Small Business Financing: Security Interests sought by Investors

There is a bewildering array of options for business wanting to raise money these days but small and medium sized businesses are still heavily reliant on traditional forms of financing. Businesses stepping into the world of fundraising for the first time to aid their growth or improve returns should ensure that they are familiar with these traditional approaches before simply opting for the latest trends such as crowdfunding platforms.

Loans and Bonds

Normally, financial institutions such as banks or building societies, help businesses by contributing finances in the form of loans or bonds. Alternatively, private financiers such as business angels or venture capitalists may join with the business to give it money in exchange for shares. With both types of financing there can be risks for both the business and financier but typically businesses gain access to expertise as well as money.

Additional mechanisms also exist to compliment these traditional financing routes. For example the Government has introduced the National Loan Guarantee Scheme which means business can access loans with slightly lower interests than regular loans, making them attractive for investment.

Whatever forms of financing businesses choose there a numerous considerations that first-timers need to be aware of when they start raising capital.
Security Interests: Traditional financing options

The first issue is the introduction of charges over the property or assets of the business. It is common when a bank or building society provides a loan that they require some form of security; this takes the form of a charge. There are two types of charges, a fixed charge and a floating charge, both of which have implications for the business.

A fixed charge is where a bank or other lender has security over a fixed asset, such as the business premises, which can then be enforced if the loan defaults. This means that the business risks losing its main premises, plant and equipment in the event interest is not paid on time or certain covenants (conditions) in the loan agreement are not met.

The second type of charge is a floating charge which is a general security which “floats” over the assets of the company as they change over time. If the loan goes into default, the charge “crystallises” into a fixed charge on all the assets at that time, which can then be enforced. Charges mean that businesses are under significant pressure to structure their finances to ensure repayment can be made when required and that other conditions are met during the lifetime of the loan.

You may also hear people refer to “debentures” – this is usually a reference to a fixed and/or floating charge held by a bank.
If investment is made in exchange for equity, investors will want a share of the business in order to see a capital return generated over time. They may also require board representation, that is, a seat on the board.

Care must be taken to ensure that the investor does not gain too much control and take the business in a direction adverse to that intend by the original directors and shareholders. There are important thresholds to bear in mind when it comes to issuing shares in companies – basically, the greater the shareholding, the great the rights granted to the shareholder under the Companies Act 2006.

Detailed negotiations, usually involving lawyers and other professionals, are necessary to ensure that the business is well structured to allow it to function effectively and to ensure investors get a return.
There are many factors that a business must consider when deciding how to arrange financing. Where it is accessible and managed appropriately, traditional forms of business financing are still a good option to raise capital quickly and to bring valuable financial and business expertise on board.

Obviously, the directors of startup companies need to consider what is the option is for the company and act accordingly.

Biography – Leigh Ellis is a company lawyer with London small business law firm, Drukker Solicitors. He advises on startups secure business investment and step around mistakes others have made which compromise their best interests.