In this series we have focussed on how to go about raising funds from banks, primarily in the form of overdrafts and loans. Whilst these are the most common sources of finance for the majority of companies, there are a wide variety of alternative sources of finance that are available, some or all of which may be appropriate for individual companies. The purpose of this article is to give an introduction to the wide range of alternative funding available to companies, which should illustrate the potential benefits from looking beyond the relationship bank to arrange finance.

When arranging finance for particular projects it is often both possible and desirable to raise that finance through the main relationship bank, either in the form of a loan or an overdraft. However, by clearly defining the purpose of raising finance, it can be possible to arrange the funding in a more appropriate, and cheaper, way. Some or all of the following methods of raising finance may be appropriate in particular circumstances for individual companies.

Supplier credit/Stock Finance

Perhaps the easiest, and cheapest, way to arrange finance is to negotiate longer terms with your suppliers. At the very least, this will reduce your need to draw on what can be relatively expensive overdraft facilities. It is recognised that the use of trade credit varies from industry to industry. You will (or should!) know if this is a realistic option for your company.

Leasing and lease purchase

Leasing and lease purchase (also known as hire purchase) is often used by companies to finance the use of plant, machinery, vehicles and computer equipment. In both cases, banks or other specialist providers will lend money to a company, using the asset that is being used or purchased as security for the debt. This practice is also known as asset based finance or ABF.

Leasing, where the lender keeps the ownership, and lease purchase, where the borrower purchases the asset ‘in instalments’, are common means of financing items for which there is a second-hand market, which gives the asset a value independent of the user.

Leasing

Under the terms of a lease, the ownership of the leased asset is kept by the lender. Broadly speaking, there are two types of lease – the finance lease and the operating lease. The finance lease requires the borrower to pay the asset’s capital costs and financial costs over the period of the lease. The initial (or primary) contract period is approximately equal to the asset’s life. The borrower usually has the option of extending the lease into a secondary period on payment of a minimal charge.

Under an operating lease, the lender will look to the residual value of the asset as a means of final repayment and so the lender is taking the residual value risk. The primary contract period is less than the asset’s life and so the lender will be seeking to add to its return by selling the asset at the end of the primary contract period.

Contract hire is a form of operational leasing, which often covers servicing or other running costs as a part of the lease.

At the moment, a finance lease is shown as an asset and a liability on the borrower’s balance sheet. An operating lease is treated as a revenue expense, and therefore is an ‘off-balance sheet’ expense with the lease commitments shown in the notes to the accounts. This may change as the accounting treatment of both finance and operational leases are currently under review by the Accounting Standards Board.

Lease purchase

Lease purchase, also known as hire purchase, allows the borrower to obtain the ownership of the asset over time. Because the lease purchase agreement is a commitment to purchase, assets financed by lease purchase are shown as an asset a liability on the borrower’s balance sheet.

Factoring and invoice discounting

Factoring and invoice discounting are further forms of asset-based finance. Both forms of financing enable a company to ‘sell’ its debtors to the factor or the invoice discounter. The effect of both factoring and invoice discounting is to convert debtors into cash, irrespective of the agreed credit terms. In the case of factoring, the factor takes control of the company’s sales ledger as well. It could be said that the company outsources its credit control function to the factor.

Factoring

Under pure factoring, the factor will lend usually up to about 80% of sales value to the borrower in the form of a pre-payment on the strength of an invoice. The factor takes control of the sales ledger and collects all due payments. Once payments have been received, the factor will pay the balance of the purchase price, less any service charges, to the borrower.

If full payment is not received, then the borrower will re-assume responsibility for the debt after a specified period of time. In this case, the borrower may have to repay part of the pre-payment or to replace that uncollected with new debtors. Under a non-recourse factoring agreement, the borrower will not have to take responsibility for any debt caused by a debtor going bankrupt – in this case the factor will assume the risk.

Invoice discounting

Because factoring involves the borrower losing control of the sales ledger, the borrowing company may choose to raise funds from an invoice discounter instead. The principle of invoice discounting is the same as factoring – the invoice discounter lends the borrower up to about 80% of sales value in the form of a pre-payment. Unlike factoring, the borrower retains control of the sales ledger and is responsible for collecting payments, which are then deposited with the invoice discounter. Once all the payments are collected, the invoice discounter pays the balance of the purchase price less any discounting charges. The invoice discounter takes a larger credit risk than the factoring company, because the borrower retains control of the sales ledger. A company that wants to use the services of an invoice discounter will have to face significant scrutiny of its sales management process.

As well as being a source of finance, factoring can also be used to protect against bad debts (this is known as non-recourse factoring) and to improve the quality of credit control procedures (this is particularly true for invoice discounting, where the invoice discounter will want to ensure that the company has sufficient controls in place).

Factors and invoice discounters are, like leasing companies, often subsidiaries of the clearing banks, but there are also a number of independent specialist companies.

Finance costs for factoring are typically the same as overdraft rates, with an additional factoring charge of between 0.25% and 2.75% of factored sales. This figure will depend on the nature of the service offered. Non-recourse factoring, where the factor pays the full sales price irrespective of whether all the debts are collected, will attract a higher fee than recourse factoring, where the factor can reclaim any prepayment uncovered by collected debts. In effect the factor and the invoice discounter will cover the cost of an increased risk by increasing their fee to you.

One of the benefits of both factoring and invoice discounting is that, whilst they may not be cheaper forms of finance than bank finance, they are potential new sources of finance for the company. This can be important when the relationship bank decides that it does not want to increase its exposure to you. However, you will have to ask your relationship bank’s permission to approach a factor or invoice discounter if your bank holds a floating charge (or a negative pledge) as this will include debtors.

Commercial mortgages

Longer-term loans often take the form of commercial mortgages to provide finance for the purchase of business premises. These will be available through the relationship bank, but better terms can be found from specialist providers. These can be arranged over an extended period of time, normally up to as long as twenty-five years.

Equity and venture capital

No analysis of sources of finance would be complete without a reference to sources of equity funding whether in the form of ordinary or preference shares or some form of debt that is subordinated to other lenders. It may be that more equity is required to balance other forms of debt or that bank or finance house borrowing is an inappropriate form of finance. The main sources of equity are venture capital, the public markets and private placements. Banks will often offer assistance in these markets but may lack the specialist expertise to obtain the best deal. They also lack independence when they have a specialist in-house supplier of the services that might be required.

There are 133 members of the British Venture Capital Association handling more than £5 billion a year in investments. Typically they lend and/or invest cash in return for an equity stake in the business. They are less concerned with interest returns than capital gains from the subsequent disposal of their stake. A venture capitalist looks for growth of 30 per cent per annum or more and, thus, seeks a strong management team capable of controlling the company.

Debt issuance

The public markets are an alternative for the better-established company that is already, or is contemplating becoming, a public company. As the banks’ ability to lend will remain limited, the public debt markets are likely to grow in importance. Any medium- or larger sized company should monitor the developments in these markets. Not all banks have adequate experience available in these specialist areas. Advice should be sought from experienced advisers who specialise in the areas of most interest.

The private placement market also requires specialist advice from intermediaries who are able to identify and appropriate sources of finance. Private placements are not traded or listed; they are simply a private loan or equity arrangement between investors and individual companies.

This is also true of other specialist financing techniques whether it be advice on mergers or acquisitions (M&A), management buy-outs (MBOs) or debt restructuring. No matter what the claims, the general banker has inadequate experience to advise in these areas.

Government assistance

There is a broad range of government schemes and assistance available to companies from all tiers of government from the European down to local authority. Some of the finance is in the form of loans and some in the form of grants. In general terms, grants do not have to be repaid, which seems attractive, but there are usually a number of strict conditions attached to any system of grant. In addition, the process of awarding grants, particularly for large sums, can take a number of months.

For companies operating in England, this support comes for a variety of purposes:

1. Regional assistance.

   There are a number of grants available for companies to encourage them to relocate or stay in disadvantaged areas. These range from Regional Selective Assistance to Enterprise Grants. The European Structural Funds support projects that promote competitiveness throughout Europe. Details on these grants can be found from the English regional government offices (www.local-regions.detr.gov.uk/go/goindex.htm) and from the National Assembly for Wales, the Scottish Executive and the Northern Ireland Office. Similar schemes operate in all the other EU member states. Information about the European Union’s support for business can be found at www.cec.org.uk/pubs/notice.htm.

2. Support for research and development.

   Support from both the European Union and LINK is available to support research and development – more information at www.dti.gov.uk/ost/link.

3. Support for small firms.

   Loan guarantees for small business can be got from, SMART awards are available to help businesses assess the way that they use technology. A network of Business Links around England is available to support small and medium-sized businesses. This support comes in the form of advice about both general business issues and how to get some of the listed grants. More information can be found at the Business Link website – www.businessadviceonline.org/businesslink – which is provided by the small business service.

4. Support for training.

   There are a number of schemes available to enhance training programmes for employees both through the government’s New Deal programme www.newdeal.gov.uk and through Training and Education Councils www.tec.co.uk.

5. Support for exports.

   Both the Department of Trade and Industry and the Export Credits Guarantee Department provide a certain amount of assistance for exporting companies. More information can be found at www.tradepartners.gov.uk and www.ecgd.gov.uk

Credit and corporate purchasing cards

Purchasing cards might one day be seen as a replacement for petty cash but they are also a source of very short-term finance. These are credit cards geared towards business use. They are typically used to pay travel and entertainment expenses for company staff, or can be used to purchase supplies. While the bills for these expenses go unpaid they represent a form of finance.

Purchasing cards can be set up so that they are tied into particular suppliers. A member of a company can only use the card to purchase supplies or services from specific suppliers with a specific maximum value. More information on the use of corporate purchasing cards can be found in Treasury Today March 2000 and April 2000.

Get the right mix

The purpose of this article is to indicate the broad range of alternative sources of finance that are available to companies. For most companies, the relationship bank will remain the most important single source of finance for their business. However, the use of alternative methods of finance for some parts of the business – for example, the use of leasing to fund a vehicle fleet – can reduce both the financial costs and the risks associated with the transaction. There is no one perfect solution, but most companies should be able to see significant advantages if they use the right mix of financing.

In summary

This article shows the breadth of the range of alternatives to bank loans and overdrafts that are available for the small and medium sized company. These include:

• Leasing and lease purchase
• Factoring and invoice discounting
• Equity and venture capital
• Debt issuance
• Government assistance
• Credit and corporate purchasing cards

We plan to look at all of these in more detail further issues of Treasury Today.