best-practice guideline

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1 best-practice guideline SME Finance Author: Marc Mullen November 2012 Issue 58 BUSINESS WITH confidence icaew.com/cff

2 contents 02 Introduction 03 Investment readiness 05 The right type of finance 06 Debt finance 08 Equity finance 12 Alternative sources of finance 14 Making the most of your assets 14 Other help for SMEs INTRODUCTION For SMEs, obtaining and securing the right source of finance can present a major challenge. Lack of available funding for SMEs has been brought into sharper focus post-credit crunch. Many growth businesses are started by entrepreneurs, often with little experience of how to raise finance to fund this growth. This guideline first and foremost seeks to help them when it comes to looking for sources of finance. It sets out the main financing options and the key issues to consider when choosing between those options. Accountants and other advisers to SMEs may also find it a useful reference tool. GOVERNMENT SUPPORT FOR SMES The guideline also seeks to raise awareness of UK government schemes which have been launched to respond to credit and other finance constraints faced by small businesses through the economic downturn. The main schemes are indicated throughout the text in red. AUTHOR Marc Mullen is an ACA, who trained with PwC. He is a freelance journalist and editor of ICAEW Corporate Finance Faculty magazine, Corporate Financier. Box 3 Box 9 Box 11 Box 12 Box 13 Box 14 GrowthAccelerator Enterprise Finance Guarantee Business Angel Co-Investment Fund Enterprise Investment Scheme Seed Enterprise Investment Scheme Venture Capital Trust Scheme E marc.c.mullen@googl .com Copyright ICAEW 2012 Text copyright The Department for Business Innovation and Skills 2012 All rights reserved. If you want to reproduce or redistribute any of the material in this publication, you should first get ICAEW s permission in writing. The views expressed in this guideline are those of the contributors. ICAEW does not necessarily share their views. ICAEW will not be liable for any reliance you place on information in this guideline. ISBN For a business seeking finance it may not always be clear what type of finance is most appropriate whether the business is better suited to incur debt or to sell an equity stake in the business. Forms of debt can go beyond the familiar concepts of borrowing, overdrafts and leasing. An investor may buy a stake in a business and structure the deal with some of the stake in debt so that the investor receives a payback over time. It is also vital that businesses are aware of support that exists to get them investment-ready not only by increasing their awareness of financing options, but also by showing them how to develop a finance strategy. This means turning their business proposition into a pitch that, in very simple terms, sums up the business and where the growth will come from, and can then be used to approach potential investors. With the strategy clear this pitch can be adapted for different sources of finance. 02 SME Finance

3 guideline INVESTMENT READINESS Many small businesses would benefit from further support to turn their business propositions into attractive investible opportunities. Securing funding is often closely related to how well businesses make themselves investment-ready for potential investors. THE BUSINESS PLAN Preparing a solid business plan is key to securing funding. A robust plan will help potential lenders or investors understand the vision and goals of the business. The process of preparing a business plan will bring focus to management s understanding of their strategy where the risks are and the impact of any deviation from the plan in particular when it comes to funding. The information will depend on the target audience, but in each case it should incorporate: an executive summary, highlighting the main points and designed to grab the attention of potential lenders or investors; details of key people as well as their responsibilities, skills and relevant business experience; market research, with details of competitors and how the product or service fits into the marketplace; the marketing plan to increase sales of the product or service to new or existing customers; financial information covering the last three years of trading (if available) accounts (audited, if available) and key accounting ratios; financial forecasts for the next three to five years, ideally presented in the same way as the historical information, highlighting key underlying assumptions; additional forecasts, which clearly show the financial impact of key downside scenarios, such as sales growth targets not being met, also need to be included; a cash flow forecast covering the next two to three years (or in the case of a start-up or turnaround, until the business moves into profit), indicating the amount of funding needed; how creditors, capital expenditure, debtors and stock will be managed over the forecast period; and how any potential lenders will get their money back, or investors will see the value of the business and therefore their shareholding grow. Any business plan must clearly show how much of the existing owner s money is committed to the business. If a lender or investor thinks the existing owner is not demonstrating a willingness to risk enough of their own capital, securing a loan or an investment is likely to be more difficult, if not impossible. The business plan should also clearly detail any backing already received from other banks or investors which may demonstrate the investibility of the business and attract new lenders or investors. In general terms, if a business is looking for debt finance, the plan needs to demonstrate how the business will be able to meet the interest payments and repay the capital over the period of the loan. When looking for equity finance, the plan will need to show how the equity provider will receive dividends and how share value will grow. BUSINESS MENTORING Investment readiness may be the initial goal of an SME looking for funding, but before a business plan can be prepared the business may need to access experienced advisers knowledge and information in order to make the right choices. Business mentors have the practical experience and contacts to help businesses make those right choices. A mentor acts as an independent sounding board, can provide guidance and support from an external perspective and signpost a business to appropriate external advice. Box 1: Mentorsme.co.uk Mentorsme.co.uk is a mentoring gateway that links businesses to mentoring organisations across the UK and can help find a mentor that suits the business, including those offering specialist financial support. The British Bankers Association (BBA), the hosts of the portal, has provided 1000 volunteer bank mentors recruited from the business community who can offer expert financial support and all are accessible via mentorsme.co.uk. icaew.com/cff 03

4 guideline Business coaching Coaching will help the business produce a robust financial strategy and business plan. Presentation training will give management the skill to present the company and their plans in the best possible light, and deal with the rigorous scrutiny of those plans by potential lenders or investors. At this stage the adviser should be able to introduce the company to a network of investors or lenders. Many independent advisory firms offer coaching and mentoring services. Box 2: ICAEW Business Advice Service ICAEW s Business Advice Service (BAS) is a scheme offering business support to SMEs in England, Scotland and Wales. The scheme offers businesses a free advice session with an ICAEW-qualified chartered accountant. Businesses can visit to find the nearest office participating in the scheme. BAS offers to help SMEs overcome the challenges of: how to grow a business; securing loans, capital and finance; keeping staff and creating new jobs; meeting tax and regulatory requirements; export planning; planning for long-term sustainable growth; debt management; and legal issues. Box 3: GrowthAccelerator GrowthAccelerator is a 200m government-backed programme to provide business coaching to English SMEs. A private sector consortium of business growth specialists, led by Grant Thornton and comprising Winning Pitch, Oxford Innovation and Pera, delivers the scheme. Coaching is not prescriptive it is tailored to meet the specific needs of individual businesses. Proven business experts work with the business s management team to identify the barriers to growth, devise and agree a strategy to overcome those barriers and then work with them to execute the plan. GrowthAccelerator focuses on four main areas: Commercialising innovation teaching business leaders how to commercialise their ideas, develop innovation strategy and generate profitable intellectual property. Business development helping business owners to develop and execute a clear growth strategy in line with their specific needs. Access to finance this provides an assessment of business suitability and potential for raising finance; it helps create a business that is investible, and introduces a business to potentially suitable investors. Leadership and management GrowthAccelerator provides grants for training courses that will enable senior managers and chief executives to create an effective management structure and run their business better. In addition to business coaching, GrowthAccelerator fast tracks clients to trusted providers of business advice. It introduces businesses to networks of investors. It also connects them to similar businesses. English SMEs with no more than 250 employees and turnover of up to 40m can apply for the GrowthAccelerator programme. It aims to help 10,000 SMEs per annum once fully up and running. 04 SME Finance

5 THE RIGHT TYPE OF FINANCE After the preparation of a robust detailed business plan with realistic financial forecasts the next step for SMEs is choosing the right type of finance. This may be a mix of two or more types of finance. The first port of call could be further finance from the existing owners of the business. This is not always possible. What must be determined before approaching lenders or investors is how much funding the business is likely to require, what the funding is specifically needed for and when it will be required. For start-up businesses, running expenses must be factored in, in addition to the initial start-up costs. Sufficient capital should be available to cover the projected running expenses for at least six months as customers may not pay up immediately. A start-up business is unlikely to generate surplus funds in these early stages. It is critical that the owners establish how much money the business will need to survive. A start-up business may look to use credit unions or even the owner s credit card to fund that early stage growth. However, as with all means of financing, owners must look closely at the cost, particularly if using their own credit card to fund the start-up. Taking a business on to the next stage moving to larger premises, acquiring a competitor or investing in new machinery to handle bigger orders will almost always require a further tranche of funding. Most businesses will use a mixture of financing sources. Choosing the most suitable depends on the nature of the business, how much is actually needed and what exactly it is for. The overarching decision is between equity (shares) and debt. It may be that if the business is at an early stage pre-revenue or pre-profit the only option is equity. Knowledge-based businesses which are rich in intangible assets can find it difficult to access debt finance. Equity finance may be particularly suitable for these businesses. See Other Help for SMEs for information on other sources of funding for knowledgebased businesses. In practice a business generating turnover and making a profit will use a mix of permanent and temporary finance. Grants may also be available in certain situations. Another option may be to make use of some alternative forms of debt financing, such as invoice discounting or export factoring. Box 4: Friends and family It might be possible for a business to raise some or all of the funding required from relatives or friends. A loan is probably the most appropriate option for immediate or short-term funds. For longer-term or permanent funding friends or family could be given the opportunity to invest in shares in the business. The advantages of friends and family financing can include: low or zero interest repayments; loan obtained without the business giving any security; a longer loan period before the lender expects repayment of part or all of the loan, or the investor a return on their investment; greater flexibility; and requirement for a less detailed business plan if the lender or investor already knows the circumstances of the business. Despite the seemingly informal nature of the investment or loan from the friend or family member, they must be made aware of the risks involved in investing or lending. They should not invest or lend more money than they can afford to lose. If conventional lenders are unwilling to offer finance to the business, then the friend or family member must seriously consider the reasons for that and whether it is a viable proposition. One potential issue is when an inexperienced investor tries to get involved in the running of the business. Their involvement may not be welcome and may be detrimental to the business achieving its plans. It is imperative that where a passive partner is required, that is made clear from the outset. To maintain control of the business a majority of the shares should be retained by the original business owners. Other problems can arise if the investor or lender demands their money back prematurely. To avoid such problems, both parties should seek independent advice and formalise any agreement in writing. The agreement should detail the nature and timing of the return of any loan, a repayment schedule or timed plan of dividend payments, and the respective responsibilities of both parties. There should also be an agreed procedure for the resolution of any problems which may arise, to help prevent any future misunderstandings. It is important to be aware that the exact nature of any agreements could have tax implications for either or both parties. icaew.com/cff 05

6 guideline INDEPENDENT ADVICE It is important to obtain independent advice when considering financing options. The type of finance sought should match the needs of the business. Advisers can help the business establish whether they need to raise finance or whether their problems can be addressed in other ways such as better financial management and control. DEBT FINANCE BANK FINANCE LOANS AND OVERDRAFTS Overdrafts and bank loans are the most common sources of additional finance for SMEs. The most significant advantage they have over raising equity is that neither involves relinquishing any share of ownership or control of the business. It is almost always the case that an entrepreneur will benefit from the knowledge, insight and network of advisers who deal with banks on a day-to-day basis. However, businesses themselves should cultivate relationships with banks because that relationship may prove fruitful, particularly when looking for followup funding. Broadly, loans are often better for larger long-term purchases, such as investment in plant and machinery. Authorised overdrafts are more suitable for day-to-day borrowing. SECURING A BUSINESS LOAN OR OVERDRAFT To successfully obtain a loan or overdraft, the business owner will have to prove to the lender that the business will generate the income necessary to repay the facility in accordance with the terms of the loan. Market conditions affect greatly the ease with which a business can access a loan or overdraft. A business will generally need to: show a comprehensive and credible business plan, including cash-flow projections demonstrating that there will be sufficient income to cover outgoings and meet interest and capital repayments; provide evidence of a successful track record in business or of skills and experience relevant to the business being started; provide security for any money borrowed against other personal or business assets; and demonstrate the owners personal financial commitment to the business. Box 5: Bank loans pros and cons The main advantages of loans are: the terms can be tailored to suit the needs of the business; repayments are straightforward, simply planned and the cash flow impact can be budgeted for; a loan usually costs less in interest payments than an overdraft when used over the same term; and there is tax relief on the interest payments, unlike dividends. The disadvantages are: banks can be reluctant to lend money to new business owners with no financial track record; loans are less flexible than overdrafts charges could be payable on funds that are not used and there could be penalties for early repayment; being locked into a rigid repayment schedule could be a problem if cash flow is seasonal or erratic; and in almost all instances there will be a need for a business to put up security against the loan, and/or the directors to give personal guarantees. CHOOSING A BANK ACCOUNT Bank charges vary widely as do the services offered so it is worth shopping around before opening any account. The suitability of an account will depend on the needs of the business. For example, where a business has many transactions, they should consider opting for an account which charges a fixed fee rather than an amount per transaction. Statements should be checked regularly not just for transactions but for bank charges, which can be kept to a minimum by: negotiating or switching banks to secure better interest rates and lower charges; automating as many transactions as possible, using standing orders, direct debits and electronic payments; using on-line banking where available; and adhering to the terms and conditions of the account, for instance avoiding unauthorised overdrafts. 06 SME Finance

7 It is important to notify the bank if the business is having financial difficulties. Negotiating new conditions for an account is always better than breaching a term such as exceeding a credit limit. This will incur extra fees and could affect the owner s credit rating. Box 6: Overdrafts pros and cons The main advantages of overdrafts are: they are often quicker to arrange than a loan; overdrafts give flexibility interest is only paid on the amount of money used and they are only used as finance if required; and they are regularly reviewed. The main disadvantages are: they are repayable on demand and so can be called in if the bank thinks that the business may be in difficulty; interest rates are usually higher than for loans using them for long-term borrowing will cost more; cheques bouncing may lead to penalty charges and/or higher interest rates if the overdraft limit is exceeded; penalties may be imposed if the overdraft limit is exceeded; and security may still need to be provided. DEBT FUNDING INNOVATIONS One major innovation in the supply of debt to SMEs is peer-to-peer (P2P) funding. It is still at a very early stage but the UK appears to be at the forefront of this innovation which uses the power of the internet to match would-be lenders to would-be borrowers. There are a number of websites offering this service, which can be attractive both to businesses looking for quick access to lending and lenders looking for potential returns. All parties should carefully consider the risks of what is currently a largely unregulated market. Box 7: Getting the best loan deal Shopping around for the best loan deal is a must. Carefully comparing interest rates before deciding on the best deal can save the business a lot of money because they can vary enormously. Interest rates can be fixed or variable. With a fixed rate the interest will remain constant throughout the repayment period. With a variable rate, it may fluctuate according to changes in the Bank of England base rate or the interbank lending rate, LIBOR. The annual percentage rate (APR) is the key figure to look at when comparing different loans and overdrafts. This is the rate which will be charged annually once all fees have been taken into account. It may be possible to negotiate a lower interest rate or better terms if so it is important to get this confirmed in writing. A finance broker or an accountant may be able to track down a suitable loan and deal with the application process. Similarly, having an expert such as a solicitor to review the loan agreement would be useful. The small print can be checked for any hidden costs. As well as interest rates particular attention should be paid to any set-up fees and loan terms, such as penalty charges for early loan repayment. The credentials of potential lenders can be checked with the Financial Services Authority (FSA) or, from 2013, its successor organisations. Box 8: Community Development Finance Institutions Community Development Finance Institutions (CDFIs) are independent financial institutions which provide micro-finance loans to start-up companies, individuals and established enterprises. These loans are offered to borrowers from a specific disadvantaged geographic area or disadvantaged group, who are unable to access finance from more traditional sources, such as banks. Some CDFIs are also EFG accredited (see Box 9). icaew.com/cff 07

8 guideline Box 9: Enterprise Finance Guarantee The Enterprise Finance Guarantee (EFG) scheme is a loan guarantee scheme which aims to facilitate additional lending to viable SMEs. These businesses will lack the security or proven track record for a commercial loan. Lenders are also likely to request personal guarantees. EFG is available to SMEs with annual turnover of up to 41m, seeking loans between 1,000 and 1m, and repayable over a period of 3 months up to 10 years. Accredited lenders make all the lending decisions related to EFG there are currently 46 accredited lenders, including all the main UK high street banks, Community Development Finance Institutions (see Box 8) and invoice finance providers. EQUITY FINANCE Equity finance enables the raising of share capital from external investors in return for handing over a share of the business. The main providers of equity finance for SMEs are venture capitalists (VCs), business angels and for start-ups, friends and family. Unlike lenders, equity investors do not have rights to interest or to have their capital repaid by a certain date. Their return is usually paid in dividend payments and is dependent on the growth in profitability of the business. Because of the risk to their returns equity investors expect a higher potential return than on more secure investments. Equity finance may be particularly suitable where the nature of a business deters conventional lenders such as banks (for example, where a business is rich in intellectual property but has few tangible assets), or the business will not generate enough cash to pay loan interest because it is needed to fund core activities or growth. BUSINESS ANGELS Business angels are individuals who make equity investments in high-growth businesses. Some invest on their own; some invest as part of a syndicate. Investments by business angels tend to be smaller than those offered by VCs and tend to target businesses in the early stage of development or established businesses looking to expand. Angels will invest in highrisk opportunities if there is potential for high returns. Typically between 10,000 and 2m can be raised from angels, either alone or in a syndicate. When angels invest in a business it is not just their capital they put in most also make their valuable first-hand experience available to the business, as well as their skills and network of contacts. They are likely to have local knowledge as they usually focus their investments within a small geographical area. Angels can often make an investment decision relatively quickly, without complex assessments. VENTURE CAPITAL AND PRIVATE EQUITY When VCs invest in shares in a business they are usually looking for products or services with a unique selling point, or competitive advantage, with the potential for high returns. VCs will typically look for proven track records and so will only rarely invest in pure start-up businesses. VCs bring their wealth of experience to the business. They are very unlikely to get involved in the day-to-day running of the business but will often help with business strategy. Securing a deal with a VC can be a long and complex process. A detailed business plan will need to be prepared. The legal fees incurred in the deal negotiation will be a cost regardless of whether investment is ultimately secured. Private equity (PE) firms look to make equity investments in established companies with high-growth potential. Generally, PE firms invest in businesses which are further developed than those VCs invest in. The investment is intended as medium to long term. They typically look to make operational improvements through active management of their investment over a period of three to seven years. At the end of this period they look to sell their shares and exit the investment completely, having seen the value of their stake grow. A private equity firm will consider selling the business to another private equity firm or a trade buyer as well as the option of publicly listing their shares. 08 SME Finance

9 SECURING EQUITY FINANCE Before seeking equity finance there are five questions to consider: How much funding is required? For what is it required? What skills does the business need? What level of control needs to be retained? How long are the funds needed? The answers to these questions can form the basis of a comprehensive business plan. This should also incorporate realistic financial projections, a detailed marketing plan and what the investor can expect in return. Networking and making use of suitable contacts are good ways of finding appropriate potential investors. Corporate finance advisers will have their networks of contacts in the business angel and venture capital communities and so engaging an adviser can help identify an appropriate investor. Many are private investors, only interested in specific industry sectors or geographical areas. The following associations may be helpful for tracking down investors, networks or networking opportunities: The UK Business Angels Association. The British Private Equity and Venture Capital Association (BVCA). The European Private Equity and Venture Capital Association (EVCA). Chambers of commerce. Box 10: Equity finance pros and cons The main advantages of equity finance are: the funding is committed to the business and its intended projects with investors only realising their investment if the business has performed well through a flotation or a sale to other investors; the right angels or VCs can bring valuable resource to the business, by way of skills, experience and contacts, which they can use to assist in key decision making and the development of the business strategy; investors have a direct vested interest in the success of the business and its strategy, as its growth and profitability will increase the value of the business and therefore their shareholding; and investors are often prepared to provide follow-up funding as the business grows. The main disadvantages are: raising equity finance is demanding, costly and time consuming, and the business may suffer as time is devoted to the deal; potential investors will seek background information, scrutinising past results and forecasts, as well as the background of the management team; the business will be subject to varying degrees of influence over its management when faced with major strategic decisions; management time will need to be invested in producing regular information for the investor to monitor; the owner s share in the business will be diluted, although because of the funding this may be a smaller percentage of a larger business; and there can be legal and regulatory requirements to comply with when raising equity finance. icaew.com/cff 09

10 guideline Equity funding innovations Just as with debt innovations, there are innovations in peer-to-peer equity funding. Crowdfunding creates a platform which matches companies with would-be angel investors, sometimes novice angels. Deal sizes and investment sizes are small. Limited due diligence is carried out by the platform with it left up to the investor as to how much due diligence is needed to satisfy their needs. In August 2012 the FSA issued a warning that, in its view, some crowdfunding firms may be handling client money without FSA permission or authorisation and therefore may not have adequate protection in place for investors. Box 11: Business Angel Co-Investment Fund The 50m Business Angel Co-Investment Fund makes initial equity investments of between 100,000 and 1m in early stage SMEs identified as having high growth potential. Its investments are made alongside syndicates of business angels, subject to geographical restrictions. There is an upper limit to the stake it takes in a business of 49% of any investment round. The aim of the fund is to boost the quality and quantity of business angel investing in England, and support long-term, good quality jobs in high-growth companies particularly in areas worst affected by public spending cuts. A consortium of private and public bodies with expertise in business angel investment designed and established the fund, which is funded with a grant from the Regional Growth Fund. Investment decisions are made by the fund s independent investment committee, based upon detailed proposals put forward by business angel syndicates. Box 12: Enterprise Investment Scheme The Enterprise Investment Scheme (EIS) is designed to help smaller higher risk trading companies raise finance by offering a range of tax reliefs to investors who subscribe for new shares in those companies. Investors can invest up to 1m in qualifying shares and receive 30% of the cost of the investment as a relief against income tax. Capital gains tax liability on disposal of an existing asset can be deferred if reinvested in EIS shares within a certain period. Provided income tax relief is given and the shares are held for a qualifying period, any profit on the sale of the shares will be exempt from capital gains tax. Providing that income tax relief has been given and has not been withdrawn, losses arising on a disposal of the shares may be set against income tax as an alternative to being relieved against capital gains tax. Companies can raise a maximum of 5m in any 12-month period from the government s three venture capital schemes the EIS, SEIS (see Box 13) and VCTs (see Box 14). The EIS is administered by HM Revenue & Customs (HMRC). At the time of the new shares being issued companies eligible to receive investment through the EIS must: not be listed on the London Stock Exchange or any other recognised stock exchange; have fewer than 250 full-time equivalent employees; have assets of no more than 15m; and be carrying on or preparing to carry on a qualifying trade as defined by HMRC. There are further requirements which the company must meet for a continuous period from the issue of the shares. 10 SME Finance

11 Box 13: Seed Enterprise Investment Scheme The Seed Enterprise Investment Scheme (SEIS) is designed to help smaller, early-stage companies to raise equity finance. It complements the EIS (see Box 12). At the time of the new shares being issued companies eligible to receive investment through the SEIS must: not be listed on the London Stock Exchange or any other recognised stock exchange; have fewer than 25 full-time equivalent employees; have assets of no more than 200,000; must not have had any EIS investment or investment from a VCT (see Box 14); and must be carrying on a new qualifying trade or preparing to do so. A new qualifying trade is one which has not been carried on for more than two years (whether by the company or by anyone else before the company acquired it). Companies can receive a maximum of 150,000 under the SEIS. Companies can raise a maximum of 5m in any 12-month period from the government s three venture capital schemes the EIS (see Box 12), SEIS and VCTs (see Box 14). The SEIS offers a range of tax reliefs to encourage individual investors to purchase new shares in qualifying companies. Shares must be held for at least three years and income tax relief is available at 50% of the cost of the shares, up to a maximum annual investment of 100,000. For only, there is an exemption from capital gains tax where gains on the disposal of an asset are reinvested in shares qualifying for SEIS income tax relief. Any gain on disposal of SEIS shares will be exempt from capital gains tax. Box 14: Venture Capital Trust Scheme The Venture Capital Trust (VCT) scheme encourages individuals to invest in small, unlisted higher-risk trading companies indirectly through the acquisition of shares in a VCT. VCTs are similar to investment trusts and must have HMRC approval. The maximum investment in VCT shares by any individual in any year is 200,000, which will qualify for relief against income tax at a rate of 30% of the amount invested. Shares must be held for at least five years from the date of their issue by the VCT. There is an exemption for capital gains tax on disposal of shares in a VCT, and dividends on VCT shares are exempt from income tax. VCTs invest their funds into eligible small companies. Eligible companies can receive both debt and equity investment from a VCT. At the time the VCT invests an eligible company must: not be listed on the London Stock Exchange or any other recognised stock exchange; have assets of no more than 15m; have fewer than 250 full-time equivalent employees; and be preparing to carry on, or carrying on, a qualifying trade as defined by HMRC. There are further requirements which the company must meet for a continuous period from the issue of the shares. Companies can raise a maximum of 5m in any 12-month period from the government s three venture capital schemes the EIS (see Box 12), SEIS (see Box 13) and VCTs. icaew.com/cff 11

12 guideline ALTERNATIVE SOURCES OF FINANCE COMMERCIAL MORTGAGES The advantages of buying a property for a business using a commercial mortgage includes protection against sudden rent increases. Such interest payments are also tax deductible. However most providers of commercial mortgages would expect the buyer to invest a proportion of their own money in the property. This deposit could swallow up cash that could be better deployed elsewhere in the business. Also if it proves difficult to sell the premises in the future, this could hinder any relocation plans. Because it is such a long-term commitment, the implications along with the terms of any mortgage agreement must be carefully considered. LEASE OR BUY When acquiring assets such as office equipment, company cars or vans, or machinery, a business will need to decide whether to lease or buy them. Buying equipment may be advantageous; the asset is owned and capital allowances can be claimed to offset against tax. The overall cost should be less than using a lease or hire purchase agreement. Disadvantages of buying include the fact that paying the full cost up front could create a strain on company cash flow. The business will also be responsible for maintaining and replacing machinery, the value of which will depreciate over time. Leasing can be better for equipment that becomes outdated quickly, has high maintenance costs or is only used occasionally. It is also a way for a business to gain access to a higher standard of equipment which would otherwise be unaffordable if the business was buying it outright. With leasing, it is far simpler to budget in terms of monthly payments and to forecast cash flow payments are spread over a longer time period to match income. A disadvantage of leasing is that capital allowances cannot be claimed if the lease period is less than a certain time and leasing arrangements may only be available to established companies or those prepared to offer additional security. It can also work out to be more expensive than buying the assets outright and the business could be locked into inflexible mediumor long-term agreements which may be difficult to terminate. There are two main types of lease: A finance lease is a long-term lease over the expected life of the equipment usually at least three years. After this period the business can pay a nominal rent, sell or scrap the equipment. The leasing company recovers the full cost of the equipment plus charges over the period of the lease. The business will be responsible for maintaining and insuring the leased asset and it must be shown on the balance sheet as a capital item. Capital allowances can be claimed if the asset has been bought outright for leases over seven years long. In some cases this may be as short as five. An operating lease, also called contract hire, is a good idea if a business will not need the equipment for its entire working life. The leasing company will take it back at the end of the lease and is responsible for maintenance. The business does not have to show the asset on its balance sheet. COMPLEMENTARY SOURCES OF DEBT FINANCE Debt factoring or invoice discounting can be used to raise capital by raising money against unpaid invoices. These sources of funding are collectively known as asset-based lending (ABL). Factoring is only available to businesses that sell products or services on credit to other businesses. It is potentially useful to businesses where turnover is growing by increasing cash flow. Debt factoring involves selling invoices to a factor which pays an advance typically 85% on all approved invoices. The factor will then work on behalf of the business managing the sales ledger and collecting money owed by customers. Once a customer settles an invoice with the factor, the factor will release the remaining balance less their fees. In recourse factoring, the factor does not risk bad debts and can reclaim the money advanced if a customer does not pay. 12 SME Finance

13 Invoice discounting is a similar way of drawing money against invoices, but the business retains control over the administration of the sales ledger. Discounters have strict requirements regarding the quality of sales ledger systems and procedures. Some factoring companies also offer export factoring, which is finance for international sales. This typically involves them working with an agent overseas to collect payments in the country to which the business is exporting. Careful consideration is advised if given a choice of which country to be paid in. It may also be worthwhile investing in protection against fluctuations in the exchange rate. Supplier finance or, as it is sometimes called, reverse factoring is an option for businesses that regularly supply a far larger organisation. Once the buyer has approved the invoice, the payment less a fee is made immediately (and ahead of terms) by the financier. This allows the supplier to receive quick payment while allowing the buyer to repay the financier according to the original contract terms. Both factoring and discounting are long-term agreements that can have an effect on the management and development of a business. It is important to get advice on the legal, financial and tax implications before entering into any agreement. Particular attention should be paid to the notice period required to end the factoring or discounting contract. Most companies require three months notice, but some notice periods can be as long as a year. The Asset Based Finance Association in the UK is the member organisation for asset-based lenders. Pros and cons of ABL are listed in Box 15. MEZZANINE FINANCE Mezzanine finance is a form of debt which shares the characteristics of equity. Mezzanine ranks below senior debt. Mezzanine is a flexible product that can be tailored to the risk and repayment profile of the business or transaction. It is typically used to finance the expansion of existing companies. Mezzanine financing is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full. Mezzanine finance can be used in product development, penetration of new markets, infrastructure investments or strategic merger and acquisition plans. As it can be structured with low cash dividends, this form of finance is particularly suited to high-growth companies where more senior debt may be less appropriate as mezzanine can reduce the cash burden in their early stages. However, the understanding and take-up of mezzanine is generally low in the UK, and low among SMEs. Box 15: Pros and cons of asset-based lending Pros: Should generate more cash against assets than any other form of lending. Attractive to growth companies as funding tracks sales and so avoids the need to constantly renegotiate financing lines. Costly administration processes such as credit control can be outsourced. Funding is contingent on inherent strength of sales rather the state of the balance sheet, making it available even to loss-making businesses. Personal guarantees and other forms of additional security are rarely required. Cons: Some companies and advisers have a limited understanding of the mechanics of ABL, resulting in reticence in accessing it. Some industry sectors notably construction can attract a significant risk premium. Companies with shrinking order books would see their ABL funding diminish. Putting the facility in place can be difficult. icaew.com/cff 13

14 guideline MAKING THE MOST OF YOUR ASSETS Preventing late payments In most circumstances an SME will have to produce and deliver goods or services before receiving payment. An effective invoicing system and clear payment terms is key to a healthy cash flow. In addition to the amount payable by the customer, key payment terms should cover: costs; delivery arrangements; payment terms; credit limits; credit periods (which the law will set at 30 days if not specified); the right to charge interest on late payments; and the right to claim compensation for debt recovery costs. A solicitor will be able to offer additional advice on drawing up terms and conditions. Preventing late payment is preferable to the time and effort involved in recovering debts. If recovering a late payment, the business has a statutory right (but no obligation) under the Late Payment of Commercial Debts (Interest) Act 1998 to claim interest on it. In reality, legal action to recover late payment would only be taken as a last resort. Managing your intangible assets You should make sure you keep track of, and protect, your intangible assets. These have real value, especially as your business grows. You should develop a strategy for managing these assets to maximise their value. Having this in place can help demonstrate to a lender that you have thought about the longer-term success of your business, have identified potential ways to maximise revenue and have minimised risks. Your business plan should identify your intangible assets and set out your strategy for managing them. Intangible assets include: Company names and trademarks. A trademark can help build your brand so you stand out in a market, and develop customer loyalty and goodwill. You should consider copyright in the material you produce, for example your website. If you are using other people s material, or getting a third party to develop your website, they will own copyright in that material you should make sure you have the right permissions from them to minimise any risk of disputes arising later. If you develop new technology you may wish to patent this, or alternatively you may wish to keep things within your business confidential as trade secrets. If this is the case, have your staff signed non-disclosure agreements? The Intellectual Property Office can point you to sources of help in this area including the IP Healthcheck under the IP for Business section on its website. OTHER HELP FOR SMEs TECHNOLOGY STRATEGY BOARD SCHEMES The Technology Strategy Board delivers a number of business research and development (R&D) and innovation schemes to support technology-led innovation in SMEs. Smart Previously known as Grant for Research and Development, this scheme offers funding to SMEs to engage in R&D projects from which successful new products, processes and services could emerge. Three types of grant are available: Proof of market up to 25,000 to assess the commercial viability of the project. Proof of concept up to 100,000 to explore the technical feasibility and the commercial potential of a new technology, product or process. Development of prototype up to 250,000 to develop a technologically innovative product, service or process. Pre start-ups, start-ups, and small and medium-sized businesses from all sectors may apply. Innovation Vouchers The Innovation Vouchers programme allows SMEs to obtain help from a range of expert suppliers universities, further education colleges, research and technology organisations, technical consultancies and Catapult centres, design advisers and intellectual property advisers to develop new ideas and potential new commercial products. Small Business Research Initiative SBRI enables government bodies to connect with innovative businesses, finding novel solutions to specific public sector challenges and needs. SBRI uses the power of government procurement to connect, engage and find solutions, supporting projects through the stages 14 SME Finance

15 of feasibility and prototyping which are typically hard to fund. It offers an excellent opportunity for businesses, especially early-stage companies, to develop and demonstrate technology, supported by an intelligent lead customer. Knowledge Transfer Partnerships KTPs enable companies to obtain knowledge, technology or skills which they consider to be of strategic competitive importance to the business, from the further/higher education sector or from a research and technology organisation. The knowledge sought is embedded into the company through a project or projects undertaken by a good quality individual recruited for the purpose to work in the company. EXPORTING UK Export Finance (UKEF) is a government department dedicated to providing support to UK exporters. It works with UK banks to provide exporters with trade finance solutions to help them both win and deliver specific export contracts. Its range of products can provide support to exporters of any size. It has a range of short-term products, particularly aimed at SMEs. UKEF can provide support by: guaranteeing bank loans to overseas buyers to finance the purchase of goods and services from UK exporters; insuring UK exporters against non-payment by their overseas buyers; and sharing credit risks with banks in order to help exporters raise contract bonds, access working capital finance and secure confirmations of letters of credit. Free advice for UK exporters is available through UKEF s network of Export Finance Advisors who work directly with exporters to support companies trying to access trade finance solutions whether they are from the private sector or government. OTHER INNOVATION INITIATIVES SME R&D tax credits Investing in R&D and innovation is critical for many companies so that they can remain competitive and grow by developing new technologies, products and services. The government encourages this by providing tax relief and in some cases payable credit worth the equivalent of up to about 30% of R&D expenditure. Essentially, any company with under 500 employees undertaking R&D seeking an advance in science or technology and which is liable to pay corporation tax can claim and HMRC specialist units provide free advice about how to do this. DIRECTORY Business in You Business in You supports starting and growing businesses by connecting entrepreneurs with organisations that provide information on finance, mentoring, exporting, employment, and other relevant topics. Through sharing the stories of real-life companies, the campaign inspires people to start their own business and helps others to access the essential guidance and support to make them even more successful. Visit GOV.UK This guideline is an updated version of a previous publication produced by Business Link in collaboration with ICAEW. Since the guideline was last published, Business Link has been replaced by a new on-line service, GOV.UK makes it simpler, clearer and faster for businesses to access high quality, detailed and impartial guidance. It s a single website that contains information for the public as well as guidance for specialists and professionals conducting business in the UK. You can get information about: setting up a business; trademarks, copyright and intellectual property; licences and licence applications; corporation tax and capital allowances; running a limited company; business premises and business rates, and more. Find out more at icaew.com/cff 15

16 The Corporate Finance Faculty is the largest network of professionals involved in corporate finance. It includes 6,000 members and more than 60 member organisations. Its membership is drawn from major professional services groups, specialist advisory firms, companies, banks, private equity, venture capital, law firms, brokers, consultants, policymakers and academic experts. More than 40% of the faculty s membership is from beyond ICAEW. The faculty was established by the ICAEW in It is a centre of professional excellence in corporate finance, contributing to many consultations by international organisations, governments, regulators and other professional bodies. The faculty provides a wide range of services, events and media to its members, including its magazine Corporate Financier and its best-practice guidelines. The faculty initiated the development of the first international Corporate Finance qualification (including the CF designation) for practitioners. ICAEW is a professional membership organisation, supporting over 138,000 chartered accountants around the world. Through our technical knowledge, skills and expertise, we provide insight and leadership to the global accountancy and finance profession. Our members provide financial knowledge and guidance based on the highest professional, technical and ethical standards. We develop and support individuals, organisations and communities to help them achieve long-term, sustainable economic value. Because of us, people can do business with confidence. Corporate Finance Faculty ICAEW Chartered Accountants Hall Moorgate Place London EC2R 6EA UK T +44 (0) E cff@icaew.com icaew.com/cff linkedin.com ICAEW Corporate Finance Faculty twitter.com/icaew_corp_fin facebook.com/icaew ICAEW 2012 TECPLN /12