Running a small business: Plenty of lenders - at a price

Part six of WADE GLASS and GARETH HOOLE'S 10-part series on how to start a business. Where to get finance?


We have seen that when all likely contingencies have been anticipated, the need for capital is likely to be greater than the available resources.

This means that you will probably have to seek external sources of finance and today we examine some of the possibilities available to you.

Where do you go to finance your business? The most obvious answer is to a bank and in New Zealand the entrepreneur has an abundance of banking products to choose from.

But banks have rules and lending criteria that need to be satisfied before they will make an advance.

They also have a curious desire to be repaid and thus the aspiring entrepreneur must demonstrate an ability to service the debt to the bank's satisfaction and to provide satisfactory security so the bank will get its money in the event of a default.

Banks also impose covenants on borrowers, terms and conditions within which they must manage the loan facility.

Many second-tier financiers and leasing companies offer alternatives, as well as factoring houses and specialist trade financiers.

The market is small, venture capital funds accessible to start-up businesses are limited and one should not overlook the availability of government grants.

The cardinal rule is to choose the most suitable form of finance for your needs, matching the life of the assets financed to the finance provided.

Never finance long-term assets using short-term finance and vice-versa. For instance, it makes little sense for a courier operator to buy a motor vehicle using a credit card that carries an interest rate nearing 20 per cent when tailored vehicle finance is available at around half the cost.

The cash generated by any asset should be used to repay any loans advanced to fund that particular asset. The cashflow derived from the courier vehicle over standard credit card repayment terms of 50 days will be insufficient to cover the principal and interest payments on the loan.

Longer-term vehicle finance enables the courier driver to more closely match the repayments on the vehicle to the useful life of the vehicle - several years.

The different forms of finance represent different costs and much depends on the financier's perception of the borrower's risk profile.

Clearly, if you represent a risky proposition you are likely to be charged more for the money.

The primary assessment of risk profile is the ability of the borrower to service the debt. If the business demonstrates a strong ability to generate a positive cash flow, the lender will be more comfortable and will be able to charge a lower rate of interest.

Another determinant of risk to the lender is the quality and quantity of security offered by the borrower. A financier always wants two questions answered by the applicant:

* How will you repay me?

* If you are not able to service the debt, how do I recover my money?

It is seldom that a business loan will be advanced without security.

This could take the form of a charge over the business undertaking such as a debenture, or a charge over the proprietor's house, a personal guarantee, or a security instrument registered over a specific asset.

Usually it will take the form of a combination of security arrangements.

We recently assisted two new businesses to become capitalised. In both cases, the shareholders had limited resources and significant bank borrowings were necessary.

In the first case, the bank we approached was satisfied with the ability of the business to service the loan from future cash flows and was content to seek security only in the form of a debenture over the business. This is known as cash flow lending and is not very common.

In the other case, the same bank required that a debenture be granted, but also took a mortgage security over property owned by the shareholders and personal guarantees were signed by them too.

Legislation was introduced recently that re-defines the way security may be taken by the providers of credit facilities.

The Personal Property Securities Act impacts on anyone who buys or sells goods on credit, and the entrepreneur venturing into the business world will need to gain a working knowledge of how this law will affect them.

Debt finance applied to a business purpose will incur interest, which may be tax deductible. When borrowing a proportion of the capital requirements of the business, you must take account of what is known as "gearing" or "leverage".

By way of illustration, if a loan is raised by a company at an interest cost of 15 per cent a year and it is applied entirely to a business purpose, subject to normal tax deductibility criteria, the after-tax cost of the borrowings will be 10.05 per cent

Capital committed as share capital or proprietor funds may not qualify for a tax deduction, without tax planning at the outset. It makes sense to utilise gearing in deriving the optimal capital structure for your business and makes equal sense to seek specialist tax planning advice to make sure that you are meeting all legal compliance obligations while utilising the tax laws to their maximum potential.

The Ministry of Economic Development provides a number of grants for businesses, some of which are available to start-up ventures, under a number of different criteria and conditions.

Some of them are out-and-out gifts to the successful applicant and, although they will typically not be enough to meet the capital requirements of the business, they can be a useful leg-up.

Ask the ministry or visit www.med.govt.nz for more information. Another useful website is www.technz.co.nz.

The most logical starting point in your search for debt finance is banks, which have a number of innovative products. Some might even lend on the strength of future cash flows.

You need to impress the loans officer with a concise explanation of why the loan is required and how the money will be used.

Your application must be supported with enough financial data to satisfy the bank's credit committee that your business can service the facility sought and that there is adequate security to ensure that the bank will not be exposed to potential loss through a default.

Your detailed business plan, including a concise financial model, will go a long way to providing the bank manager with the information needed to support a loan application.

Unfortunately, start-up businesses might not always meet the banks' criteria, making it necessary to seek the money somewhere else.

If you need finance to buy stock, a bank loan might not necessarily be the best fit anyway and a better deal could be found with a trade financier.

Venture capital can also be sought. There are a few specialist venture capital funds in New Zealand and many more across the Tasman and further afield.

But remember that a venture capitalist might price its capital at the upper end of your pricing tolerance and might seek an equity stake in your business, with the intention of moving to a majority stake.

While this might not seem important at the time you need the capital, it can become very expensive in the future, as well as removing control of the business from you.

Whatever the capital needs of your new venture do not make the mistake of under-capitalising and be sure that you raise the appropriate form of capital or you could find that you paid too much for it.

* In our next article we examine the importance of legal compliance and tread into the minefield known as human resources.

* Wade Glass (assistant manager) and Gareth Hoole (associate director) are chartered accountants in the Corporate Recovery Services unit of Staples Rodway, Auckland. The views expressed are their own and not necessarily those of Staples Rodway.