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Finance options for SMEs

01 September 2016 by David Petrie

Finance options for SMEs - read more

With such a variety of options, corporate finance advice is critical

Growing a business from the first seed of an idea is not a smooth linear journey. The destination is seldom decided as the business idea takes form, becomes a reality and then grows into a successful enterprise. To grow successfully, businesses need certainty, particularly when it comes to raising finance.

Despite the rise in alternative forms of funding, such as peer-to-peer lending, SMEs are still most likely to go to their main bank when seeking finance. For start-up companies the success of the Enterprise Investment Scheme and Seed Enterprise Investment Scheme have also contributed to a steady rise of equity investment in both deals and investment amounts.

This reflects a shift away from the use of traditional loans and overdraft facilities to fund business growth. More and more SMEs are turning to alternative sources of finance, as online providers of funding for SMEs compete with the traditional high-street banks. Research by Amicus Finance of 400 SME business owners shows 16% have been turned down by a mainstream lender, up from 11% in 2015. Furthermore, 31% said that their inability to secure finance terms with traditional lenders has led to a lost investment opportunity.

A growing number of finance options have become more established, mainstream and accessible to smaller businesses over recent years − firms can now take inspiration from large companies’ funding methods.

ICAEW and the British Business Bank have recognised that to do this companies must come out of the dark and, with a number of leading business organisations, have come together to produce a new, digital and interactive Business Finance Guide, to reflect the changing landscape. There is a growing need for information and advice, and businesses and investors should consider the implications of the various finance options available.

Equity finance

In simple terms, equity financing is the raising of capital through the sale of shares in the business. Equity can be sold to third-party investors with no existing stake in the business. Alternatively, equity financing can be raised solely from existing shareholders, through a rights issue.

Founding shareholders will have put the initial equity into the business. Friends or family may have ‘invested’ in the early stage of a business’s journey. Business ‘angels’ (see below) may then take an equity stake.

Venture capital, corporate venture capitalists or private equity investors also tend to be an option at the growth phase. Financial institutions or the wider public may invest in equity through a listing of the company’s shares. The public may also acquire equity stakes through equity crowdfunding platforms.

However, in reality, it is not that simple. Business angels, for example, may invest at many stages of the business’s growth. As it progresses, a company’s shareholder register will almost certainly comprise a mix of investors who have taken stakes at different stages of its journey and in some cases in different classes of share.

Shareholder return is usually paid in dividends or realised through capital growth, but both are dependent on the business’s ability to generate cash. Because of the risk to their returns, equity investors will expect a higher return than debt providers. Where a project requires longer-term investment than conventional debt offers, equity will be the most suitable, and often the only form of finance available.

Business angels

Angels are typically high-net worth individuals who invest in early stage or high-growth businesses looking for expansion capital. Unlike online peer-to-peer lending, angels often act as mentors too. Most angels can bring valuable first-hand experience of growing businesses, sharing skills, experience and a network of contacts with the business.

Venture capitalists

Venture capitalists invest in businesses with the potential for high return. They invest in a portfolio where a significant number of businesses may fail, so those that succeed have to compensate for those losses. Like angel investors, venture capitalists bring a wealth of experience to the businesses – and although they are unlikely to get involved in the day-to-day running of the business, they may be able to help with the overall business strategy.

Securing venture capitalist investment can be complex, costly and time consuming. A detailed business plan is a must. Legal fees will be incurred through the deal negotiation, regardless of whether investment is ultimately secured.

Equity crowdfunding

The use of equity crowdfunding is becoming common and can be an alternative to seeking angel or venture capitalist finance. In effect, it is a means to connect companies with thousands of potential investors. It does this by matching companies with would-be angels via an internet-based platform.

Before putting a pitch for equity investment on a crowdfunding platform, businesses need to show that they are investment ready. As with attracting traditional angel or venture capitalist investment, a business plan and financial forecasts must be produced.

Private equity

Private equity makes medium to long-term investments in, or offers growth capital to, companies with high-growth potential. Private equity investors usually improve the profitability of a business through operational improvements and grow revenue through investment in new product lines or services. This model of governance consists of the combination of strategic, financial and operational expertise. The provision of non-financial support includes facilitating access to established marketing or distribution channels.

Debt finance

Along the financing journey it is likely you will need to consider both equity and debt finance options. Debt, in its simplest terms, is an arrangement between borrower and lender. A capital sum is borrowed from the lender on the condition that the amount borrowed is paid back in full. Interest is accrued on the debt and the business’s repayment usually has an element of capital repayment and interest.

Unlike equity, debt does not involve relinquishing any share in ownership or control of a business, although the lender will typically take security via a charge (the ability to assume ownership) against the assets of the business or of its owners. A lender is also far less likely to help a business hone its strategy than a business angel or venture capitalist investor.

Peer-to-peer lending

One major innovation in the supply of debt to business is peer-to-peer (P2P) business lending. This is where internet-based platforms are used to match lenders with borrowers. For businesses looking for a direct alternative to a bank loan, P2P can be arranged quickly and allows partners, customers, friends and family who invest through the platform to share in the returns of the business.

Platforms have set criteria to define which businesses can borrow through the platform. They usually require borrowers to have a trading track record, to submit financial accounts and they perform credit checks as part of the credit assessment. Platforms offer either a fixed rate, or in some cases, lenders bid for loans by offering an interest rate at which they would lend. In this instance, borrowers accept loan offers at the lowest interest rate.

Asset finance

Leasing and hire purchase are types of finance used by businesses to obtain a wide range of assets – everything from office equipment to vehicles. This could be a perfect solution if you need new equipment that would otherwise be unaffordable because of cashflow constraints.

Merchant cash advances

These are unsecured advances of cash, based upon future credit and debit card sales. These are repaid via pre-agreed percentage of a business’s card transactions. Unlike many other forms of business funding, company or personal assets are not required as security. If the cash advance takes longer to pay off, the originally agreed repayment cost remains the same.

Bonds and mini-bonds

Retail bonds or corporate bonds are a way for companies to borrow money from investors in return for regular interest payments. A lender is tied in until the predetermined ‘maturity’ date when the bond is redeemed and investors are repaid. Bonds can have an advantage over loans in that the business issuing the bond can have more control over the specific terms of the finance.

Traditionally, corporate bonds and retail bonds would be traded on the stock market and would only be available to larger companies with a trading history. However, crowdfunding platforms now offer a one-stop-shop for raising finance through bonds. These platforms operate in a similar way to peer-to-peer lending platforms but offer the flexibility that bonds do and generally work with larger amounts of funding.

Mini-bonds are similar, but they are not traded on a stock market and can only be promoted to certain types of investor.

Invest in advice

For all companies, wherever they are on the business journey, knowing the options along the way is key to making successful progress. For many, finance falls under the category of administration, and many entrepreneurs prefer to focus on doing business.

However, it is essential to make sure the business can move forward, by stepping out from the business and asking the questions that need answering. By taking a fresh look at prospects and challenges it is possible to make a new assessment of where the business is and where opportunities and risks may lie. Corporate finance advice along the business journey is critical.

Businesses must think about the range of financing options and assess how appropriate and attainable they may be.

For more information access the new digital Business Finance Guide: thebusinessfinanceguide.co.uk

David Petrie is Head of ICAEW Corporate Finance Faculty

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