Undoubtedly one of the main reasons businesses fail is that they are under-capitalised, that is, there is not enough capital invested in the business to survive, when things go bad.
Lack of capital often arises when you may have borrowed too much money to start the business so that if, or, more likely, when things slow down or you fail to reach your sales targets, the monthly payments to the bank become harder and harder to make. This situation can lead to the downward spiral that inevitably results in the business failing.
Under-capitalisation can also occur if inexperienced owners, buoyed by the fact their business is doing well, increase their borrowings for non-productive assets such as expensive cars or holiday homes or simply extract funds from the business in order to maintain and fund their extravagant life styles. Unfortunately, far too many examples of this have been seen in recent times across the globe.
How can the Banks allow this to happen over and over? Well, the banks have never understood the nature of SMEs. However, when the times were good they are happy to keep lending them money against their properties and encouraging them to buy new cars and other such things regularly.
But as an owner of a business, you must realise that borrowing money is easy; paying it back is not.
Debt funding, if used effectively, has an important role to play in business. All good businesses need a mix of loans (debt) and the owner’s own capital. Funding your business by creating a debt (that is, taking out a loan) will help to increase your profits and, if the debt funding is structured carefully will help you to fast track the expansion of your business.
The thing to be careful about is finding the right balance between debt funding and your own capital.
Some key points to note are:
- Always match the type of finance with the asset you need to purchase; for example, do not use your overdraft to fund purchases of capital equipment, because overdraft rates are too expensive for this type of purchase.
- Monitor your overdraft level regularly. Restructure your ‘hard core’ overdraft into a long-term facility, doing this will save you interest.
- Arrange a line of credit for unexpected emergencies.
- Don’t carry a high overdraft limit all the time, because you will end up using it.
- Have a debt-reduction plan in place. Imagine how much extra money you would have if you paid all your loans off!
- Don’t fall into the trap of thinking “I have worked very hard, and now I deserve a new BMW” – or worse, a Porsche! Non-productive assets can put pressure on cash flow in slow times, jeopardising your business.
- Don’t rely on the banks to tell you whether you have the capacity to repay the loans. You know your business best, so work it out yourself.
- Always have a ‘worst-case scenario’ prepared. How would you get out of the situation if the need arose?
Venture Capital
Apart from the vanilla variety of funding that is ‘debt’ (borrowing from the bank), it is also possible to raise equity by selling a share of your business to another party, either a partner or perhaps a venture capitalist.
The venture capital industry in the Region has grown in recent years and funds are now much more easily accessible than in the past. Venture capitalists are usually more interested in rapidly growing businesses that have reached a reasonable size than in little mum-and-dad businesses.
But make no mistake – these investors are not fairy godmothers or angels wanting to make your wishes come true. They are hard-nosed business people who are only interested in one thing –money! How much money will they make out of the deal? Does your business have the potential and the capability to reach the next level? Unlike the debt funds (loans) provided by the banks, venture capitalists do not charge you interest on their investment; instead they require a share of the profits (dividends) and a capital gain on the way out.
They are also concerned about their exit strategy – how will they get out? Venture capital providers receive hundreds of business plans and proposals each year, they know exactly what they are looking for.
Venture capital providers will often require a seat on the board and will want to have a say in your management – as a business owner, you may find this difficult to accept if you have not prepared yourself for this level of intervention.
There are other options too.
Partnerships
If the business is small enough a simpler option could be to seek an equity partner, either active or passive. Such a partner could, for instance, be another person like yourself who wants to start a business, but rather than set up a new business they want to invest in an established one with a healthy track record of profits and sales.
For the smaller business, there are also business angels (passive investors) who are often keen to invest on a smaller scale in mum-and-dad-type businesses. These investors are often retired business people with a keen desire to invest in growing businesses.
Having described the types of partners you could invite into your business, I now need to add that my simple rule for partnerships is to avoid them if at all possible. If there is no alternative, make sure all agreements are well documented, including roles and responsibilities, financial obligations and exit clauses.
At the end of the day it comes down to you to manage your business’s finances carefully and conservatively. My suggestion is to tread with caution when it comes to borrowing money. Things don’t always go to plan in your own business, so always have funds in reserve – put a little aside for a rainy day.
Amer q's Blog 