Major Sources of Finance and Funding for SMEs

Funding the Backbone of Economies: Advantages and Disadvantages of SME Finance Sources

Introduction
Small and medium enterprises (SMEs) are the backbone of all economies and account for a key pillar of economic growth, dynamism and flexibility in advanced industrialised economies and an essential engine of growth in emerging and developing economies. SMEs have the largest number of any form of business organisation, making up over 95% of enterprises (in some countries the figure is as high as 99%) (OECD 2006). But not every small business will grow into a multinational and they all have one problem in common when they are starting out – where are they going to get the money to allow them to get off the ground and build up the business and to test their product or service. In this essay we will be exploring the main sources of finance for SMEs and start ups, we will also be discussing the pros and cons of these various sources. I will also be referring to lectures points, seminars with different enterprise and others in ascertain these sources and their pros and cons. In this current time of recession, funds are hard to come by. All though there are various ways in which money could be generated and they all have their own advantages and disadvantages. The cost of borrowing and how long the money will be needed and what the money is for and ultimately if the firm can repay will determine what form of finance will be the cheapest. Burns (2007)
Balance equity and debt and ensure the source of finance is appropriate; this is the crucial factor in determining the source of finance for SMEs. Debt and equity (money borrowed) deals differ in that financial institutions require payment of interest and capital repayments, whereas debt is secured against a business assets or the owners personal properties. Sources of finance for start-ups and SMEs can be internal (personal savings, family and friends) or external (trade credit, venture capitals, business angle, hiring and leasing, bank loans, Factoring and invoice discounting, grant, bank overdraft).

Internal sources:
The most common source for most SMEs, to start with probably an owner using his/her savings to start up the business and when later in the business others may be willing to help you out such as in the case shown in class of Amazon where his parents and friends at some point helped also is the same for most of the entrepreneur brought on in the seminar. Also, friends and family should know the reasons behind any funding since some may give to get a share of the business which may be implicit, a written agreement would be better to specifically state the basis behind any funding. One positive aspect of this is that it indicates that the owner has at least some skin in the game, and if done right this could also potentially make it easier to raise funds from 3rd parties. You need to be able to do much more with little money invested, without having to assume that there is a high probability that your business plan failed.

External sources:
Grants Grants can be in the form of money and are often available at councils, local authorities and through other Government agencies for specific reasons. For instance the government or council might have plans for revitalising a particular sector or region. Or there is some institutions that maintain entrepreneur to lunch new business. The downsides of this route is that such grants tend to be very competitive some businesses are considered more important than others and it is very hard to find individual or organization will to dispense fund for small business. The positive side is that most grants are interest-free and do not need to be repaid.
Bank Overdraft: An overdraft is the agreed amounts which a custome can draw over the limit of his current account. Bank overdraft is a better source of short-term finance to support a business with seasonal lack of funds which does not require long-term solution. These charges depend on the various data types and the current bank rate. The good thing with the overdraft is that it is always available when needed and costs nothing (if small fees are charged) it helps to keep a good cash flow. And it is faster and easier to set-up than a loan. Overdraft disadvantages. The once-escalating rate for an overdraft can be high, particularly for small companies, as the risk to the lender that they will lose money is higher for small firms. Moreover, the enterprise is not permitted to surpass their overdraft limit. If they do, the bank may decline to honour cheques to creditors and could slap the firm with an expensive fee for going overdrawn. Overdraft facilities can be re-negotiated but if this is attempted too many times then it can indicate to the bank that a business has lost control over its finances.

Venture capitals (VCs): It is also referred to as private equity financing. This type of source is frequently at a pre-seed stage (or post seed if you are talking the type of VCs) when a new company is being created, the risk of failing is high, but so are the potential returns. Everything regarding a venture capital deal is, around about £500,000 to £10 million, or there or thereabouts. Business angels are virtually always first round investors in a startup followed by Venture Capital. Venture capitalists invest millions of dollars to get a percentage of the firm’s equity and also expect a healthy return on their investment. Venture capitalists in most cases are firm or stand for a parent firm. The advantages of getting a VC are they give you large sum of finance and the significant expertise, contacts and experiences they have acquire while running other businesses. In addition, attracting a first venture partner can make it relatively easier to raise subsequent funding from others. Well-known examples of this are the Dragon’s Den. The downside getting a deal with a venture capitalist can be long and arduous process. It will be necessary to create a comprehensive plan, and financial projections, both of which will likely require paid help, whether from professionals or friends with similar knowledge; these possible legal requirements will need to be paid for before even reaching the negotiation stage, and all of these services will need to be paid for, regardless of whether or not the fund was secured. Also on the contrary, VCs tend to meddle with the business or take charge of it.

Business Angels: They are also referred to as angle investor, these are wealthy individuals invest it a potential high growth businesses in exchange for a stake in the ownership of the business. They are usually involved in a venture in the early stages of business. Some angels will do it as an individual, and others will do it as part of a group, or a syndicate. BAs frequently offer their own skills, experience and contacts to the organization. Typically, BAs invest between £10,000 and £750,000 in businesses on an individual basis and up to £1,000,000 or above when common. BAs have the advantage to not needing a complex assessment to take a quick investment decision. (strategically when it is relevant to then or a focus of interest in their world) But it is going to take a professional polished business plan to be noticed. As time goes, most BAs bring to the table the experience, skill, time, and contacts they have build up. The majority of BAs are very dedicated and will try to do whatever they can to succeed together with the business.
The disadvantages of BAs include the fact that they are hard to come by and invest infrequently, the entrepreneur will spend more time with the BAs more than with the business dishing information, the entrepreneur may lose some control over the business, and finally locating the right investors may pose a challenge as there is a tendency for the BAs to want to control the business, thereby becoming the “devil.” British Business Angels Association (BBAA) can help you identify BA networks and assist you with the preparation and presentation of a business proposal.
Invoice discounting and invoice factoring: A company outsources its invoicing activities to a third party. It releases funds to the business, based on the values of the outstanding invoices, within few days. Then process It starts by the company selling to customers, then raising an invoice to customers, then sending a copy of the invoice to the factoring firm for where the necessary negotiations and investigations is done on the customer and an agreed percentage is paid to the company usually ranging between 70-80% of the invoice amount by the factoring companies usually within 24 hours. However, this comes with a cost such as settlement charges, interest, credit protection charges and many more, although one major advantage of this source of finance is that it is readily available and can be diverted to another area within the business, also with many factoring companies in the market the prices will also remain competitive, this ease the financial planning and cash flow process as well at the end it would be a useful and an economical means of sub contracting that aspect of the business because it reduces the time spent in chasing the payment. It is also a chance to understand the credit standing of your customers, which will allow negotiating better terms with your dealers and customers. The down side is, in addition to a reduction in the profit margin, the charges can also limit the way business is done, because the factoring company may want to vet your consumers before lending them money. It might limit the amount they borrow because the invoice is not being used as collateral, and the customer may prefer to deal directly with their suppliers. Pending in case of customer default, in the event that the business has to pay, and also could all charged fee.

Trade credit: some companies rely on a product sold to other companies (suppliers) to operate their business. An example is trade credit where a supplier offers his product to a customer on credit hoping to be paid at a later date. For example, most trade creditors give a period of 30 days or more before payment is required, which can enable the business to use these funds in the short term to help pay for other things. That being said, this should be done carefully as to not offend the supplier and jeopardize the future business working relationship. Benefits Of Trade credit- Setting up a trade credit will have less the amount to spend in starting up a business, this can be very useful to boarder to those who have small capital in setting up a business, as well as the option to buy now and pay later, the business can buy the which it can sell at a profit before payment are fulfilled. This enables the business to concentrate on other aspects of the business such as marketing etc instead of stressing over how to pay their supplier. It also allows for better cash flow and seamless running of the business. The case of QPC discussed in the seminar is an example of all these. Trade credit can be a two-edged sword, as if the business defaults on the due date it can affect their credit history negatively limiting the business’ possibility to access fundings through other means. It can also be pretty hard to obtain trade credit as they are only given to business with a good history of credit and that can be hard to establish as a new company.

Hire Purchase and Leasing — Hire purchase and leasing enables a company to acquire an asset without paying the full-price. Once delivered, the business has the option to purchase the equipment at a lower cost or return it after a set period of time. This method is mainly utilized for the purchase of heavy machinery. Nevertheless, it frees up some working capital that can use elsewhere in the business. In a lease, the business is paying to use but does not own an equipment or machinery. An equipment/machinery lease agreement might pay in the region of £250+ per month over 3-4 years. At the time of the years, the equipment or machinery is given back to the proprietor. Benefits of leasing equipment include, being able to have and use an asset without paying the full cost upfront so funds can be used for something else. it provides the business with access to modern standard of equipments, otherwise it may be too expensive to purchase outright outflows are distributed over a longer period of time., Severe leases is simply great leases for business that carry out small ventures or require equipment for a brief timeframe as they don not have to buy such types of gear out-rightly. The rent is based on the fixed period of time for which the equipment will be used and as a result, fixed monthly rental costs help the business budget for the future, forecast cash flow, and plan effectively. It also lowers the cost of maintenance since the leasing company will handle it and assumes the risk of the equipment in case of a breakdown. You can claim capital allowance on the equipment. At a discount price, the asset can be purchased. Disadvantages of leasing equipment: it may be more costly than buying the assets outright, it may not be possible to claim capital allowances on lease equipment less than five years in some cases six to seven years. And business can be squeezed into inelastic medium or long-term contracts that could prove challenging to unwind. However, that space became the Adrian Lauchlan where he obtained a big warehouse then it finds that the area is too big but it cannot break the contract for the duration of time. They are usually very complex to be manage and adds up to the management operation, businesses have to be VAT-registered in order to go for a leasing contract, after paying monthly, the asset is not owned but leased.

Bank loan: Depending on the security and business a few thousand to hundred thousands of pounds A loan refers to an amount of money borrowed for a specific period of time with the intention of paying interest on its original amount until a predetermined date. It will depend on the size, length of the loan & the rate of interest. Loan terms and conditions are provider-specific, and they are often subject to negotiation. The terms of the loans can be between 1 and 10 years, but some will stretch to 20 years, as well as each lender has multiple loan packages available for different kinds of business needs. High-risk businesses are less likely to be able to borrow, and if they do, they will pay a higher interest rate. This allows the bank to protect themselves in case the risk does not yield returns. Pros of loans: Where loans are concerned, banks are a dependable source of cash; the funds are secured for the duration of the agreement usually between three and ten years – provided no terms of the loan are broken. If the loan is for the purchase of equipment, it can be tied to the life of the equipment or other assets for what you’re borrowing the money for. Unlike the case of an investor, loans do not involve forgoing a portion of ownership in the firm instead, you must pay the cost in the form of interest. Some kinds of loans have fixed interest rates, so they are simple to calculate. Disadvantages of loan: Once the payment date is fixed most of loan are inflexible that’s loan has strict terms & conditions that customer might face hard time to pay in monthly basis when done pay on time which causes cash flow problem. Most loans require security to be provided against the business owner’s property or the asset of the business, but such properties will be on the line if the business is unable to repay the loan. Adrian Lauchlan was about to lose his house because of low cash flow. If paid before the end of that agreed period, businesses face penalties. This means interest will be charged on the unused portion in case there are borrowed funds which are more than what is required and interest will be paid on funds that are not applied. Without more security the bank will not be prepared to lend more.

In conclusion, the essay discussed some type of the major sources of finance and also discusses their advantages and the disadvantages of this different types of sources, the firms must note what antics in deciding to choose their choice in selecting the most appropriate sources of finance in which they all suit them according to the social conditions of their firms and the type of business undertakings they carry out.

References
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Most of the material is prepared to provide advice on raising business angel funding.
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