The 30 Day MBA (13 page)

Types of bank funding

Banks usually offer three types of loan:

• Overdrafts: Though technically short-term money as they can be called in at a moment's notice, these tend to form a part of the permanent capital of a business, albeit a fluctuating one.
  
• Term loans: Offered for set periods.
  
• Government-backed loans: These are available to some types of business, usually small or new ventures, where the banker's normal criteria might not be met, but the government would like to encourage the sector.
  

Overdrafts/notes payable

The principal form of short-term bank funding is an overdraft, secured by a charge over the assets of the business. A little over a quarter of all bank finance for small firms is in the form of an overdraft. If you are starting out in a contract cleaning business, say, with a major contract, you need sufficient funds initially to buy the mop and bucket. Three months into the contract they will have been paid for, and so there is no point in getting a five-year bank loan to cover this, as within a year you will have cash in the bank and a loan with an early redemption penalty!

However, if your bank account does not get out of the red at any stage during the year, you will need to re-examine your financing. All too often companies utilize an overdraft to acquire long-term assets, and that over-draft never seems to disappear, eventually constraining the business.

The attraction of overdrafts is that they are very easy to arrange and take little time to set up. That is also their inherent weakness. The key words in the arrangement document are ‘repayable on demand', which leaves the bank
free to make and change the rules as it sees fit. (This term is under constant review, and some banks may remove it from the arrangement.) With other forms of borrowing, as long as you stick to the terms and conditions, the loan is yours for the duration. It is not so with overdrafts.

Term loans

Term loans, as long-term bank borrowings are generally known, are funds provided by a bank for a number of years.

The interest can either be variable, changing with general interest rates, or fixed for a number of years ahead. The proportion of fixed-rate loans has increased from a third of all term loans to around one in two. In some cases it may be possible to move between having a fixed interest rate and a variable one at certain intervals. It may even be possible to have a moratorium on interest payments for a short period, to give the business some breathing space. Provided the conditions of the loan are met in such matters as repayment, interest and security cover, the money is available for the period of the loan. Unlike in the case of an overdraft, the bank cannot pull the rug from under you if circumstances (or the local manager) change.

Just over a third of all term loans are for periods greater than 10 years, and a quarter are for 3 years or less.

Government backed finance

One of the most notable initiatives has been the Enterprise Finance Guarantee scheme (EFG), which has offered a total value of £1.88 billion to over 18,000 economically viable small businesses.

Although established small- and mid-sized companies have benefited the most from the scheme, start-ups in the first three years of business account for 37 per cent of all loans offered, with 17 per cent attributed to businesses within their first three months.

You can find more information on the Enterprise Finance Guarantee scheme on the GOV.UK website (
www.gov.uk/government/publications/enterprise-finance-guarantee
).

The Enterprise Finance Guarantee Scheme operated by the banks at the behest of the UK government is typical of such interventions. This is aimed at businesses with a turnover up to £25 million with viable business proposals that have tried and failed to obtain a conventional loan because of a lack of security. Loans are available for periods between two and 10 years on sums from £1,000 ($1,500/€1,126) to £1 ($1.5/€1.1) million.

The government guarantees 75 per cent of the loan. In return for the guarantee, the borrower pays a premium of 1–2 per cent per year on the outstanding amount of the loan. The commercial aspects of the loan are matters between the borrower and the lender. You can find out more about the details of the scheme at
www.gov.uk/government/publications/enterprise-finance-guarantee
.

Bonds, debentures and mortgages

Bonds, debentures and mortgages are all kinds of borrowing with different rights and obligations for the parties concerned. For a business a mortgage is much the same as for an individual. The loan is for a specific event: buying a particular property asset such as a factory, office or warehouse. Interest is payable and the loan itself is secured against the property, so should the business fail the mortgage can substantially be redeemed.

Companies wanting to raise funds for general business purposes, rather than as with a mortgage where a particular property is being bought, issue debentures or bonds. These run for a number of years, typically three years and upwards, with the bond or debenture holder receiving interest over the life of the loan with the capital returned at the end of the period.

The key difference between debentures and bonds lies in their security and ranking. Debentures are unsecured and so in the event of the company being unable to pay interest or repay loans they may well get little or nothing back. Bonds are secured against specific assets and so rank ahead of debentures for any payout.

Unlike bank loans, which are usually held by the issuing bank, though even that assumption is being challenged by the escalation of securitization of debt being packaged up and sold on, bonds and debentures are sold to the public in much the same way as shares. The interest demanded will be a factor of the prevailing market conditions and the financial strength of the borrower.

Categories of bond

There are several general categories of bond that companies can tap into:

• Standard bonds pay interest, a coupon, half-yearly on the principal amount, known as the face or par value. At the maturity date the principal is repaid. The value of bonds fluctuates dependent on market conditions, the length of time to maturity and the likelihood of the borrower defaulting. None of these matters are of immediate concern to the recipient of the funds, as long as they can service the interest. The risk is for the bondholder who can see the value of their investment alter over time.
  
• Zero coupon bonds pay no interest over their life but pay a lump sum at maturity equivalent to the value of the interest such an investment would normally bear. The buyer of the bond receives a return by the gradual appreciation of the bond's price in the marketplace. This could be an attractive financing strategy for a business making an investment which itself will not bear fruit for a number of years.
  
• Junk bonds are bonds usually subordinated to, that is, put below others in the pecking order of who gets paid in tough times, other regular bonds. Such bonds carry a higher interest burden.
  
• Callable bonds are used when an issuer wants to retain the option to buy back their bonds from the public if general interest rates fall sharply after the issue date. The issuer notifies bondholders that after a certain date no further interest will be paid, leaving the holders with no reason to keep the bond. The company issuing the bond can then go out to the market and launch a new bond at a lower rate of interest and so lower its cost of capital. This process is also known as refinancing.
  

Asset-backed financiers

The banks are more covert when it comes to looking for security for money lent. Two other major sources of funds are less circumspect; indeed their whole prospectus is predicated on a precise relationship between what a business has or will shortly have by way of assets, and what they are prepared to advance. Both groups play an important role in financing growing businesses.

Leasing companies

Physical assets such as cars, vans, computers, office equipment and the like can usually be financed by leasing them, rather as a house or flat may be rented. Alternatively, they can be bought on hire purchase. This leaves other funds free to cover the less tangible elements in your cash flow.

Leasing is a way of getting the use of vehicles, plant and equipment without paying the full cost all at once. Operating leases are taken out where you will use the equipment (for example a car, photocopier, vending machine or kitchen equipment) for less than its full economic life. The lessor takes the risk of the equipment becoming obsolete, and assumes responsibility for repairs, maintenance and insurance. As you, the lessee, are paying for this service, it is more expensive than a finance lease, where you lease the equipment for most of its economic life and maintain and insure it yourself. Leases can normally be extended, often for fairly nominal sums, in the latter years.

Hire purchase differs from leasing in that you have the option to eventually become the owner of the asset, after a series of payments. You can find a leasing company via The Finance and Leasing Association (
www.fla.org
.
uk/asset/members
), which gives details of all UK-based businesses offering this type of finance. The website also has general information on terms of trade and code of conduct.

Discounting and factoring

Customers often take time to pay up. In the meantime you have to pay those who work for you and your less patient suppliers. So, the more you grow, the more funds you need. It is often possible to ‘factor' your creditworthy customers' bills to a financial institution, receiving some of the funds as your goods leave the door, hence speeding up cash flow.

Factoring is generally only available to a business that invoices other business customers, either in its home market or internationally, for its services. Factoring can be made available to new businesses, although its services are usually of most value during the early stages of growth. It is an arrangement that allows you to receive up to 80 per cent of the cash due from your customers more quickly than they would normally pay. The factoring company in effect buys your trade debts, and can also provide a debtor accounting and administration service. You will, of course, have to pay for factoring services. Having the cash before your customers pay will cost you a little more than normal overdraft rates. The factoring service will cost between 0.5 and 3.5 per cent of the turnover, depending on volume of work, the number of debtors, average invoice amount and other related factors. You can get up to 80 per cent of the value of your invoice in advance, with the remainder paid when your customer settles up, less the various charges just mentioned.

If you sell direct to the public, sell complex and expensive capital equipment, or expect progress payments on long-term projects, then factoring is not for you. If you are expanding more rapidly than other sources of finance will allow, this may be a useful service that is worth exploring.

Invoice discounting is a variation on the same theme where you are responsible for collecting the money from debtors; this is not a service available to new or very small businesses. You can find an invoice discounter or factor through The Asset Based Finance Association (
www.abfa.org.uk//files/04/62/44/f046244/public/membersList.asp
), the association representing the UK's 41 factoring and invoice discounting businesses.

Equity

Businesses operating as a limited company or limited partnership have a potentially valuable opportunity to raise relatively risk-free money. It is risk-free to the business but risky, sometimes extremely so, to anyone investing. Essentially this type of capital, known collectively as equity, consists of the issued share capital and reserves of various kinds. It represents the amount of money that shareholders have invested directly into the company by buying shares, together with retained profits that belong to shareholders but which the company uses as additional capital. As with debt, equity comes in a number of different forms with differing rights and privileges.

Ordinary shares form the bulk of the shares issued by most companies and are the shares that carry the ordinary risks associated with being in business. All the profits of the business, including past retained profits, belong to the ordinary shareholders once any preference share dividends have been deducted. Ordinary shares have no fixed rate of dividend; indeed over half the companies listed on US stock markets pay no or virtually no dividend. These include high-growth companies such as Google and Microsoft, which argue that by retaining and reinvesting all their profits they can create better value for shareholders than by distributing dividends. A company does not have to issue all its share capital at once. The total amount it is authorized to issue must be shown somewhere in the accounts, but only the issued share capital is counted in the balance sheet. Although shares can be partly paid, this is a rare occurrence.

Preference shares get their name for two reasons. First, they receive their fixed rate of dividend before ordinary shareholders. Second, in the event of a winding up of the company, any funds remaining go to repay preference share capital before any ordinary share capital. In a forced liquidation this may be of little comfort, as shareholders of any type come last in the queue after all other claims from creditors have been met.

Class A and Class B shares are cases where categories of shareholder are singled out for more or less favourable treatment. For example, class A shares are often given up to five votes per share, while class B gets one. In extreme cases class B shareholders can get no votes at all. Companies will often try to disguise the disadvantages associated with owning shares with fewer voting rights by naming those shares. One of the most famous examples was their use by the Savoy Hotel Group to ward off an unwanted takeover by Trusthouse Forte. While Trusthouse was able to buy 70 per cent of Savoy shares on the open market, they could secure only 42 per cent of the voting rights as they were only able to buy class B shares, the A shares being in the hands of the Savoy family and allies.