Business Finance Explained

Types of Funding and Finance

In this guide we have outlined the different types of funding available, explaining how each of these works while highlighting their respective advantages and disadvantages.

1. Investment finance

Investment finance (also known as equity finance) involves selling part of your business (‘shares’) to an investor. The investor will take a share of any profits or losses that the company makes.

Sources of ‘equity funding’, include:

‘business angels’ (wealthy individuals who invest in start-up businesses)
‘venture capital’ from companies who invest large sums of money in businesses that they think will grow quickly (known as ‘private equity’ companies)
‘crowdfunding’ (where a large group of people invest money in a business idea, usually via the internet)
alternative sources of funding like ‘peer-to-peer lending’

Any outside investors will own the company jointly with you and the other founders. They have a say in the running of the company and are entitled to get a share of the profits, known as ‘dividends’.

Search for equity funding

Find out about equity funding and venture capital, and search for sources of funding from the:

You can also sign up for the Seed Enterprise Investment Scheme – your investors will get certain tax reliefs, making your company more attractive to investment.

Advantages

Advantages include:

investors can bring new skills and opportunities to the business, eg marketing or exporting overseas
you won’t have to pay any interest, or repay a loan
you share the risks of the business with your investors

Disadvantages

Disadvantages include:

it can be a demanding, expensive and time-consuming process
you’ll own a smaller share of your business (although your share could eventually be worth more money if your business succeeds)
you may have to consult your investors before making certain management decisions
only limited companies can sell shares, so you can’t raise money in this way if you’re a sole trader or in a partnership

You should get legal advice before selling shares in your business. Find a solicitor on the Law Society website.

2. Loans

A loan is credit, usually in the form of cash, that you borrow and repay over an agreed length of time. Banks, community development finance institutions, other businesses and even friends and family can provide businesses with loans.

As well as repaying the amount you’ve borrowed, you normally have to pay interest on a loan. The amount will depend on:

how long you need the loan for
how much you borrow
whether the loan is ‘secured’ – eg if you own your home and agree to transfer ownership to the loan provider if you don’t keep up your payments
other factors, like the Bank of England base rate

The interest rate may be:

fixed, so it won’t change for the length of the loan
variable, so it will change with the Bank of England base rate or the bank’s cost of borrowing

Reasons for getting a loan

Loans are generally suitable for:

paying for assets – eg vehicles or computers
start-up capital
instances where the amount of money you need won’t change

It’s not a good idea to take out a loan for ongoing expenses – you might find it difficult to keep up repayments.

Advantages

Advantages include:

unlike overdrafts, loans are not repayable on demand – this means that you’re guaranteed the money for the whole term (generally 3 to 10 years)
loans can be tied to the lifetime of equipment or other assets you’re borrowing the money to pay for
you won’t have to give the lender a percentage of your profits or a share in your company

Disadvantages

Disadvantages include:

loans aren’t very flexible – eg you may have to pay charges if you repay early
you might struggle to meet monthly payments if your customers don’t pay you
if your loan is secured against your personal property or assets (eg your home) you could lose them if you don’t keep up the payments
the cost of repayments for variable rate loans can change, making it harder to plan your finances

You can appeal if you’re refused a business loan by a bank.

3. Grants

A grant is an amount of money given to an individual or business for a specific project or purpose.

You can apply for a grant from the government, local councils and charities.

You won’t need to pay a grant back, but there’s a lot of competition and they are almost always awarded for a specific purpose or project.

Advantages

Advantages include:

you won’t have to pay a grant back or pay interest on it
you won’t lose any control over your business

Disadvantages

Disadvantages include:

you’ll have to find a grant that suits your specific project, which can be difficult
there’s a lot of competition for grants
you’ll usually be expected to match the funds you’re awarded, eg a grant might cover part of the cost of a project but you’ll have to fund some of it yourself
grants are usually awarded for proposed projects, not ones that have already started
the application process can be time-consuming

To find and apply for government grants, visit the new Find a Grant service.

4. Overdrafts

An overdraft is a credit facility you agree with your bank. It allows you to temporarily spend more than you have in your account to cover short-term financing needs.

It should not be used as a long-term source of finance – if an overdraft is used persistently your bank may question whether you are in financial difficulty.

You’ll need to agree your overdraft limit with your bank. You’ll usually be charged interest on any money you use, and may also have to pay a fee.

Advantages

Advantages include:

it’s flexible – you only borrow what you need at the time, making it cheaper than a loan
it’s quick to arrange
you normally won’t be charged for paying off your overdraft earlier than expected

Disadvantages

Disadvantages include:

there will usually be a charge if you want to extend your overdraft
you could be charged if you go over your overdraft limit
the bank can ask for the money back at any time
you can only get an overdraft from the bank that you hold your business current account with

5. Invoice financing

Invoice financing is where a third party agrees to buy your unpaid invoices for a fee. Invoice financiers can be independent, or part of a bank or financial institution.

Types of Invoice financing:

Factoring

‘Factoring’ – also known as ‘debt factoring’ – usually involves an invoice financier managing your sales ledger and collecting money owed by your customers themselves. This means your customers will know you’re using invoice finance.

When you raise an invoice, the invoice financier will buy the debt owed to you by your customer.
They make a percentage of the cost (usually around 85%) available to you upfront.
They then collect the full amount directly from your customer.
Once they’ve received the money from your customer, they make the remaining balance available to you.
You’ll have to pay them a discount charge (interest) and fees – the amount depends on which invoice financier you use.

Example
You’re owed £40,000 by a customer. You sell the invoice to an invoice financier for £34,000 (85%). They collect £40,000 from your customer and pay you the remaining £6,000 when they receive the money. You pay them interest and any fees you owe.

Invoice discounting

With ‘invoice discounting’, the invoice financier won’t manage your sales ledger or collect debts on your behalf. Instead, they lend you money against your unpaid invoices – this is usually an agreed percentage of their total value. You’ll have to pay them a fee.

As your customers pay their invoices, the money goes to the invoice financier. This reduces the amount you owe, which means you can then borrow more money on invoices from new sales up to the percentage you originally agreed.

You’ll still be responsible for collecting debts if you use invoice discounting, but it can be arranged confidentially so your customers won’t find out.

Advantages

Both kinds of invoice financing can provide a large and quick boost to your cash flow.

Advantages of factoring include:

the invoice financier will look after your sales ledger, freeing up your time to manage your business
they credit check potential customers meaning you are likely to trade with customers that pay on time
they can help you to negotiate better terms with your suppliers

Advantages of invoice discounting include:

it can be arranged confidentially, so your customers won’t know that you’re borrowing against their invoices
it lets you maintain closer relationships with your customers, because you’re still managing their accounts

Disadvantages

Some disadvantages of invoice financing are that:

you’ll lose profit from orders or services that you provide
invoice financiers will usually only buy commercial invoices – if you sell to the public you might not be eligible
it may affect your ability to get other funding, as you won’t have ‘book debts’ available as security

If you use factoring:

your customers may prefer to deal with you directly
it may affect what your customers think of you if the invoice financier deals with them badly

6. Leasing and asset finance

Leasing or renting assets (eg machinery or office equipment) can save you the initial costs of buying them outright.

Advantages

Advantages include:

you’ll have access to a high standard of equipment that you might not have been able to afford otherwise
interest rates on monthly instalments are usually fixed
it’s a less risky alternative to a secured bank loan – if you can’t make payments you’ll lose the asset but not, for example, your home
the leasing company carries the risks if the equipment breaks down
as long as you make regular repayments for the period of the lease, the agreement can’t be cancelled
it’s widely available

Disadvantages

Disadvantages include:

you can’t claim capital allowances on a leased asset if the lease period is less than 5 years (or 7 years in some cases)
it can be more expensive than buying the asset outright
some long-term contracts can be difficult to cancel early
you may have to pay a deposit or make some payments in advance

7. Crowdfunding

Crowdfunding (also known as crowd financing or crowd-sourced capital) involves a number of people each investing, lending or contributing smaller amounts of money to your business or idea. This money will then be pooled to reach your funding target.

Your idea will usually be showcased through a crowdfunding website.

Advantages

Advantages of crowdfunding include:

it provides an alternative to funding from conventional means, eg bank loan
you can raise finance relatively quickly, often without upfront fees
it can raise awareness of your new business

Disadvantages

Disadvantages of crowdfunding include:

your idea could be copied if you haven’t protected it with a patent or copyright
any money you raise will normally be returned to investors or contributors if you don’t reach your funding target