Where do shares that are being issued come from?

Answer 1

What Are The Sources Of Business Cash?

For any business there are essentially two sources of finance: money generated within the business itself, and money introduced into the business from outside.

How a business can be run so as to generate the maximum amounts of cash internally and use this as efficiently as possible (bootstrapping) has already been largely covered in the previous chapters where it can be seen that this is a matter of the following.

• Squeezing money out of working capital (or to look at it another way, making whatever cash you do have go as far as possible in funding trading) by actively managing both to: minimise the investment in current assets (stock and debtors); andmaximise the finance available from its normal sources of trade credit
• where a technique such as consignment stocking in effect helps both sides of the equation.
• Retaining as much as possible of the profits from trading in the business, which is a matter of restricting the dividends paid out to shareholders (dividend policy) or cash drawn by the partners or owner.

The range of sources of external finance will be covered in detail in section B and divides into three broad categories.

Debt

• This is money that has been lent to a business by a creditor. Debt can be:
• Institutional, by which I mean formal lending by a financial institution set up to advance funds as a business such as banks, building societies, venture capital firms (in respect of some parts of their investments) and a range of businesses known as Asset Based Lenders (ABLs). These institutions offer a range of financing services such as overdrafts, mortgages, leasing, hire purchase, sale and leaseback, trade finance, factoring and invoice discounting.
• Non-institutional, by which I mean both: loans in the normal sense such as directors' loans into the business;credit provided normally in relation to a transaction or series of transactions by a third party, which is the equivalent to a loan. Examples of these would include trade credit, sums due to the Crown by way of VAT or PAYE/NI and vendor finance where the seller of a business allows the buyer time to pay for some or all of the purchase price over a period of time.

GrantsGrants are defined by the DTI as a 'sum of money given to individual or business for a specific project or purpose', where as long as you keep to any conditions attached to the grant you will not have to repay it as you would with a loan, nor will you have to give up any shares in your business, as you would with an equity investor.

Within grants I would include soft loans which are loans (a form of debt) but on favourable or discounted terms.

EquityEquity is money or other assets put into a business by investors in return for their share of the profits of the business after the creditors have been paid.

At its simplest this is the personal capital put into or retained in a business by its proprietor or partners or the investment in shares and retained earnings by its shareholders.

However, it can become more complex: for example, where a business has acquired an investment from a third party such as another individual investor like a business angel, or an institution such as a venture capitalist, or from the public and/or institutions by way of a listing on a stock exchange.These situations may lead to different classes of shares being issued with differing rights to:

• control the company's affairs by voting;
• receive payments where some shares may be preference shares which have a fixed rate of dividend (akin to a rate of interest on debt) and have to be paid in priority to the ordinary shares; and even;
• convert into other types of shares or be repaid under certain conditions.

How Do You Go About Raising Cash?Raising external cash from any investor or institutional lender will involve a process, the starting point for which is a business plan.

There are many good books on business planning available (see www.howtobooks.co.UK ) but essentially any business plan needs to cover:

• What you are going to do.
• How you are going to do it.
• Why you think you will be successful.
• Why you will need cash, how much you need and how long for (this is your cashflow forecast which you should first put together ignoring sources of finance. Then having established the funding requirement, you should decide what the most appropriate package of funding may be and work this in.)
• Why it is a good idea for them to provide the cash you are looking for, which is essentially a matter of: the risks involved (and what you are doing to manage these); versusthe return they will get.

You also need to understand the lender's or potential investor's perspective and what they are looking for in any proposal.

Of course each lender or investor will have their own financial criteria on which to assess a proposal, but over and above this most will also have a wider ranging set of sometimes informal criteria which any proposal has to meet.

A good starting point is an old banker's acronym, CAMPARI (Character, Ability, Means, Purpose, Amount, Repayment, Insurance), capturing seven key criteria as listed below. This is one of a number of traditional checklists that bankers have for assessing any proposal (another version is known as the 7Ss but covers much the same ground). In my view any investment proposal will need to cover the points raised to the satisfaction of almost any external lender or investor.

CharacterNo one knowingly gives their money to a crook or a fool if they want to get it back (with a return).

• Will the investor or lender see you as honest? Will they trust your integrity and reliability, or have you any financial skeletons in the closet or made exaggerated claims in the past?
• Will they have confidence that you will keep them informed as to progress?
• Do they feel that you are someone they can work with over a medium to long-term period?

A track record of previous financial problems such as County Court Judgements, mortgage arrears or even insolvency proceedings (collectively known as adverse) is not necessarily a bar to obtaining funding. But it does tend to make it more expensive, as lenders and investors will want to build in an extra return required in light of the apparent extra risk involved in so called sub prime or non-status lending.

A track record of dishonesty can make raising finance extremely difficult, if not impossible, but even here I can think of a small number of ex-criminals who have gone on to run successful businesses which will have required financing.

AbilityHowever good your proposal, the lender or investor has to be confident that you can make it happen.

• Do you and your management team clearly have the necessary skills and ability to run the business? Do you have a successful track record in this type of business?
• Can they have confidence in your ability to manage your finances? Do you seem to be in control of your business (and its numbers)?
• Will you be prepared get in help as and when you need it?

From a financial management point of view the more that you can demonstrate that you have future proofed your business by having and using good management information including forecasts, so that you can have finance in place before you need it, the better. No funder likes surprises. If you can foresee a requirement for cash coming then you have the time and information with which to speak to your funders about how to cover it.

The alternative is that you blunder into a cash crisis and end up writing cheques that take you over your agreed limit, which leaves the bank with the decision whether to meet the payment or to return it, something they dislike doing. One banker described this situation to me as application for overdraft by way of cheque, and it was the equivalent of the owners raising a red flag over their business saying I am not in control of my finances.

MeansHow much are you worth (both as a guide to your past money making performance and your ability to provide cash to cover any short-term problems)? PurposeYou don't just go to the time, trouble and expense of raising or borrowing money for the sake of it. You do it because you have a plan.

• What is the plan and what are you intending to do with the money?
• How confident can the funder be that your plan is going to work? Is it a feasible idea, that appropriately matches funding against the need?
• Is the idea something that the lender feels is acceptable, given its own policies as a funder may not be able to become involved if the proposal conflicts with its own internal policies on: ethics (as the funder may not be able to finance certain activities); sector strategy (as the funder may wish to avoid certain sectors due to previous poor experiences or an assessment that they are overly risky); geography (for example some building societies only wish to lend locally, as do most business angel investors, see Chapter 12, who wish to invest in businesses within easy reach); concentration (where the funder already has significant exposure to a particular sector and wants to keep its risk spread across other sectors); orcompetition (where the proposed activity is in some ways potentially in competition with some of the funder's other interests).

AmountThis really covers two areas.

• How much are you putting in compared with the risk you are asking the lender or other investors to take?
• Are you asking for enough to properly see the project through to completion?

Your plan therefore has to set out clearly what commitment you are making to the project, together with a clear picture of the further support you need (how much, how long, how it is to be paid back).

Repayment/ReturnJust as you do not go to the trouble of raising cash unless you have a plan that requires it, lenders and investors do not take the trouble and risk putting money into a plan unless they can see what and how they are going to:

• get their money back; and
• earn out of it by way of a reward for the risk taken.

As discussed above, your plan should already show how long you will need the money for and how is it to be repaid. But it also needs to show what interest a lender is going to earn, or return an investor is going to make on their money if they provide it.

The funder's job will then be to assess what risk your plan calls for them to take and whether the reward offered is commensurate with this.

Banks will typically have a matrix which gives the manager an interest charge that needs to be obtained for a given level of risk assessed as being taken by the bank.

Many investors will work on the basis of calculating the value today of the cash they expect to earn on the investment from dividends, repayments and growth in value of their shares over the period of the investment. This is done by applying an annual discount to the future streams of cash on the principle that £1 received today is worth more than £1 in a year's time, which in turn is worth more than £1 in two years' time and so on (see Chapter 11 for more details).

By applying this sort of approach to arrive at a discounted cashflow the investor can then calculate what this equates to as a rate of return on the proposed investment (known as the internal rate of return or IRR). They can then judge whether this provides a sufficiently high return for the risk involved.

InsuranceThis means insurance for the lender in a somewhat colloquial sense: what assurance is there that they will get their money back? In practice for institutional lenders this translates into what sort of security is available to enable the loan to be repaid if the business is not able to make the instalments from:

• selling off the business assets;
• you, by way of calling on a personal guarantee that you have given (PG) which may also be backed up by a charge over your personal assets outside the business (a Supported PG);
• or the Small Firms Loan Guarantee Scheme (see Chapter 7).

Additionally, many lenders and investors will need you to take out insurance cover (eg key man life cover) as part of their insurance that their money is safe.

What Are The Issues To Be Aware Of?When thinking about the sources of finance for your business there are a number of issues that you will need to take into account. AppropriatenessThe need to match the type of funding (long- or short-term) to the underlying requirement has already been discussed at length. Gearing And Financial RiskThe advantages in increasing the shareholders' rate of return and reducing the requirement for the owners to put up their own cash to finance the business through using borrowed funds, has to be balanced against the increased financial risk of default borne by the business. Scalability And FlexibilityBear in mind that your finance does not simply need to support your business today, but into the future too, so ensure that your financing arrangements are flexible enough to be able to support your future plans and prospects, so that for example growth does not expose you to the risks of overtrading, or you are able to reduce your exposure if required. Reliability And Attitude To RiskEnsure that you understand to what extent you can rely on your sources of funding. Are your funders in with you for the long-term or short? What is their attitude to risk? Are they likely to support you through bad times as well as good and if not, what should you be doing about this? CertaintyHow certain is it that the finance being discussed will actually be made available in the agreed form by the investor or lender? Until you have actually signed the documentation and drawn down the funds there is always an element of uncertainty. You might be amazed by how many financing deals actually fall apart at the last minute. Speed Of FundingAll finance raising exercises will take some time as a lender or investor will have a process they will wish to go through to assess the proposal before handing over any cash. This can range from a few days for a commercial bridging loan to three or four months for a venture capital investment. So you need to be looking forward to see what your requirements will be and to put applications in motion, allowing sufficient time for these to be completed before the need arrives. Costs Of FundingHow much is your finance going to cost you?

• Financially, in terms of the cost of raising funds in the first place such as valuation fees, accountant's costs, and in ongoing payments such as charges and interest cost or a share in the eventual value of your business for an equity investor.
• In time, both to raise finance and to manage external providers after they have come on board.
• In control, with: bankers requiring copies of regular management accounts and forecasts; ora business angel taking an active role in the management; ora venture capitalist appointing an independent director to keep an eye on their investment and driving the timing of an eventual sale of the business to give them their exit; ora stock exchange requiring regular trading announcements and compliance with the appropriate levels of corporate governance for a publicly quoted company.

Tax EfficiencyGenerally speaking, interest is recognised as an expense of the business and is therefore deductible from profits before calculating tax. Dividends or drawings are payments to the owners of the profits made and are not tax deductible expenses of the business.

However, there has been a recent development where the HM Revenue & Customs has noticed that many venture capital investments were making a large part of the investment by way of debt (carrying tax deductible interest) rather than shares (requiring dividend payments from after tax profits). The Revenue has argued that this was an abuse of the rules and has therefore introduced a rule that where debt is provided by the main funder of a business, then the interest may not be tax deducible. The problem with this is that the rules at the time of writing seem quite unclear, for example if most of your funding comes from a bank overdraft, does this mean they are your main funder and therefore the interest is not tax deductible?

The practical position seems to be that for most purposes interest will continue to be deductible, but if you are contemplating obtaining an investment from a venture capitalist which may come as both debt and equity you will need to take appropriate tax advice.

On the other side of the coin, there are various schemes designed to encourage investment in small and medium-sized businesses such as the Enterprise Investment Scheme (EIS, see Chapter 12). So if you are seeking investors you can seek to structure the funding required to make it as tax efficient for both sides as possible.

CommunicationFinally you will need to be thinking about how you can go about maintaining the confidence of your lenders or investors. Most institutional lenders or investors will have highly developed early warning systems to spot borrowers or investments that look as though they may be getting into difficulty (after all it is their job to protect their investments or loans). They will be very alive to risk and have an internal credit scoring process with which to assess their portfolio of borrowers or investments, which will then impact on:

• the margins they will look to earn from you given the level of risk they perceive they are taking; and
• their attitude towards providing further support if requested.

Having seen some of these matrixes, some of the factors that are used to flag up risk can be very sensitive and are things that the business itself may well not notice or consider particularly important. But you must appreciate that it takes lenders many, many successful accounts earning a few per cent interest over base rate to cover a bad debt that they suffer from a business that goes down. So they will move to starting to try to exit from a relationship far sooner than most businesses ever realise.

So you will need to expend time and effort in communicating with your suppliers of outside cash, be they bankers or venture capitalists. In short you will need to manage your bank manager.

Debt Or Equity Source?As will be covered in detail in Section B, the question of whether your business's cash requirements can be met by borrowing, and if so from which source, or whether you require an equity investment, will generally come down to the question of the available security. Whilst it is a bit crude, the flowchart in Figure 5 provides a rough and ready guide to the likely answer to this question.

Fig. 5.

Flowchart for debt v equity source.

Having covered the key issues the next section will look in more detail at the three broad streams of external finance available:

• debt (which will include some quasi debt sources of funding);
• grants;
• equity.

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