Small Business Finance: What you need to know
From alternative finance to bank debt, read our guide on the options available when funding your business
For any business, initial funding is a crucial element of success, but raising finance will almost certainly be the most difficult element of starting and running a business.
Thankfully, you have an array of options open to you when it comes to raising finance.
Before proceeding to raise finance, you should first ensure your business plan is economically sound.
If it is, you should be able to build a solid financial base if you know what you are doing.
This article should serve as an introduction to financing your business.
It will cover how to assess your funding needs, then explore the multitude of different funding options – exploring your options for external investment, bank finance, and other finance options.
How do I know how much finance to seek?
To identify your funding needs, follow these steps:
Create or refine your business plan
Learn how to write a business plan here.
Draw up a budget
Use your business plan as your guide for drawing up a budget – you should have separate budgets covering sales, costs and cashflow, as well as a prospective balance sheet. Use this guide to help you draw up a budget.
- Use your budget to identify how much finance you require and when. Look especially at your cashflow forecast – you will definitely require outside funding if you expect to dip below your overdraft limit at any time.
- Allocate extra funding to deal with contingencies. Work out what would happen if things go wrong – for example, if a major customer goes bankrupt or pulls out?, how much extra finance would you need to deal with this? The less sure you are of your projected figures and the more space for potential risk, the more contingency funding you will need.
- Work out a clear financing plan. Plan everything ahead of time and don’t wait until the last minute to raise finance.
What forms of investment finance are there?
Generally, you will need some form of initial investment in the company in order to obtain other sources of finance, such as bank loans – lenders will want to see some evidence of financial commitment to the business. Your options include:
Your own money
It’s unusual that someone would start their own businesses without putting in at least a small bit of their own money. In this instance, savings are ideal, but you should generally only commit money you can afford to lose
Friends and family
Using investment from friends and family can often be risky but a lot of people do use this as an option.
If your businesses or investment fails or doesn’t return, then you risk destroying personal relationships with people that are the most likely to help you.
If you plan to use this method, give your prospective backers your business plan and let them decide whether to invest on its own merits not just because they know you.
Given the fact that most of your family or friends won’t have much business expertise, it’s imperative that you explain to them the risks in layman terms. Namely, that they could lose their money and they should only invest if they can afford to do so.
Just as with any investment, there should be clear terms and conditions (are you giving them equity in return, or will it be a loan?), and everything should be put in writing.
Don’t forgo regular business practices and procedures because you’re dealing with a friend or close relative, failure to do so could cost you both a lot of money.
Alternative finance is becoming an increasingly attractive and more viable option for many small businesses when it comes to raising finance.
With crowdfunding, investors and members of the public get together and collectively contribute small amounts of funding to back your business. It is especially suitable for businesses with a self-evidently exciting or disruptive proposition.
You have various options here:
If your business is already growing at a good rate, or you have a truly novel and disruptive offering, you might be able to attract seed stage investment from angel backers or a venture capital firm. Visit the BVCA and the UK Business Angels Association for help and advice on obtaining private backing.
Property can also represent an alternative source (as mortgage rates are often lower than loan interest rates).
Finally, government and EU-backed funds exist to invest in small businesses, especially those with potential to grow the economy as a whole. Search for finance and support for your business here.
What forms of bank finance are available?
Whilst the availability of bank finance has been declining in recent years, it is still an important source of funding for many start-ups. Forms of bank finance include:
It’s not unusual for most small businesses to have an overdraft. Must will use it to deal with short-term cashflow shortfalls or other smaller financial issues. However, its important you never use it as a long-term finance option, as overdraft fees are often much more severe than comparable loan interest rates and the bank can theoretically call in the debt at any time. Furthermore, maxing out your overdraft could see cheques and transfers bounce, damaging your business’ credibility, and is often the first step on the road to bankruptcy. Overdraft limits are typically reviewed by your bank every six to 12 months, and will be based on your past credit history and ability to repay.
Loans are a more suitable option for long-term finance and certainly a safer option than an overdraft. You take out an initial loan and pay back a certain amount plus interest at fixed points – interest could be a certain percentage over the Bank of England base rate, or based on a fixed rate (for example, 10%). Loan periods are normally between one and 10 years, although mortgages and other loans secured against valuable assets can often be much longer.
What alternative forms of finance are available?
Invoice factoring services allow you to get ready cash in exchange for unpaid invoices sent to customers. Typically, you receive 80-90% of the value of the invoice right away, paying a fee and receiving the rest of the balance when the customer pays. Typical factoring fees range from 0.75 to 2.5% of total turnover.
Instead of buying business equipment, look into leasing it over a period – this is an especially useful way of financing a business vehicle, as the vehicle will count as a pure business expense for tax purposes. The regular payments involved with leasing can help you plan out your cashflow.
Hire purchase agreements are similar to lease agreements, in that payments are spread out over a fixed period, but you end up owning the equipment at the end of the agreement (assuming you have met all your payments). You will qualify for full tax relief on hire purchase interest payments.
What kind of security should I provide for loans?
Most loans will require some kind of security – in other words, something that will ensure the lender gets at least some of their money back if you end up not being able to meet your debts.
A personal guarantee is one option available to you. This is where you, or another individual, assumes personal responsibility for the businesses’ debts.
You should avoid making personal guarantees wherever possible – if your business fails, you could go bankrupt yourself if you are unable to meet the debts.
You can charge over business assets such as premises, vehicles and equipment can be used as security for loans.
Government backed loan guarantee scheme The Enterprise Finance Guarantee (EFG) is designed to encourage additional lending to small and medium-sized businesses.
Although eligibility is determined by individual lenders, in general the scheme is open to businesses with a turnover of less than £41m seeking funding of between £1,000 and £1m. More details can be found here.
How do I keep a good relationship with my bank?
Maintaining a healthy working relationship with your bank is always a smart idea, as it increases your chances of obtaining funding in the future.
Quite simply, remember to keep the bank in the loop about as much things as possible. If the bank has provided finance to your business, keep them up dated. Provide them with regular management information on sales, profit margins and overheads. Explain any fluctuations or differences, and keep them updated on your long-term plan for the business.
Similarly, if you believe trouble may be brewing and you expect to run into difficulty, don’t keep it to yourself. Your bank manager will appreciate being trusted, rather than surprised with a sudden request for emergency finance out of nowhere. This may help you in the future when requesting a finance or similar assistance.