Businesses require finance for starting up, expanding, investing in equipment, or managing cash flow. The main sources are equity (owner's' capital, shareholders) and debt (loans, bonds, overdrafts). The choice depends on business size, stage, risk profile, and cost of finance.
| Feature | Debt Financing | Equity Financing |
|---|---|---|
| Ownership | No ownership given to lender | Investor gains ownership stake |
| Repayment | Must be repaid with interest | No repayment (permanent capital) |
| Risk | Lender bears default risk | Investor shares business risk |
| Control | Lender has no control (unless secured) | Investors may gain control/voting rights |
| Cost | Interest is tax-deductible | Dividends paid from after-tax profits |
| Security | Often secured against assets | Not secured, but may give rights to assets on winding up |
Gearing is the ratio of debt to equity in a company's capital structure. Higher gearing means more debt relative to equity, which increases financial risk (interest must be paid regardless of profits) but can increase returns for shareholders. Debt financing provides tax relief on interest payments, making debt potentially cheaper than equity.
Banks offer various lending products: TERM LOANS (repaid over fixed period with regular payments), OVERDRAFTS (flexible short-term borrowing up to a limit), INVOICING DISCOUNTING (selling unpaid invoices to bank), ASSET FINANCE (borrowing against business assets), and REVOLVING CREDIT facilities.
Banks typically require SECURITY for business loans. FIXED CHARGE secures against specific assets (property, equipment). FLOATING CHARGE secures against changing assets (stock, receivables, cash). PERSONAL GUARANTEES from directors may be required, especially for small businesses or start-ups with limited trading history.
Many banks require directors to provide personal guarantees for company loans. This makes directors PERSONALLY liable if the company cannot repay. Personal guarantees put directors' personal assets (family home, savings) at risk. Understand the implications before signing - a guarantee is a binding commitment.
Bank loans often have covenants (conditions): maintaining certain financial ratios (current ratio, interest cover), limiting further borrowing, restrictions on dividends/distributions, and providing regular financial information. Breach can trigger default and demand for immediate repayment.
Equity finance comes from: OWNER'S CAPITAL (savings, retained profits), FAMILY AND FRIENDS (informal investment), BUSINESS ANGELS (wealthy individuals investing in early-stage businesses), VENTURE CAPITAL (professional investors in high-growth companies), and PUBLIC MARKETS (issuing shares on stock exchanges).
For established companies, the largest source of finance is often retained profits - profits kept in the business rather than distributed as dividends. This is "internal" equity financing that has no acquisition cost and does not dilute existing shareholders.
Angel investors are typically wealthy individuals who invest their own money in early-stage businesses, often in sectors they understand. They typically invest £10,000-£250,000 in exchange for equity. They often provide mentoring and business expertise as well as capital. The UK Business Angels Association (UKBAA) networks angel investors.
Venture Capital (VC) firms invest in high-growth potential companies in exchange for equity. VC investments are typically £500,000 to £10+ million. VCs often take significant ownership stakes and may require seats on the board. They have investment horizons of 3-7 years and seek high returns (10x+) through exit via sale or IPO.
Equity financing DILUTES existing shareholders' ownership. Issuing new shares to investors reduces the percentage ownership of existing shareholders. Founders need to balance the need for capital against maintaining control. Different share classes (voting vs non-voting preference shares) can help manage this.
Start Up Loans provide government-backed personal loans of £500-£25,000 to start or grow a new business. Available to entrepreneurs aged 18+ who are unable to secure finance from elsewhere. Fixed interest rate (currently 6% per annum) and repayment terms of 1-5 years. Borrowers also receive 12 months of mentoring support.
EFG facilitates lending to viable businesses that lack sufficient security for a loan. The government guarantees 75% of the loan, encouraging lenders to provide finance that they would not otherwise offer. Available for loans from £25,000 to £1.2 million. The business must be viable and have a turnover under £41 million.
EQUITY crowdfunding: investors receive shares in the company. DEBT crowdfunding (P2P lending): investors lend money to the business with interest. DONATION crowdfunding: supporters give money without expectation of return. REWARD crowdfunding: backers receive products or perks.
Equity and debt crowdfunding are regulated by the Financial Conduct Authority (FCA). Platforms must be authorised and investors must receive appropriate risk warnings. Equity crowdfunding can ONLY be offered to sophisticated investors, high-net-worth individuals, or those investing less than 10% of net assets.
Advantages: Access to finance without traditional lenders, marketing benefits through campaign, validation of business idea. Disadvantages: Time-consuming campaign preparation, must hit target or receive nothing, public disclosure of business plans, fees charged by platforms (typically 5-8% of funds raised).
INVOICE DISCOUNTING: selling unpaid invoices to a finance provider, who advances a percentage of the invoice value (usually 80-90%). Customers pay the finance provider directly. FACTORING: similar, but the finance provider collects payments from customers and may provide credit control services. Both improve cash flow.
Invoice finance can be expensive compared to traditional bank loans. Customers will know that you're using a factor/discounter (they pay the finance company), which may affect perception of your business. Ensure you understand the fees and notice periods.
HIRE PURCHASE: pay in instalments, own the asset at the end. LEASING: rent the asset, never own it, return at end. FINANCE LEASE: rent the asset with option to purchase at end. OPERATING LEASE: rent the asset for short term, return it.
Hire Purchase is commonly used for vehicles, equipment, and machinery. The business pays a deposit followed by fixed monthly payments over a set period (typically 1-5 years). The business owns the asset at the end of the contract. VAT is charged on the full purchase price and included in the payments.
Leasing avoids large upfront costs and payments are tax-deductible as revenue expenses. However, leasing is usually more expensive overall than buying outright. LEASE vs BUY decisions should consider: usage period, technological obsolescence risk, tax position, and cash flow requirements.
P2P platforms match businesses needing loans with individual lenders who want to lend money. The platform handles the loan agreement, collections, and credit assessment. Businesses typically pay interest rates of 6-20% depending on risk rating. Lenders diversify their lending across multiple businesses to spread risk.
P2P lending is not covered by FSCS. There's risk that borrowers default and lenders lose money. P2P platforms can themselves become insolvent (as seen with collapses of major platforms). Secondary markets (selling loan parts early) may not be available. Interest received is taxable income.
SEIS offers tax relief to investors who buy shares in qualifying early-stage companies. Investors can claim 50% income tax relief on investments up to £100,000 per year, plus capital gains tax exemption on exits. Companies must be under 2 years old, have fewer than 25 employees, and have gross assets under £200,000.
EIS offers tax relief to investors in growing companies. Investors can claim 30% income tax relief on investments up to £1 million per year, plus capital gains tax exemption on exits. Companies must have fewer than 250 employees and gross assets under £16 million before investment. The company must be carrying on or preparing to carry on a qualifying trade.
SEIS and EIS make it easier to raise equity finance from angel investors because of the tax reliefs. Many angel investors will only invest through SEIS/EIS. The schemes also provide CGT deferral on reinvestment of gains, helping investors recycle their capital.
An IPO is the first sale of shares by a private company to the public. The company issues new shares and existing shareholders may sell some of their holdings. IPOs raise substantial capital but are expensive (fees can be 7% of funds raised), time-consuming, and require extensive disclosure and ongoing compliance with listing rules.
MAIN MARKET: for large, established companies. AIM (Alternative Investment Market): for smaller, growing companies with lighter regulation. Professional Securities Market: for professional investors. Each market has different admission requirements and continuing obligations.
Publicly traded companies must comply with: Continuous Disclosure Obligations (RNS announcements), Market Abuse Regulation, Listing Rules, Corporate Governance Code, and shareholder rights. There are substantial ongoing costs for administration, compliance, and investor relations.
Friends and family may provide LOANS (often interest-free or at favourable rates) or invest as EQUITY partners. Loans may be informal but should be documented with a written agreement to avoid misunderstandings. Equity investment gives ownership stake and may involve family members in the business.
Mixing personal and business relationships can strain or destroy relationships if things go wrong. Be clear about risks and whether the money is a loan or investment. Document arrangements in writing. Consider whether you'd want family involvement in business decisions.
SHORT-TERM CASH FLOW: overdraft, invoice finance, credit cards. LONG-TERM ASSETS: term loans, hire purchase, leasing. STARTUP EQUITY: personal savings, family/friends, angels, SEIS. GROWTH EQUITY: venture capital, private equity, EIS, AIM listing. EXPANSION: bank loans, asset finance, bond markets.
Consider: COST (interest rates, fees, equity dilution), RISK (security required, personal guarantees, loss of control), FLEXIBILITY (can you repay early? are there restrictions?), SPEED (how quickly can you access funds?), IMPACT (effect on credit rating, cash flow, ownership).