Formation and initial growth
Without the Finance support of owners and owners’ families, you can’t start a business. If you start an unincorporated business, then the difference between owners’ capital and owners’ debts is almost irrelevant. If your business finance is integrated then it converts into one, there are important differences between share capital and loans. Share capital is more or less permanent and can give some confidence to suppliers and creditors that the owners are serious and willing to risk significant resources. If the owners’ friends and family don’t want to invest themselves (perhaps they don’t have the money to invest), then the owners have to find outside sources of capital.
The main sources are:
- bank loans and overdrafts
- leasing/hire purchase
- trade credit
- government grants, loans, and guarantees
- venture capitalists and business finance angels
- invoice discounting and factoring
- retained profits.
Bank loans and overdrafts
In the current economic climate, it is likely to be difficult for a startup business to get a bank loan, especially if the business finance and its owners have no track record.
Banks will certainly require:
- A business finance plan, including cash flow forecasts.
- Personal guarantees and charges on personal assets.
Personal guarantees and charges on personal assets get around the company’s limited liability which will mean that if the company fails, the bank will be left with nothing. Thus the bank can ask the guarantors to pay the loans personally, or the bank can seize the charged assets that were used as security.
Note that overdrafts are repayable on demand and many banks have a reputation for withdrawing overdraft facilities in advance, not when business finance is in trouble, but when the bank faces more difficult times. There is fear. On a more positive note, where it is known that the need for finance is temporary, an overdraft can be very suitable as it can be repaid by the borrower at any time.
Leasing and hiring purchase
In financial terms, a lease is similar to a bank loan. Instead of receiving cash from a loan, buying the asset, and then spending it on paying off the loan, the leasing company buys the asset, makes it available to the lessee, and receives a monthly payment from the lessee.
Leasing can often be cheaper than borrowing because
- Large leasing companies have greater bargaining power with suppliers so the asset costs them less than the cost of the lessee. It can be partially left to the tenant.
- Leasing companies have efficient ways to dispose of old assets, but leasing usually does not.
- If lease payments are not made, the leasing company has a form of pre-existing security because it can reclaim the asset.
- The cost of finance for a large, established leasing company is likely to be lower than for a start-up company.
This is most important for any business. It will help to decide whether debt finance or a lease will be cheaper. (This is a separate topic in the Finance Management syllabus, but is not covered in this article.)
It simply means taking credit from suppliers – usually 30 days. This is very short-term, but it can be very helpful for new businesses. Generally, credit providers to new businesses will want some kind of reference, either from the bank or from other suppliers (trade references). However, some will initially be willing to offer modest credit without references, and this can be increased as trust builds.
Government grants, loans, and guarantees
Governments often encourage the establishment of new businesses, and support is offered from time to time and from region to region. Government grants are usually very small, and direct loans are very rare because governments see the provision of credit as the function of financial institutions.
Currently, in the UK, the government runs the Enterprise Finance Guarantee Scheme (EFGS). It is a loan guarantee scheme aimed at providing additional bank lending to small and medium enterprises (SMEs) with insufficient security for a typical commercial loan. The borrower must be able to demonstrate to the lender that he or she will be able to repay the loan in full. The government provides collateral to the lender for which the borrower pays a premium.
The scheme is not a mechanism by which businesses or their owners can choose to withhold the security that a lender would normally lend. Nor is it intended to facilitate lending to businesses that are not viable and banks have refused to lend on that basis. EFGS supports lending to viable businesses with an annual turnover of up to £25m for loans of between £1,000 and £1m.
Venture capitalists and business finance angels
These are either companies (commonly known as venture capitalists) or wealthy individuals (business finance angels) who are willing to invest in new or young businesses. They provide equity (private equity as opposed to public equity in listed companies), not debt. Equity is generally not secured by any assets and the private equity firm faces the same risk of loss as other shareholders.
Due to the high risk associated with startup equity, private equity suppliers typically seek a return on their investment in the order of 30% pa. The gross return includes the compensation of capital (eg redeeming preference shares at a premium), and potential capital gains on exiting their investment (eg through the sale of shares to a private buyer or the company on the stock exchange). After listing), and income through fees and profits.
Typically, venture capitalists will need 25%–49% equity and a seat on the board to oversee and advise on their investments. However, investors do not try to manage their investments.
Invoice discounting and factoring
Businesses generally need to be in the region of at least $200,000 before these methods can be used. Amounts due from customers, as reflected in invoices, are advanced to the company. Normally 80% of the invoice will be paid within 24 hours. Apart from this service, factors also take care of the management of the company’s receivables ledger.
A fee is charged for advancing cash (at roughly overdraft interest rates), and factors will also charge around 1% of turnover for running the receivables ledger (the exact amount depends on How many invoices and customers are there). Credit insurance can be obtained for an additional fee. The invoicing company remains responsible for any bad debts until it is cleared.
Retained earnings are not good for startups, and are often worthless for the first few years of a business’s life when there are only losses or very modest profits. However, assuming the business finance is successful, profits must be made, and retaining people in the business finance may allow the company to pay off debt capital and invest in expansion.
How much capital is needed?
Capital is needed:
- for investment in non-current assets
- to sustain the company through initial loss-making periods
- for investment in current assets.
Cash flow forecasting is an essential tool in planning capital requirements. Typically, capital providers want a three- to five-year forecast. One of the biggest dangers facing successful new businesses is overtrading, where they try to do too much with too little capital. Most businesses know that financing non-current assets will require capital, but many overlook that current assets also require financing.
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The company starts with a healthy liquidity position (stage 1). The business finance then doubles, without investing in more non-current assets and without raising more equity capital. It is a reasonable assumption that if turnover doubles, so do inventory, receivables, and payables (step 2). But here it forces the company to rely on overdrafts (perhaps unexpected and unplanned) to finance its net current assets. Permanent reliance on overdraft finance is uncertain and the company would be advised to seek some more permanent form of capital.
When capital is raised, the company has to decide what to do with it, and there are two main uses:
- invest in non-current assets
- invest in current assets, including leaving it as cash.
The more capital invested in non-current assets, the higher the profit-making capacity of the business should be. However, leaving too little cash in current assets increases the company’s risk of liquidity problems. On the other hand, leaving too much capital in existing assets is wasteful: cash will earn little interest (but investors want more profit from the company), and cash tied up in inventory often causes costs (storage, loss, obsolescence)
Therefore, the company has to decide on its working capital policy. An aggressive policy maintains relatively less working capita than other companies. A conservative policy maintains relatively high working capital. Which policy is appropriate depends in part on the nature of the business finance. If business finance is one where the trading cash flow is very predictable, it should be able to survive with an aggressive policy.
If, however, cash flows are erratic and unpredictable, the company would be wise to build a margin of safety in its cash management. Additionally, if the company anticipates a loss period, it will need to keep cash available to see it through its lean years (perhaps earning interest in a deposit account).
Note that companies do not need to raise capital to be available for emergency use. They require a pre-agreed-upon right to borrow a particular amount on demand. This is known as a line of credit. Many of us use lines of credit in our personal lives, but over there we call them credit cards. So we don’t need to keep $1,000 in the bank in case our car needs major repairs, but it’s comforting to know that if repairs are necessary, we can pay for them immediately. Of course, credit card debt will have to be paid off at some point, but the payments can be spread out.
Long, medium, and short-term capital
Capital can be short, medium, or long-term. Definitions vary somewhat, but the following are often seen:
- Short term – up to two years. For example, overdrafts, trade credit, factoring, and invoice discounting
- Medium-term – two to five or six years. For example, term loans, and lease finance.
- Long term – over five years, or so, to permanent.
In general, it makes sense to match the length of the finance to the life of the asset (equivalence principle), and, again, we often apply this in our lives, where we use a 25-year mortgage to buy an apartment. will A 3-5 year loan to buy a car, and a credit card to pay for a vacation.
|Premises, plant and machinery||Equity capital, bonds (larger companies), term loans (at least five years). There are also leasing companies that specialize in certain major pieces of machinery, such as printing presses and aircraft.|
|Equipment, motor vehicles||Equity capital, bonds (larger companies), term loans of around five years, leasing, and hire purchase.|
|Inventory, receivables||Equity capital, bonds (larger companies), term loans, overdrafts, factoring, and invoice discounting, and trade credit.|
Note that long-term capital (equities and bonds) can be used to fund all classes of assets. Although each piece of inventory and each receivable are very short-lived assets, the aggregate will typically have fairly stable amounts of each that must be funded on an ongoing basis. Therefore, it makes sense to fund most of these assets with long-term capital and use short-term capital to fund seasonal peaks.
One of the problems with short-term finance is that it runs out quickly and further negotiations have to be done if the need for finance remains. Long-term capital is either permanent or comes in relatively infrequently for renewal.
Once a company has existed profitably for some time and grown in size, additional sources of finance can become available, in particular:
- public equity
- public debt
Some stock exchanges provide different sorts of listings. For example:
- London Stock Exchange: The Main Market and the Alternative Investment Market (AIM). AIM focuses on helping smaller and growing companies raise the capital they need for expansion.
- NASDAQ: This is an electronic stock exchange in the US and has the NASDAQ National Market for large, established companies (market value at least $70m) and the NASDAQ Capital market for smaller companies.
|No trading record requirement||Normally a three-year record is required|
|No minimum prescribed level in public hands||25% of shares have to be in public hands|
|No minimum market capitalization||A minimum capitalization (£700,000, set deliberately low)|
An initial public offering is the first time shares are offered to the public. A company seeking to list has to issue a prospectus, which is a legal document that describes the shares offered for sale and contains a description of the company’s business, recent financial statements, and directors’ details. and including matters such as their compensation.
Shares can be listed via
- An offer for sale at a fixed price: a company offers shares for sale at a fixed price directly to the public, for example in newspaper advertisements. The shares are usually first sold to an issuing house which sells them to the public.
- An offer for sale by tender: investors are asked to bid, and all who bid more than the minimum price that all shares can be sold at will be sold shares at that minimum price.
- A placing: shares are offered to a selection of institutional investors. Because less publicity is needed, these are cheaper than offers for sale and are therefore suited to smaller IPOs.
- An introduction: this is rare and only happens when shares are already widely held publically. No money is raised.
Following equity offers will be rights issues in which additional shares are issued to existing owners in proportion to their current holdings. The shares are issued at a lower price than their current market value to make the offer more appealing, although, in theory, it makes no difference at what price the rights issues are made. If the shareholders exercise or relinquish their rights, they will be neither better off nor significantly worse off. Transferring money from the shareholder’s bank account to the company’s account does neither generate nor destroy wealth.
Getting listed opens up a huge source of potential new capital. However, with listing comes increased scrutiny, comment, and accountability. While this will help the status and prestige of the company’s founders, who are used to running their companies their way, often resent outside interference – even though they are now expected to own more shares. Will be. at large scale
It refers to quoted bonds or loan notes: instruments that pay coupon rate interest and whose market value may fluctuate. Bonds will generally be secured by either fixed or floating charges and may be redeemable or non-redeemable. Well-secured bonds in companies that are not highly leveraged are low-risk investments and will require relatively low returns to bondholders. The value of the bonds to the borrower falls further after taking into account the tax exemption on interest.
Convertibles start life as loan capital and can later be converted, at the lenders’ option, into shares. They are a clever and useful device, particularly for younger companies, because:
- In the very early days of the company’s life, investors might not want to risk investing in equity, but might be prepared to invest in the less risky debentures. However, debentures never hold out the promise of massive capital gains.
- If the company does not do so well, the investors can stick with their safe convertible loan stock.
- If the company does well, the investors can opt to convert and take part in the capital growth of the shares.
Convertible bonds, as a result, provide a “wait and see” strategy. Because they allow later entry into what may turn into growth stocks, the initial interest rate they have to offer is lower than pure bonds – and that’s good for a company that borrows. is taking.
When deciding what type of finance to issue, companies should always keep their average cost of finance in mind. This article does not go into any detail except that some borrowing can reduce the cost of capital. If there is no borrowing, all the finance will be equity and this is a higher price to compensate for the higher risk associated with it. Debt finance is cheaper as it carries less risk and gets tax relief on interest.
The previous paragraph briefly described the traditional theory of gearing. Modigliani and Miller proposed an alternative theory, but the very precise conditions and constraints required by their theories are often not met in practice.