Raising finance - an overview
When
a company is growing rapidly, for example when contemplating investment in
capital equipment or an acquisition, its current financial resources may be
inadequate. Few growing companies are able to finance their expansion plans
from cash flow alone. They will therefore need to consider raising finance from
other external sources. In addition, managers who are looking to buy-in to
a business ("management buy-in" or "MBI") or buy-out
(management buy-out" or "MBO") a business from its owners, may
not have the resources to acquire the company. They will need to raise finance
to achieve their objectives.
There
are a number of potential sources of finance to meet the needs of a growing
business or to finance an MBI or MBO:
-
Existing shareholders and directors funds - Family and friends -
Business angels - Clearing banks (overdrafts, short or medium term
loans) - Factoring and invoice discounting - Hire purchase and
leasing - Merchant banks (medium to longer term loans) - Venture
capital
A
key consideration in choosing the source of new business finance is to strike a
balance between equity and debt to ensure the funding structure suits the
business.
The
main differences between borrowed money (debt) and equity are that bankers
request interest payments and capital repayments, and the borrowed money is
usually secured on business assets or the personal assets of shareholders
and/or directors. A bank also has the power to place a business into
administration or bankruptcy if it defaults on debt interest or repayments or
its prospects decline.
In
contrast, equity investors take the risk of failure like other shareholders,
whilst they will benefit through participation in increasing levels of profits
and on the eventual sale of their stake. However in most circumstances
venture capitalists will also require more complex investments (such as preference
shares or loan stock) in additional to their equity stake.
The
overall objective in raising finance for a company is to avoid exposing the
business to excessive high borrowings, but without unnecessarily diluting the
share capital. This will ensure that the financial risk of the company is kept
at an optimal level.
You
are required to suggest:
Business
Plan
Once
a need to raise finance has been identified it is then necessary to prepare a
business plan. If management intend to turn around a business or start a new
phase of growth, a business plan is an important tool to articulate their ideas
while convincing investors and other people to support it. The business plan
should be updated regularly to assist in forward planning.
There
are many potential contents of a business plan. The European Venture Capital
Association suggest the following:
-
Profiles of company founders directors and other key managers; -
Statistics relating to sales and markets; - Names of potential customers
and anticipated demand; - Names of, information about and assessment of
competitors; - Financial information required to support specific projects
(for example, major capital investment or new product development); -
Research and development information; - Production process and sources of
supply; - Information on requirements for factory and plant; -
Magazine and newspaper articles about the business and industry; -
Regulations and laws that could affect the business product and process
protection (patents, copyrights, trademarks).
The
challenge for management in preparing a business plan is to communicate their
ideas clearly and succinctly. The very process of researching and writing the
business plan should help clarify ideas and identify gaps in management
information about their business, competitors and the market.
Types
of Finance - Introduction
A
brief description of the key features of the main sources of business finance
is provided below.
Venture
Capital
Venture
capital is a general term to describe a range of ordinary and preference shares
where the investing institution acquires a share in the business. Venture
capital is intended for higher risks such as start up situations and
development capital for more mature investments. Replacement capital brings in
an institution in place of one of the original shareholders of a business who
wishes to realise their personal equity before the other shareholders. There
are over 100 different venture capital funds in the UK and some have
geographical or industry preferences. There are also certain large industrial
companies which have funds available to invest in growing businesses and this
'corporate venturing' is an additional source of equity finance.
Grants
and Soft Loans
Government,
local authorities, local development agencies and the European Union are the
major sources of grants and soft loans. Grants are normally made to facilitate
the purchase of assets and either the generation of jobs or the training of
employees. Soft loans are normally subsidised by a third party so that the
terms of interest and security levels are less than the market rate. There are
over 350 initiatives from the Department of Trade and Industry alone so it is a
matter of identifying which sources will be appropriate in each case.
Invoice
Discounting and Invoice Factoring
Finance
can be raised against debts due from customers via invoice discounting or
invoice factoring, thus improving cash flow. Debtors are used as the prime
security for the lender and the borrower may obtain up to about 80 per cent of
approved debts. In addition, a number of these sources of finance will now lend
against stock and other assets and may be more suitable then bank lending.
Invoice discounting is normally confidential (the customer is not aware that
their payments are essentially insured) whereas factoring extends the simple
discounting principle by also dealing with the administration of the sales
ledger and debtor collection.
Hire
Purchase and Leasing
Hire
purchase agreements and leasing provide finance for the acquisition of specific
assets such as cars, equipment and machinery involving a deposit and repayments
over, typically, three to ten years. Technically, ownership of the asset
remains with the lessor whereas title to the goods is eventually transferred to
the hirer in a hire purchase agreement.
Loans
Medium
term loans (up to seven years) and long term loans (including commercial
mortgages) are provided for specific purposes such as acquiring an asset,
business or shares. The loan is normally secured on the asset or assets and the
interest rate may be variable or fixed. The Small Firms Loan Guarantee Scheme
can provide up to £250,000 of borrowing supported by a government guarantee
where all other sources of finance have been exhausted.
Mezzanine
Debt
This
is a loan finance where there is little or no security left after the senior
debt has been secured. To reflect the higher risk of mezzanine funds, the
lender will charge a rate of interest of perhaps four to eight per cent over
bank base rate, may take an option to acquire some equity and may require repayment
over a shorter term.
Bank
Overdraft
An
overdraft is an agreed sum by which a customer can overdraw their current
account. It is normally secured on current assets, repayable on demand and used
for short term working capital fluctuations. The interest cost is normally
variable and linked to bank base rate.
Completing
the finance-raising
Raising
finance is often a complex process. Business management need to assess several
alternatives and then negotiate terms which are acceptable to the finance provider.
The main negotiating points are often as follows:
-
Whether equity investors take a seat on the board - Votes ascribed to
equity investors - Level of warranties and indemnities provided by the
directors - Financier's fees and costs - Who bears costs of due
diligence.
During
the finance-raising process, accountants are often called to review the
financial aspects of the plan. Their report may be formal or informal, an
overview or an extensive review of the company's management information system,
forecasting methods and their accuracy, review of latest management accounts
including working capital, pension funding and employee contracts etc. This due
diligence process is used to highlight any fundamental problems that may exist.
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