital.
• * Understand the difference between variable rate and fixed rate interest. Seek advice if you are unsure what is best for you.
• * Remember, interest rates and fees are negotiable. Make sure you get the best deal by shopping around.
• * Consider a request for security carefully. You have to match the bank’s needs against those of your family.