Sources and types of bank and non-bank financing

Financing is one of the key conditions to successfully complete a project or an investment.

In order to avoid or limit financial risks which can lead to the early disappearance of a company, entrepreneurs have to determine in advance which type and source of financing is most suited to their needs by taking into account:

  • the life cycle of the business;
  • the type of project to be financed: creation or takeover of a business, investments, financing of the working capital needs.

In order to finance a project or an investment, the business can resort to:

  • internal financing, i.e. using the business's own available resources;
  • external financing, i.e. using third-party resources (shares, participations, loans, etc.).

Who is concerned

Bank and non-bank financing may be needed by any sole proprietorship or larger company who wants to develop its business activity through:

  • the creation of new businesses;
  • capital investment (acquisition of machinery or equipment);
  • international expansion;
  • cash flow requirements (payment of suppliers, balancing unpaid invoices by clients);
  • internal growth (development of activities, creation of subsidiaries);
  • external growth (merger or takeover of another business).
Choosing a particular type or source of financing is conditioned by several factors as all types of financing are not suited to the needs of every business.

Prerequisites

Some criteria may have an influence on the business's capacity to raise funds:

  • the integrity, skills and qualifications of the entrepreneur, partner or manager;
  • the implementation of the project/product;
  • the market situation, etc.

How to proceed

Types of financing:

Selection criteria

Entrepreneurs must choose their type of financing depending on:

  • the project to be financed:
    • financing of a medium to long-term investment project (creation, improvement, development, etc.);
    • financing of a standard investment project (material, equipment, vehicle fleet, etc.);
    • financing of growth (stock, receivables, etc.);
    • financing of intangible and capital asset projects (taking over or purchasing a business, purchase of funds or licences, etc.);
  • inhouse available resources or not:
    • internal financing;
    • external financing.
Other factors may influence the entrepreneur's choice, such as the cost, risk or constraints that come with each type of financing.

Financing source

Internal financing is usually carried out with own capital whereas external financing can be carried out with owned, borrowed or mezzanine capital.

The use of borrowed capital is often unavoidable for businesses seeking to make up for a lack of own capital and to create leverage.

Internal financing

External financing

Own capital

  • Shareholders' equity
  • Profit
  • Reserves

Owned capital

  • Financial markets
  • Venture capital
  • Business angels

 Mezzanine capital

Loaned capital

  • Financial markets
  • Credit institution
  • Microfinance institutes
  • Public aid

Internal financing

We speak of internal financing or self-financing when a business can meet its own financing needs with resources that are available internally.

Within the framework of internal financing, owned capital consists of:

  • own funds (equity), i.e. the funds coming from the entrepreneur or the partners, which are mainly:
    • the minimum capital determined by the legal form of business or the articles of association;
    • additional contributions (e.g. a personal contribution in cash or in kind);
  • business profits (made during the financial year and profits carried forward from previous years);
  • reserves from previous years.

Although this is often the entrepreneurs' preferred source of financing, the amount of owned capital is often limited for young businesses who do not yet make profits or have reserves and where the entrepreneurs have already invested their personal funds.

External financing

We speak of external financing when the business calls upon capital from third-parties.

Owned capital

Businesses can turn to third-parties to obtain own capital through:

  • the financial markets: the issue of shares is suited for businesses who are in a phase of growth or development but this is only possible for a minority of businesses and requires professional assistance;
  • venture capital consists in the temporary acquisition of a minority shareholding (short-term) by professional investors who receive remuneration with capital gains realised through the difference in price between the sale and the purchase of their shares. In addition to own capital, venture capital allows businesses to get access to the network and the contacts of the professional investors. This type of financing is adapted to highly innovative businesses that are highly profitable during their creation and development phases;
  • Business Angels, i.e. persons who made their fortune in a specific area and who wish to share their knowledge and experience with others. Unlike venture capitalists, business angels are usually natural persons who are more focused on long-term returns.
    Their contributions often take the form of a capital increase and participation in the decision-making process.
    This type of financing is much more accessible than venture capital for any business in the seed or creation phase.
    In Luxembourg, businesses can turn to the

Loaned capital

In order to finance its projects, a business can borrow capital from:

  • credit institutions; bank loans are the most common type of financing used by small and medium-sized businesses in Europe. There are different types of credit which are adapted to businesses and their projects to be financed. Banks generally do not want to be involved in the management of the business but, in return, require guarantees to ensure that the loans granted are fully reimbursed;
  • microfinance institutes; any person with a project concerning the start up or development of a business and who does not have access to bank loans can turn to a microfinance institute. The maximum amount of microcredit granted is EUR 25,000. In addition to financial services, entrepreneurs may benefit from free support services tailored to their needs.
  • financial markets; the issuance of bonds is limited to large businesses only;
  • public aid; the Luxembourg State offers a wide range of public aid schemes to help young businesses and investors finance their projects. These aid schemes may vary depending on the project activity and take the form of:
    • capital grants;
    • interest relief;
    • tax exemptions.
    Under no circumstance may the investment decision depend on the grant of public aid.

Mezzanine capital

Mezzanine capital is a hybrid financing scheme somewhere between owned capital and borrowed capital. It is particularly suitable for growing businesses or to finance the takeover of a business.

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