Financing New Businesses
by Mike Brooks

A young business will tend to encounter funding problems at certain key stages of its growth. The following offers a guide to raising enough finance to get through these make-or-break situations intact.

There are two myths that all start-up entrepreneurs believe in implicitly without a moment’s hesitation. The first is that no one should be allowed to repress the natural exuberance of a nascent businessman with his petulant misgivings about the need to find enough finance for what’s clearly the best idea since the Internet – or at least paper clips. The other is that, even if the miserable money men are right, the world is full of far-sighted investors who are simply bursting to thrust their money at the best business idea.

The seriously fortunate starter-up of a business never understands that both beliefs are completely unjustified. Such a person may glide effortlessly from having the idea to overseeing a billion-dollar business without ever facing a shortage of money. But the rest will one day find out that what their mothers told them is true: life isn’t fair.

The typical small business that wants to get bigger will suffer financial crises at regular intervals – possibly from the time it first changes from an idea into a physical reality. As with many business issues, an understanding of what might happen and what solutions are available may help to control the pain.

Right at the beginning, working capital is the bit of the business plan that no one wants to know about apart from the accountants. The common misconception here is that the creditors will automatically finance stock and debtors from the outset. Some potential suppliers will even encourage this false belief to gain your business but then quickly restrict credit once the first orders have been taken and the deliveries start.

The real problem here is knowing the safety margin required. Few entrepreneurs want to delay getting the business up and running while this is being determined. The best way to handle the situation is to win the support of your bank from the beginning. But let’s be honest: bankers are not risk takers, despite what they say. They want all sorts of personal guarantees and other collateral before they will lend you a penny. But it is vitally important to get the bank on-side before you really need it, even if this means paying commitment fees for an overdraft you don’t yet need. If you go back to the bank under pressure, it will charge you more – if it will help you at all.

Banks usually like doing business in formats they already know, so talk to them about trade financing and leasing before you request a corporate overdraft. Once they have done some traditional transactions with a growing business, they will be happier to move into what are, for them, murkier waters.

There are no universal norms for a business’ working capital requirements. What is required depends on the length of its typical transaction cycle. This could be months or even years in manufacturing, or as short as a day in retailing. There are even some business models that can produce a negative working capital requirement. If your business is one of the few that fall into this category, ensure that all those in the transaction chain understand this from the outset – some of them may think they do not have to pay you until they get paid.

A new business often encounters funding problems when it makes its first big investment. For some companies, taking on their first employees represents a major change of scale. For others, this will be represented by the purchase of new machinery or a relocation to bigger premises. The basic principle here is to ensure that the timescale of the financing and the grace period for repayment of the principal and interest matches reasonably closely the timing of the cash flows resulting from owning the asset. If your new employee will generate cash revenues only a few months after joining, then short-term finance such as an overdraft is all that is needed. If the investment will take any longer to generate the cash to service its financing, a corresponding delay should be built into the terms of the financing.

Everyone who has worked in this area has horrendous stories to tell of how this aspect can be mishandled. Since short-term finance is easiest to obtain (and delaying paying trade creditors beyond the agreed credit terms is the quickest – and the riskiest – option of all) it is often the first to be tried. This can lead to repeated and increasingly frantic refinancing at rapidly escalating cost, entailing higher interest charges and arrangement fees.

Even for a business that has moved successfully from the garage to the small rented unit and then to a bigger factory and the first major capital investment, a time will come when an order-of-magnitude change is needed. This could reflect the intrinsic needs of the business – it may have reached a stage where the alternative to serious growth is a stately, but inevitable, decline. Or it could reflect the requirements of the owners – they may be ready to cash in some of their investment or they may hanker after the kudos that comes from running a larger business.

Whatever the reasons, the move to the next stage will be a shock for all involved. Whether this expansion is funded by further debt or, as is more likely, an equity injection, their world will suddenly be populated by financial advisers, lawyers and new shareholders. It is vital that the organisation acquires suitable financial advisers at this stage. Such professionals should be experienced in handling the size of transaction contemplated. You would not get the investment banks to do a five million dollar deal, even if you could afford them.

It will most certainly be essential to prepare a fully worked out business plan, possibly to a level of detail not previously required. As well as the “base case plan”, you will need to write other versions to show the resilience of the business to adverse factors such as higher costs than expected, slower sales growth and reasonably foreseeable business shocks. Such shocks might include restrictions in the availability of raw materials or the sudden loss of a major customer. Potential investors will not be fobbed off easily with bland reassurances here. Many of them will have already invested in businesses where the unthinkable happened.

In all but the smallest equity and loan financings, it will be necessary for the business to prepare an information memorandum (IM). If this contains commercially sensitive information, it is best practice to arrange for the recipient to sign a confidentiality agreement before seeing the document. Copies of the IM should be numbered and a record of who has received a copy should be kept. Where possible, recipients who decide not to proceed should be asked to return the IM and any other restricted data they may have been given.

After the initial distribution of the IM, the management team should expect to spend a lot of time making presentations to potential investors and their advisers. Those involved will need to delegate much of their routine work to other colleagues, and it may be beneficial to recruit interim managers to provide cover. This stage will require both patience and resilience. There will be numerous disappointments and delays, yet each presentation must look and sound as fresh as the first. This is easier to achieve if there is a realistic understanding from the start of how long it will all take. Experienced financial advisers know this, but their warnings often go unheeded – a classic case of a client’s unwillingness to hear the very advice that they have hired the adviser to give.

At the end of this process, the business will have acquired the new financing it needs and a new group of stakeholders. As the sun rises over the skyline of the financial district and the lawyers pop the champagne, the wise but exhausted Finance Director will quietly wonder whether this the end of the beginning or the beginning of the middle – or something else. Only time will tell.

Mike Brooks is a freelance business writer and consultant. This article is contributed by CIMA, The Chartered Institute of Management Accountant.