Simple Business Guide #3 - Sources of finance for your business
Having decided on the best business structure for your new business, one of the most important things to do next is to think about where you are going to get the money from to start your business. All businesses, no matter how small, need some money to get up and running, and you have a number of different options to choose from. If you have done a business plan, then you should know roughly how much cash you will need to find to get the business up and running, and support it until your sales start to bring in new cash.
Let's start with the basics. There are two main sources of finance for a business; debt and equity. Debt is basically money that you borrow, from banks or other institutions, whilst equity is the money that the owners of the business put into it. These two different types of finance come in various different forms and both have some distinct advantages and disadvantages. These largely come down to cost and control.
Debt vs Equity
There are many different forms of debt available to businesses. The main thing to remember about debt is that you can usually borrow the money without giving away any control of the company. The company who lends you the money will expect to be paid interest for doing so, but usually won't interfere in the day-to-day running of the business. Also once you have paid back what you borrowed from them, then the interest cost and their involvement in your business stops. Debt can therefore be a good way of raising short-term finance without giving away any long-term control over the business.
Equity on the other hand is the money put into a business by it's owners. Equity also usually comes with a cost, as they will expect to get a return for their investment. However, unlike debt, you usually do not have to pay your equity holders a return, so this can be a cheaper source of finance than debt as interest always has to be paid, even if the business isn't performing very well. Don't forget though that with equity you are giving away part of your business, and potentially some of the control as well, as equity holders normally have rights to decide how the company is run.
Practically speaking, raising Equity for a small business from someone other than you, the business owner, will prove very difficult, so for the rest of this article we will focus on Debt finance.
Different types of Debt
Here are some of the main sources of debt available to businesses:
Personal money
If you are lucky enough to have spare cash available personally, then you can "lend" this money to your business. This can be better than putting the money in as Equity, as it is much easier to get the money back later if you need it. It is possible to pay yourself interest from the business for the money you have lent it, but this is usually not advisable as it has negative tax and other administrative implications on both you and the business.
It might also be possible for you to borrow money personally and put this into the business, if it proves difficult for the business to borrow money in it's own right. This should be done with caution though as if something goes wrong with the business, you may not get your money back.
Bank overdrafts/loan/mortgages
Bank borrowings are one of the most common ways for businesses to raise finance. There are many different types available, some short-term such as overdrafts and some long-term such as commercial mortgages. For new businesses banks will undoubtedly want to see a good business plan before they will lend, so make sure yours is complete before you go and see them.
Credit cards
There are many credit card companies who also offer credit cards to businesses as well. However these are normally very expensive if you do not pay them off in full, so should only really be used in emergencies, or possibly for small day-to-day expenses where the balance is paid off in full at the end of the month.
Asset finance
Asset finance is similar to a commercial mortgage, but is for other types of assets, like machinery or vehicles. The money is borrowed from an asset finance company, secured against the asset, and is then paid back, with interest, over a number of months or years. Different types of asset finance include Hire Purchase, Finance Leases, Operating Leases and Contract Hire.
Invoice finance
Invoice discounting and factoring are another common way for businesses to raise cash. This is where a company essentially lends you money based on how much money your customers owe you. As your customer pays you back, you pay back the finance. This is another good source of short-term finance, and can be very flexible because the amount the invoice finance company will lend you normally grows as your business grows.
Trade credit
Many people forget this as a source of finance and it is one of the best as it is normally free. As you buy from your suppliers and build up a good payment history with them, you can ask them to provide you with credit, so that you pay them after 30 days for example, rather than straight away. This is especially important where you have to offer your customers credit, as it matches your purchases with your sales.
Other sources of finance
Business investors
Many of us have seen the TV programme Dragons' Den, but real life Dragon's do exist for smaller businesses as well. Often called Business Angels they are investors with surplus cash who look to invest in new or growing businesses. However securing investment may prove difficult for start-up businesses and generally the investor will be looking for a high return for his investment, so this kind of finance can be expensive.
Grants
Depending on where you are based and what sector your business is in, there may be grants available to help you get your business off the ground or help it grow. These can either be from the Government or from the private sector, but can be difficult to obtain.
Conclusion
As you can see there are many sources of finance available to businesses. In reality most businesses use a combination of these. The best way to do this is to match the type of finance with what you are using it for. So if you are buying long-term assets, then using a longer-term loan, such as a mortgage or asset finance, is much better than using your overdraft.
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