Financing a New Business
Your new business may need financing to cover the cost of equipment and other expenses before sales generate enough cash to make the operation self-supporting. There are a number of ways to obtain financing, and your choice among them will depend on your situation.
"Angel investor" is a term for an individual investor who is willing to invest money in a business. The amount available from angels is usually much less than from venture capitalists, but angels are often willing to take bigger risks.
Equity, or shareholder capital, is the money introduced into a business by the owners. The person starting the business will normally introduce equity capital, but equity capital can also be raised from external investors, including business angels and venture capitalists. If the business is a company, the equity is invested in exchange for shares of stock. Investors also expect a portion of the business's profit, which in the case of limited companies takes the form of dividends. Investors will also be looking for a good return when they sell their shares. Equity is best suited, therefore, to businesses that expect to grow quickly.
Loan financing is money that is borrowed from a finance company, such as a bank. Loans are repaid over a period of time, at fixed or variable rates of interest. The lender will usually require that the loan be secured by a business or personal asset. Terms can vary in length from one year to 25 years, and will usually be determined by the asset that is being financed. The interest rate will reflect the lender's perception of the risk in providing the loan. Loan financing can be provided in different ways:
- An overdraft is money that a business can borrow from a bank up to an agreed limit. It provides a business with short-term financing, effectively by running a negative balance on the bank account. This is a particularly good way of funding short-term requirements, such as providing working capital during the course of each month.
- Term loans are funds borrowed for a fixed term. Usually, such loans are repayable in equal installments over the term of the loan, although sometimes they can be repaid in a lump sum at the end of the term. Term loans are more attractive than overdrafts for long-term borrowing because repayments are fixed and the cost is usually less. However, lenders are increasingly writing into the small print that term loans are repayable on demand. If the loan has been used to finance capital assets, demand for repayment could put you in a financial tight spot.
- Credit financing is an excellent way of borrowing money, effectively at no cost. Typically, suppliers may give 30 to 60 days' credit before payment for their goods or services is due. If you can sell your product or service and get paid before paying your creditors, the result is cash for your business. Your business may have to establish a good credit rating before credit is given, and credit can be withdrawn at any time.
- Debt financing is particularly useful if your business is growing rapidly and is providing credit accounts to your customers. Instead of waiting for your own customers to pay your invoices within a 30– or 60-day period, you can use the services of a third-party invoice discounting or factoring firm. Factoring can be an expensive way of speeding up cash flow, but it may reduce administration costs since the factor normally takes on the role of invoice clerk.
- Capital asset financing can be done in different ways. Finance leasing allows you to finance the use of an asset rather than owning it. The equipment remains the property of the leasing company, and your business has the legal right to use the equipment for the period of the lease, provided that the lease payments are up to date. Lease purchase gives you an option to purchase the equipment at the end of the lease period. Hire purchase means that you pay regular installments to a third party, normally a finance company, to purchase ownership of plant and machinery from a supplier. The finance company will own the equipment throughout the period of the agreement, until the last installment has been paid.
The working capital of a business is its current assets (typically stock, cash at the bank, and accounts receivable) minus its current liabilities (typically accounts payable, outstanding loans, and lines of credit drawn upon). This information is summarized on the balance sheet, although the balance sheet gives only a snapshot of the working capital requirements at a specific moment in time (generally, the financing required for the short-term).
The amount of working capital needed will vary during the course of the year and even during the course of a month. You need to allow for the maximum likely requirement. As a rule of thumb, aim for minimum working capital of a month's average sales multiplied by the number of months it takes to collect payment. If you want to be more accurate, follow these steps:
- Determine the average number of weeks that the raw material is in inventory.
- Deduct from this figure the credit period from suppliers, in weeks.
- Add the average number of weeks to produce goods, the average number of weeks finished goods are in inventory, and the average time customers take to pay.
- Divide the total by 52 (the number of weeks in the year). Multiply the result by your estimated sales for the year, and the answer will be the required maximum working capital.
It would be more accurate to use the cost of sales (direct and fixed), rather than the full selling price, but the above calculation is accurate enough for most purposes. If your business is growing, use the budgeted sales figures and calculate your working capital needs on a regular basis.
Leverage is the proportion of debt to total capital in the business. The more debt there is relative to equity, the higher the leverage. Introducing more equity or retaining more of the profits can reduce the leverage ratio. Most banks look for a leverage of no more than 50 percent; in other words, your debt should be no more than half of the total capital.
Once you have built up a track record with your bank, you should be able to obtain medium-term loans (three to seven years) to cover the cost of plant and equipment. Established companies may be able to raise long-term debt as a debenture or convertible loan stock, which normally receives a fixed rate of interest and is repayable in full at the end of the term. Long-term debt is usually included with the capital on the balance sheet. The banks will also be more comfortable with a higher leverage—but not too high. Companies that provide lease purchasing or hire purchasing will not have as great a concern about leverage as will banks, but these firms will be concerned about your cash flow and whether you can afford the repayments.
If you expect to grow quickly and do not have enough of your own money to provide the necessary financing, then you may need to look for equity early on. Banks will be reluctant to keep on providing working capital that simply increases the leverage and, thus, increases their risk. Growing too quickly is a major cause of business failure. The banks will also want to reassure themselves that you can afford the interest on the loan, so they will look for profits that are at least three or four times the expected interest charge.
Regularly calculate the total level of funding required for the next year, and split the funding into fixed-asset requirements and working capital requirements. When considering financing, think carefully about the term, cost, suitability, timescale, and security required. Remember that cost should not be the sole criterion for choosing financing. Keep your lenders informed of your financial position, giving ample warning if you are likely to need to increase your loan amount, for example.
In times of recession, keep as much of your debt as possible as fixed medium-term loans, and draw only minimally on your line of credit. In times of expansion, when financing is more readily available, it may be more cost effective to use a line of credit.
Alterowitz, Ralph and Jon Zonderman.
Fullen, Sharon.
Association for Financial Professionals: www.afponline.org
U.S. Small Business Administration: www.sba.gov
U.S. Department of Commerce: www.commerce.gov