So you’ve got a great idea for a new retail business. You’ve spotted a gap in the market and know you can make a go if it but you need to obtain finance to kick start the process. What are your options?
Because of the difficulty of finding alternative financing options, many business start-ups rely on debt financing whereby money is borrowed from a third party, such as a bank, and then paid back with interest.
The interest on such arrangements is tax deductible to the business
The advantage of debt financing is that control of the business remains with the owners of the business (although lending institutions can sometimes set targets to the business that must be met if the financing isn’t to be called in). Also, because interest on the debt is often set at a fixed percentage, the business typically has a clear picture of how much needs to be repaid and when, which makes budgeting easier.
The disadvantage of debt financing is that the business owners can often be left personally liable for the debt if the business fails. In addition, in these times of tighter lending restrictions, many new businesses are finding it increasingly difficult to obtain debt financing for new ventures, or even to expand existing ventures.
Whilst it may not be ideal, many small businesses choose to fund themselves by drawing down on equity within their home or even using their own credit cards (a practice known as boot-strapping). That can help cut out many of the difficulties faced in obtaining business loans but it’s also seriously risky; if the business fails, your home is at risk or your personal credit rating may suffer. The interest paid on that part of the mortgage (or credit card debt) that relates to the funding of the business will at least be tax deductible though.
If you choose to set up your new retail enterprise through a corporate structure, you can look at issuing equity (shares) in the new venture to potential investors, including friends, family, business associates and even venture capitalists and business angels.
Investors are rewarded with an ongoing stake in the business. Cash returns for the investors are generated either through annual dividends paid out of the profits of the business, or capital gains on the ultimate sale of their shares if the business is a success (or a combination of both).
The downside for the new business is that an element of control is lost; investors will often want a say in how the business is run in order to protect their investment.
The investors will pay tax on either or both of the dividends they receive or the capital gains they make on disposal of their shares. The business itself does not get a tax deduction for dividends paid; these are paid out of after-tax profits.
A business angel is typically a high net-worth investor who likes to take a punt on investments into new, promising businesses. Typically, they will take an equity stake, will demand decent returns on their investment and will often use an established track record in business to provide advice and support to the owners of the new business. Whilst it can be enormously helpful to have support from a business figure who understands how to turn a business like yours into a success, business angels are thin on the ground and even if you find one, you need to be aware that their primary motive is to make money for themselves and their view on how this can be achieved might conflict with your own vision for your business.
Crowdfunding is a relatively new way of funding a business start-up that harnesses the power of the internet to solicit donations of money from the general public. There are many crowdfunding websites that do this.
Typically, you’ll post your business idea onto one of the crowdfunding websites and a large number of people will then donate a relatively small amount of money in exchange for rewards based on the amount they donate, such as free products or discounts on purchases.
The advantage of crowdfunding is that as well as raising money for your business, you also build a database of engaged customers, who will themselves act as brand ambassadors to their friends and family. The downside is that if your business model fails to strike a chord with investors, your crowdfunding appeal may fail – although arguably that should be a red flag that maybe your business model needs tweaking before taking it any further.
The downside of crowdfunding is that the money you earn may be taxable, so for every dollar you make from investors, a chunk may need to be paid to the ATO. This is a difficult area; typically you don’t have to pay tax on crowdfunding income if the business hasn’t yet started (which will often be the way with crowdfunding, where the intent is to raise funds to enable the business to commence) but the ATO can argue that if your intent was to make a profit (regardless of whether you are in business), then the proceeds are taxable. Make sure you get detailed taxation advice before undertaking crowd funding.
Mark Chapman is the tax communications director at H & R Block