Business Financing — SQE1 FLK1 Business Law and Practice

Your client needs £200,000 to fit out a second production line. The bank will lend it at 10% a year. An investor will pay £200,000 for new shares and expects a dividend of £20,000 a year. The finance director tells the board the two cost the same, because each takes £20,000 a year out of the business. That is wrong.

One of them is cheaper, and the reason is tax. This is Business Financing, the topic where the exam asks you to choose. Debt or equity. Overdraft or term loan. A charge, a guarantee, or neither. Most of the marks sit in the consequence of the choice rather than the choice itself. Keep that production line in mind. We are coming back to it.

Here is the route. Debt against equity first, and what gearing does to a company that gets it wrong. Then bank lending, and the security a bank will take. Then equity: retained profits, angels, venture capital, and the tax schemes that bring the angels in. Then crowdfunding, peer-to-peer, invoice and asset finance. Then the public markets. And last, matching the money to the need.

Start with the answer. Borrowing is cheaper, because of where the payment sits in the tax computation. Interest is an expense. It comes off the profit before Corporation Tax is charged. A dividend is not an expense at all. It is a distribution of profit that has already been taxed.

Put the numbers back. Profits of £500,000 before interest, Corporation Tax at 25%. Borrow, and £20,000 of interest leaves taxable profits of £480,000 instead of £500,000. That saves £5,000 of tax. So £20,000 of interest costs the company £15,000. A £20,000 dividend costs the whole £20,000. That gap is the tax shield.

So why does anyone issue shares? Because debt has to be repaid, and repaid whether or not there is a profit. That is the whole of the difference. A lender takes no ownership and no share of the upside. An investor takes both, and takes the risk with you.

Gearing is the ratio of debt to equity. Two companies, £4 million of capital each, £500,000 of operating profit each, interest fixed at 10%. The first is £3 million of debt to £1 million of equity. The second is the other way round. A recession cuts profits by up to 60%. Which one fails?

The first. Its interest bill is £300,000 against £500,000 of profit, so its interest cover is about 1.7 times. Take 60% off the profit and it has £200,000 against a £300,000 bill. The second pays £100,000, cover of five times, still two times after the same fall.

High gearing magnifies the returns while trading is good. It magnifies the failure when it is not.

Bank lending, then. Term loans, repaid over a fixed period with regular payments. Overdrafts, flexible short-term borrowing up to a limit. Invoice discounting, asset finance, revolving credit. The idea running through all of them, and the one the exam tests, is matching.

Match the finance to the life of the need. A retailer buys extra stock in October and November, sells it by December, and has the cash back by the end of January. It needs £200,000 for about three months of each year. Term loan at 8%, or overdraft at 10%?

The overdraft, and it is not close. A five-year term loan drawn in full charges 8% on the whole £200,000 for five years, including the nine months a year when the money is not needed. The overdraft charges 10% on what is drawn, while it is drawn. Headline rates are the wrong test.

There is a price for that flexibility. An overdraft is repayable on demand. The limit is a permission, not a commitment, and the bank can cut it whenever it likes, whether or not you have missed a payment. On a demand, the courts have held, you get the time needed to effect the mechanics of payment. Not time to find the money elsewhere.

A committed term loan is different. You are entitled to the money for the agreed term, and the bank can accelerate, that is call in the whole balance early, only on a defined event of default. So borrow on overdraft for a need you could survive losing.

Before the bank lends your manufacturer that £200,000, it will want security. A fixed charge attaches to specific assets from the outset: the factory, the machines. A floating charge hovers over a shifting pool: stock, book debts, cash. And there is the distinction that decides exam questions.

Under a floating charge the company goes on dealing with those assets in the ordinary course of business, until the charge crystallises on default or enforcement. So it can sell a batch of finished goods without asking anyone. It cannot sell a strip of land caught by the fixed charge. The House of Lords settled the test in Re Spectrum Plus, in 2005. What makes a charge fixed is the restriction on dealing.

Security over company assets is often not enough. A bank lending £50,000 to a company that has traded 18 months, with few assets, will want the director's personal guarantee. Sign it and you are personally liable. The company fails owing £200,000, the unsecured creditors get nothing, and the bank demands £50,000 from you.

Can it do that? Yes. Limited liability protects a member as a member. It says nothing about a separate promise you made in your own name. The bank need not wait for the liquidation or exhaust its remedies against the company. It can sue you and enforce against your house.

And a variation trap sits on top. The rule in Holme v Brunskill discharges a surety where the underlying contract is materially varied without consent. Every standard bank guarantee contracts out of it, permitting variations, extensions and indulgences without release. Read the form before you sign.

Loans also come with covenants. Keep a current ratio above this figure. Keep interest cover above that one. Borrow no more without consent. Break one and you are in default, even though every instalment has been paid on time. The bank may then accelerate, enforce, or waive the breach for a fee. Its choice, not yours.

Now the number to learn. A charge a company creates must be registered at Companies House within 21 days of creation. That is s.859A of the Companies Act 2006. Miss the window and s.859H bites. The charge is void against a liquidator, an administrator and any creditor, and the secured debt becomes immediately repayable.

It still binds the company and the lender. Only the outside world ignores it. And notice makes no difference. A later lender who knew about the earlier charge, whose solicitors read a copy of it, still takes priority by registering. Registration is decisive, not knowledge.

There is one way to beat every charge. Own the goods instead. A supplier selling on credit can keep legal ownership until it is paid, using a retention of title clause, or Romalpa clause. The goods never became the buyer's, so on insolvency the supplier takes them back ahead of the secured creditors.

It has limits. A simple clause works over goods still identifiable, unsold and unmixed. Reach for the proceeds of sale, or for timber already made into finished tables, and it usually fails. The court recharacterises it as a charge, and a charge nobody registered is void.

Ownership beats security. A dressed-up charge does not.

Equity now, and the biggest source is the one nobody thinks of. Retained profits, kept in the business rather than paid out as dividends. No acquisition cost, no dilution, and for an established company usually the largest source there is. After that, the ladder starts close to home.

Family and friends, often interest free. Write it down, because an undocumented loan becomes an argument. And be clear which it is: a loan gives them a debt, equity gives them a share.

Business angels come next. Wealthy individuals investing their own money in early-stage businesses, typically £10,000 to £250,000, usually in a sector they understand, and bringing mentoring as well as cash. Then venture capital: professional funds, £500,000 to £10 million and beyond, a significant stake, a seat on the board, a three to seven year horizon.

Every pound of equity costs you ownership. Two founders take £2 million from a fund for 40% of the enlarged share capital, and drop to 30% each. They may prefer to issue non-voting shares and keep control, and the fund may accept that, but only at a lower valuation. But they cannot pick the structure just because it suits them. They are directors too, and a director must act to promote the success of the company for the benefit of the members as a whole.

Government schemes. Start Up Loans are government-backed personal loans of £500 to £25,000, for people aged 18 or over who cannot get finance elsewhere. Fixed interest at 7.5% for new loans from April 2026, terms of one to five years, and twelve months of mentoring.

Read that word again. Personal. Sign a Start Up Loan yourself, then incorporate a company and pay the whole £20,000 into it, and the debt is still yours. The company was never a party. Separate legal personality protects you from the company's debts. It does not run backwards.

The Growth Guarantee Scheme is the other one. Where a smaller business lacks the security a lender wants, the government guarantees 70% of the lending. That runs through the British Business Bank and its accredited lenders, on facilities up to £2 million. It replaced the Enterprise Finance Guarantee, which closed to new lending in 2020.

Now the schemes that make angels say yes. The Seed Enterprise Investment Scheme gives an investor 50% income tax relief on up to £200,000 a year, and a capital gains tax exemption on exit. The company must be young: under three years of trading, fewer than 25 employees, gross assets under £350,000. It can raise £250,000 in total, no more.

The Enterprise Investment Scheme is the bigger sibling: 30% relief on up to £1 million a year, for companies with fewer than 250 employees. So a company wanting £300,000 takes £250,000 under the seed scheme and the last £50,000 under the enterprise scheme. Order matters. The seed shares must be issued first.

Crowdfunding comes in four kinds. Equity: the backers get shares. Debt, which is peer-to-peer lending: they lend at interest. Donation: they simply give. Reward: they get the product. The first two are regulated by the Financial Conduct Authority, and the regulation is where the marks are.

Equity crowdfunding cannot be offered to just anyone. The platform must be authorised, and the investor must be a sophisticated investor, a high net worth individual, or someone putting in less than 10% of their net assets. Savings of £15,000 and no experience of shares leaves the last category. Ten per cent of £15,000 is £1,500. That is the cheque.

Peer-to-peer lending works from the other side of the platform. It matches businesses that want to borrow with individuals who want to lend, at rates from 6 to 20% depending on risk. It is not covered by the Financial Services Compensation Scheme. An authorised firm is not the same thing as a protected product.

Invoice finance turns unpaid invoices into cash today. Invoice discounting sells them to a finance provider, who advances 80 to 90% of face value. Factoring goes further: the provider collects the payments from your customers and may run your credit control. So your customers find out, and that can cost you your largest customer.

Asset finance is for things rather than cash. Hire purchase: a deposit, then instalments, and you own the asset at the end. A finance lease: you rent, with an option to buy. An operating lease: you rent short term and hand it back. Leasing avoids the upfront cost, but usually costs more over the life of the asset.

So which one leaves you owning the machine? Hire purchase. Hold that. It decides the quick check.

The public markets sit at the top of the ladder. An initial public offering is the first sale of shares by a private company to the public. It raises serious capital, and it costs: fees can reach 7% of the funds raised. The Main Market takes large established companies, the Alternative Investment Market smaller growing ones, with lighter regulation.

And a listing changes what a board does. Continuous disclosure through regulatory announcements. Then market abuse rules, the listing rules, the corporate governance code, and the cost of complying with all of it.

Which brings us to the question the exam actually asks. Match the money to the need. Short-term cash flow: overdraft, invoice finance. Long-term assets: term loan, hire purchase, leasing. Starting up: savings, family and friends, angels, the seed scheme. Growing: venture capital, the enterprise scheme, a listing.

Five factors decide between them. Cost, counting fees and dilution, not just the rate. Then risk, flexibility, speed, and the impact on cash flow, credit rating and ownership.

A word on how this is tested. SQE1 will not ask you to recall a case name or a section number. You get a scenario, five answers, and one instruction: pick the best. So learn the rules. The names in this episode are memory pegs, nothing more.

If you keep only three. The 21 days in s.859A of the Companies Act 2006, because a charge registered late is void against the people who matter. The Romalpa clause, because ownership beats security. And Holme v Brunskill, the rule that a variation without the surety's consent discharges the surety, because the bank's standard form contracts out of it.

Four traps. One: a personal guarantee is not a formality. It puts the family home and the savings behind the company's borrowing, and banks ask for one from almost every young company with few assets. That is exactly when a director is least able to refuse.

Two: dilution is the price of equity, and it is easy to underestimate. New shares reduce everyone else's percentage. Founders who take the money three times can find they no longer control the company. Different share classes can manage that. Nothing makes it disappear.

Three: know which crowdfunding is which. Equity and debt crowdfunding are regulated by the Financial Conduct Authority, and the investor restrictions come with them. Donation and reward crowdfunding give backers a product or a perk, not an investment. And on any platform, hit the target or get nothing, and the platform takes a fee, typically 5 to 8%.

Four: an authorised platform is not a protected investment. If the borrowers default, or the platform itself collapses, the loss is the lender's. And the interest that did arrive is still taxable income.

Quick check. A company took machinery on hire purchase: a deposit, then monthly instalments, with title passing on the last instalment. It has gone into insolvent liquidation. The machinery is the only substantial asset left. The liquidator says the company has built up an interest in it worth more than half the price, and proposes to sell it for the creditors. The finance company demands it back.

Three candidate answers. One: no, because the company has by now paid more than half of the total price. Two: yes, because title remains with the finance company until the last instalment is paid. Three: no, because the finance company ranks as a secured creditor for the balance. Pause here if you want a moment.

The answer is two. Under hire purchase the customer hires the goods with an option to purchase, and ownership stays with the finance company until every instalment and the option fee are paid. The company never owned the machine, and property that does not belong to the company is no part of its estate. The liquidator cannot sell it.

Why the others fail. Paying more than half transfers nothing. The rule you are thinking of stops repossession once a third of the price is paid. That is the protected goods rule in s.90 of the Consumer Credit Act 1974, and it does not reach a company's business agreement. And the finance company is not a secured creditor but an owner, which is stronger: no charge is needed to recover your own goods.

Five things to take away. One: debt is cheaper than equity because interest comes off before tax and a dividend is paid out of profit already taxed. Our finance director was wrong. Two: gearing is the price of that discount, because interest must be paid whether or not you make a profit.

Three: match the finance to the need, and compare total cost, not headline rates. Four: 21 days to register a charge, and a charge registered late is void against a liquidator, an administrator and any creditor, however much they knew. Five: ownership beats security, whether it is a Romalpa clause or a machine on hire purchase. Next time, Charges and Security.

Practise this topic with exam-style questions at sqe1prep.co.uk. This episode is for education and exam revision only, not legal advice, and we are not affiliated with or endorsed by the SRA or Kaplan.