Choose the right finance when starting up

Every new business needs money when starting up.

Before the first sale is made, the majority of businesses will need to:

• buy equipment
• establish the workplace
• meet marketing costs

Once you're trading, you'll need cash to pay the bills and keep the business going.

There are a range of financing options when starting up, and choosing the right ones for your needs is essential.

You can:

• use your own money
• borrow from banks
• borrow from family and friends
• attract outside investors

Grants and government support may also be available.

Most businesses use a combination of these alternatives, according to their specific needs and circumstances.

For more information please see Starting a business: Useful links and information.

When starting your business, you need to prepare a business plan.

This plan sets out how you intend to operate your business and includes essential financial forecasts.

These forecasts will help you determine how much funding the business is likely to need, what it is needed for, and when you will need the money.

Good planning will also make it easier to raise the money you need.

Use your business plan to explain your business to your bank and other potential sources of finance.

A good plan helps convince them that you know what you are doing and that it is worth risking their money backing you.

How much will you need and when

It's essential to have an accurate idea of your financial needs. Once you have calculated the amount you'll need to cover your initial start-up costs, you'll also need to factor in your running expenses.

Customers may not pay you immediately - but you will still need to pay all your bills to keep trading.

It's sensible to have sufficient capital to cover projected expenses for at least six months.

Consider your own needs

At the same time, you need to make sure that you have taken into account how much money you need to live on.

In the early stages, a new business is unlikely to produce spare cash that you can spend on yourself.

The type of finance you choose will depend on:

• what kind of business you are starting
• how much money you need
• what you will use it for

Many people use their own savings or personal borrowings to fund the business.

This may be the only choice if you can't convince anyone else to lend you money or invest in the business.

Family or friends

Family or friends might back you.

You should carefully consider the risk that they could lose their money if your business fails.

Borrow from a bank

If you have a credible business plan, you may be able to borrow from a bank.

Many businesses use overdrafts for day-to-day borrowing, and loans to finance large purchases such as equipment.

If your business is likely to have peaks and troughs in its cashflow, it's essential to be able to clearly illustrate these to your bank so you can plan an overdraft.

Outside investors

A larger business with good prospects might attract outside investors.

For example, 'business angels' typically invest £10,000 or more in exchange for a share in the business.

Grants

You might qualify for a grant - for example, if you are setting up a business in a deprived area.

If your business is setting up in a deprived area, or in a sector that is not normally catered for by mainstream lenders, you might be able to attract finance from a community development finance institution.

Use a mixture of finance sources

Most businesses use a mixture of finance sources.

For example, you might:

• invest your own money in market research,
• bring in outside investors to share the risk, and
• borrow from the bank to purchase equipment and machinery.

If you're starting a new business, it's likely that you'll have to put up at least some of the money yourself.

It's usually difficult to borrow from a bank or attract other investors unless you're also investing some of your own money.

The easiest way to provide your own financing is if you have savings you can use.

If not, you'll have to think about other possibilities, such as:

• getting a mortgage, or second mortgage
• borrowing privately
• getting an unsecured loan, or borrowing on credit cards
• selling possessions or assets

You should think carefully before borrowing to finance your business and should match the financing to your needs.

For example, using credit cards for long-term expenditure can be cripplingly expensive, while some loans can be inflexible - you could end up paying interest over many years.

Don't over-extend yourself. If you borrow too much, you may not have enough money left to cover your living costs while the business gets going.

You should also try to leave a contingency fund, in case you need extra money to see you through a difficult period.

Advantages

Self-financing your business gives you far more control than other finance options.

Outside investors or lenders could decide to withdraw their support at any time and most will expect a good return on their investment in the form of interest, shares or dividends.

Disadvantages

You must be aware of the risks. If your business fails you could lose your home and other personal possessions.

Knowing how much you have borrowed can put a lot of pressure on you and your family.

If you can't raise enough money to start your new business yourself, friends and family may be willing to help.

They might loan money to you, your new business, or they might invest in your business, e.g. by buying shares.

You should provide potential investors with an up-to-date business plan.

It will help demonstrate how their money will be used and explains the long-term plans for the business.

You should also make sure that you have a written agreement in place that sets out terms and conditions, including any interest and repayment terms. This should help avoid misunderstandings.

There may also be tax implications for you and your family, especially on interest-bearing loans.

Advantages

• Friends or family may be more willing to lend you money than a bank, particularly if you cannot provide security for a loan.
• Friends and family may offer easy terms - eg an interest-free loan.
• If you can raise some finance from your own resources or friends and family, it should make it easier to get additional finance from the bank.

Disadvantages

You need to be careful.

You may feel under personal pressure, particularly if your business starts to struggle and there's a risk that friends or family will lose their money.

Remember that they may worry about their money too, and this may put a significant strain on your relationship.

As a rule of thumb, you should never ask them to lend you more than they can afford to lose.

You should also seriously reconsider whether your business is a viable prospect if traditional lenders such as banks are unwilling to lend you money to start up.

It is wise for both sides to take professional advice before proceeding with any agreement. You should consult your financial adviser or solicitor.

You might want to bring in outside investors. If the business does well, they share in the profits - but if the business fails, they lose their money.

Typically, your company issues ordinary shares (standard shares with no special rights or restrictions) to investors in return for their capital.

Outside investment can suit promising businesses that do not expect to produce a lot of spare cash in the short term but offer the potential of greater returns over the longer term.

Advantages

• Attractive for businesses looking to bring in additional expertise as well as funding.
• Unlike loans and overdrafts, you do not normally have to make payments to investors until the business can afford them.
• Increasing the capital invested in the business makes it easier to borrow from the bank.

Disadvantages

• Your share of the business, and of its profits, will be lower.
• Investors may want control over how you manage the business.
• Investors may want the business structured in a way that makes it easier to sell their shares in the future.

Sources of investment

There are different sources of investment:

• individuals, such as friends and business contacts
• business angels
• investment funds and venture capitalists for larger investments

Business angels

Business angels are wealthy individuals who typically invest £10,000 upwards and who may also offer business expertise.

Venture capitalists usually invest more than £2 million in businesses where they believe they will receive a high return on their investment by exiting (selling their investment) at a certain time.

Before you approach potential investors

Before approaching potential investors you need a good business plan, including evidence of your management ability.

Your plan should:

• include detailed financial forecasts
• demonstrate what you will do with funds invested in the business

You will also need to prepare a pitch, which will sell your business to potential investors.