An open mind on finance options
When considering external ﬁnancing for growth, it’s worth considering some of the more unusual sources. Michelle Perry looks at the pros and cons of various types of funding.
Uncertainty caused by Brexit is forcing many small businesses to ﬁnance contingency plans or cut back their ﬁnancing requirements altogether. What many small businesses are not doing, though, is developing expansion plans.
Small business owners’ reluctance to seek external ﬁnance cannot all be blamed on Brexit, however. There is evidence that some businesses’ continued reticence to use ﬁnance is signiﬁcantly driven by risk attitudes.
Many small businesses seem willing to sacriﬁce some growth to avoid external ﬁnance, and even those which already have access to ﬁnance have not considered using more. But Britain, a nation of small business owners, won’t be held back forever and when their appetite for risk grows, businesses will ﬁnd an array of options to choose from. Interestingly, despite the falling demand for ﬁnance, awareness of and use of alternatives to traditional bank ﬁnance is growing.
Around a third (36%) of smaller businesses currently use external ﬁnance, slightly down from 38% in 2017 and signiﬁcantly below the 44% in 2012, according to the research Small Business Finance Markets from The British Business Bank. Traditionally, bank debt was the main source of ﬁnance for small businesses, but since the global financial crash of 2008 and 2009, a dynamic and varied array of alternatives have been emerging, ensuring greater options for business. We outline some of the options below.
Debt comes in many forms but there are three main categories: loans and overdrafts; ﬁnance secured on assets; and ﬁxed-income debt securities.
Bank debt remains aﬀordable and available for the right investment. For early-stage businesses, a start-up loan, overdraft or bank loan might be suﬃcient. Bank debt allows a company to grow without giving away a stake in the business. But taking out a business loan involves monthly debt repayments, so owners must have a clear overview of their cash management to ensure they can service the repayments.
A lender is far less likely to help mould a business strategy than a business angel or venture capital investor. Remember that overdrafts are repayable on demand but loans are less ﬂexible than overdrafts, and there may be charges and penalties attached to both.
Finance secured on assets
This includes debt instruments such as asset ﬁnance (leasing or hire purchase) and asset-backed ﬁnance (invoice discounting, factoring, asset-based lending and supply chain ﬁnance). Most banks oﬀ er these options alongside specialist asset ﬁnancial ﬁrms and online-only oﬀerings.
New entrants to the industry, and digital business models, are driving strong competition and increasing diversity in the asset ﬁnance industry. This market, through the provision of leasing and hire purchase, helps businesses invest in vehicles, equipment, plant and machinery. With these options, businesses can avoid the upfront cost of the equipment and ease pressures on cash ﬂow.
The UK is the largest invoice ﬁnance market in the world. Invoice ﬁnancing can support cashﬂow and release funding for investment by generating money against unpaid invoices.
It also provides other beneﬁts, such as shortened and more predictable payment cycles. It may also come with optional add-ons such as bad debt protection, backend payroll support and expertise in how to do business in particular industries.
These features can free up time and oﬀ er some protection from late payment, other poor payment practices or default risk. Peer-to-peer lending Peer-to-peer business lending is one of the platforms that has evolved as a result of digitalisation. Digital platforms match lenders with borrowers.
The UK is at the forefront of innovation in this growing form of alternative online ﬁnance. It can be quicker than a bank loan, and allows customers, friends and family to invest and share in the returns of the business.
Equity ﬁnance is a vital source of funding for innovative and high-growth companies. Usually this type of ﬁnance is suitable for early-stage businesses that can’t secure debt ﬁnance. It can also be used for established businesses looking to scale up by expanding through launching a new product or service, or entering a new market or geography.
Equity ﬁnancing raises capital through the sale of shares in a business and can involve venture capitalists, business angels, crowdfunding platforms or private investors.
The beneﬁts of an external equity investor outside the obvious ﬁnancial capital include their experience, investment expertise and access to broad business networks.
But equity investors take a ﬁnancial stake in the business and a seat at the top table. They have a say in the business’s growth and want an exit date on which they earn a good return.
Many owners may not want to give part of their business away, which can deter some from equity ﬁnance. However, investors back only businesses they consider to be both successful and have greater potential.
Equity ﬁnance is typically associated with high-growth technology businesses, but over the past decade the UK equity ﬁnance system has matured and now supports businesses at all stages of their growth, from start-up to ‘unicorn’ (valuable start-up).
But according to The British Business Bank’s Business Finance study, almost half of equity deals are in London, despite the capital accounting for only around 20% of high-growth ﬁrms. To counter this regional ‘favouritism’, there are now three regional funds – the Northern Powerhouse Investment Fund, the Midlands Engine Investment Fund and the Cornwall & Isles of Scilly Investment Fund – that aim to supply both debt and equity ﬁnance to businesses outside London.
Venture Capital (VC) or private equity (PE) investors
In growth phase, PE- or VC-backed companies can be indispensable to companies looking for capital and expertise in a market sector, geography or product launch. However, the owner’s share of the business will be diluted, and the scrutiny of past and predicted performance is intense. Owners need to have a clear growth strategy, all necessary, clean data on their past performance and future goals, and know why they are seeking capital.
PE- or VC-backed investors will need to exit to realise ﬁnancial returns too, so plan for their exit carefully. Raising ﬁnance can be costly, and requires a great deal of management time and resources, which can distract from the day-to-day running of a business.
Angels and seed investors
Business angels are high-net-worth individuals who invest their own funds through an equity stake in small growing businesses. They are an important source of ﬁnance for small businesses, and often invest in groups with a lead angel. Many business angels use the Enterprise Investment Scheme to gain tax relief for their investments.
Business angel activity is concentrated in London. But a new £100m initiative called Regional Angels Programme has been speciﬁcally designed to develop clusters of angel activity to support much needed early-stage equity to businesses across the country – particularly those outside the London and the south-east.
At seed stage, angels can oﬀ er small amounts of funding, but growth-stage businesses may require large sums. The beneﬁt of angels is that they can oﬀ er multiple rounds of ﬁnance, and frequently co-invest with other sources of equity and co-investment funds as further growth ﬁnance is required.
The British Business Bank Angel Survey found that 89% of angels reinvest some or all gains from successful exits into further investments.
Many angels bring local, ﬁrst-hand expertise and knowledge and many focus on investments within a small geographic area, so they also have local business networks.
Michelle Perry is a freelance journalist