External Finance

This section explains External Finance covering, Sources of External Finance and Methods of External Finance.

External finance refers to the funds a business raises from sources outside of the organisation itself. This can be particularly important when internal finance options, such as personal savings or retained profit, are insufficient to meet the business’s needs. External finance is generally required for expansion, large investments, or addressing cash flow problems. This guide will cover various sources of external finance and methods of external finance available to businesses.

Sources of External Finance

Family and Friends

Businesses often turn to family and friends for financial support, especially in the early stages of setting up a business. These informal arrangements can provide quick and flexible funding, and often come with fewer formal requirements than more traditional sources.

Advantages:

• Flexible terms: Lenders may be more understanding and flexible than banks.
• Lower or no interest: In some cases, there may be no interest charged, or the rate may be significantly lower.
• Quick access: Funds may be available faster compared to more formal methods of financing.

Disadvantages:

• Risk to personal relationships: Financial problems can strain personal relationships if the business fails to repay.
• Limited funds: The amount available depends on what family or friends can afford to invest.

Banks

Banks are one of the most common external sources of finance. They offer a range of products, including loans, overdrafts, and credit facilities, which can be used to fund business activities.

Advantages:

• Large sums of money: Banks can provide substantial amounts of finance.
• Range of options: Banks offer a variety of financial products to suit different needs, from short-term to long-term finance.

Disadvantages:

• Interest and fees: Loans and overdrafts typically come with interest, which can increase the cost of borrowing.
• Eligibility requirements: Banks often have stringent eligibility criteria, and smaller businesses may find it difficult to secure funding.
• Repayment terms: The business may be required to meet specific repayment terms, which can strain cash flow.

Peer-to-Peer Funding

Peer-to-peer (P2P) funding is a method of raising capital through online platforms where individuals can lend money to businesses in exchange for interest payments. This alternative to traditional banking allows businesses to borrow money from a pool of individual investors.

Advantages:

• Accessibility: Easier to access than traditional bank loans, especially for small businesses.
• Lower interest rates: Often, P2P loans have lower interest rates compared to bank loans.

Disadvantages:

• Risk of rejection: If the business has a poor credit history or insufficient collateral, it may be rejected by investors.
• Variable terms: P2P lenders may have different terms and conditions, which can make it more difficult to predict future costs.

Business Angels

Business angels are wealthy individuals who invest their own money into small or start-up businesses in exchange for equity (ownership) or convertible debt. They often provide not only capital but also expertise and guidance.

Advantages:

• Expertise: Business angels bring valuable experience and knowledge, helping the business grow.
• Long-term support: Angels are often willing to take a more patient approach to investment, which can help businesses in the long term.

Disadvantages:

• Equity loss: The business will have to give up a portion of its ownership in exchange for funding.
• Limited funding: Business angels may only be able to invest small to medium amounts compared to other sources like banks.

Crowdfunding

Crowdfunding is the process of raising small amounts of money from a large number of people, typically through online platforms. In return for their investment, backers may receive rewards, equity, or simply the satisfaction of supporting a project.

Advantages:

• Wide exposure: Crowdfunding platforms can provide businesses with exposure to a large audience.
• Variety of incentives: Businesses can offer various types of rewards, such as early product access or equity stakes, depending on the platform.

Disadvantages:

• Time-consuming: Running a successful crowdfunding campaign can require significant effort and time.
• No guaranteed success: There is no certainty that the campaign will meet its funding target.

Other Businesses

In some cases, businesses may seek finance from other companies through joint ventures, partnerships, or corporate investors. This source can be particularly useful if the two businesses have a complementary relationship.

Advantages:

• Strategic alliances: Partnering with other businesses can offer mutual benefits beyond just financial support, such as shared expertise or access to new markets.
• Shared risk: The financial risk is often shared between the businesses involved.

Disadvantages:

• Complex agreements: Partnerships and joint ventures often require detailed legal agreements, which can be costly and time-consuming to set up.
• Shared control: Businesses may have to share decision-making power with the other company, which could lead to conflicts.

Methods of External Finance

Loans

A loan is a sum of money borrowed from a financial institution, which is repaid over an agreed period with interest. Loans can be short-term (for immediate needs) or long-term (for larger investments).

Advantages:

• Larger sums: Loans can provide substantial amounts of capital.
• Ownership retention: The business does not have to give up equity.

Disadvantages:

• Repayment terms: Loans must be repaid with interest, which can strain cash flow.
• Security requirements: Banks may require collateral to secure the loan.

Share Capital

Share capital is money raised by issuing shares in the business to shareholders. In return, investors receive equity in the company. This is commonly used by limited companies or corporations.

Advantages:

• No repayment: Unlike loans, share capital does not need to be repaid.
• Capital for growth: This can provide large amounts of capital for expansion or other needs.

Disadvantages:

• Loss of control: Issuing shares dilutes the ownership and control of existing shareholders.
• Dividends: Shareholders may expect dividends, reducing retained profits.

Venture Capital

Venture capital (VC) involves professional investors who provide funding to high-risk businesses with high growth potential, typically in exchange for equity. VC firms often provide expertise as well as capital.

Advantages:

• Large investment: Venture capital can provide significant sums of money for growing businesses.
• Expertise and mentoring: VC firms often bring valuable business advice and networks.

Disadvantages:

• Loss of control: The business owners may have to give up a significant portion of equity and control.
• Pressure to grow: VC investors expect rapid growth and may push for aggressive expansion strategies.

Overdrafts

An overdraft is a facility provided by a bank that allows a business to withdraw more money than it has in its account, up to an agreed limit. This is a short-term financing option typically used to cover short-term cash flow problems.

Advantages:

• Flexibility: Overdrafts provide quick access to funds when needed.
• Only pay for what you use: Interest is typically only charged on the amount overdrawn.

Disadvantages:

• High-interest rates: Overdrafts can have high-interest rates, making them an expensive option.
• Repayment pressure: The bank may require repayment at short notice.

Leasing

Leasing allows a business to rent equipment or property rather than buying it outright. This method is particularly useful for businesses that need expensive machinery or property but cannot afford to purchase it upfront.

Advantages:

• Preserve capital: Leasing frees up capital for other investments.
• No large upfront costs: The business does not need to make a large initial payment.

Disadvantages:

• Ongoing payments: Leasing involves long-term payments, which can add up over time.
• No ownership: At the end of the lease term, the business will not own the asset.

Trade Credit

Trade credit is a short-term financing option where suppliers allow businesses to purchase goods or services and pay for them later, typically within 30, 60, or 90 days.

Advantages:

• Cash flow management: This method helps businesses manage cash flow by delaying payments.
• No interest: Most trade credit agreements do not charge interest, making it a cost-effective option.

Disadvantages:

• Limited credit: The amount of trade credit available depends on the supplier’s willingness to extend credit.
• Late payment penalties: Businesses may face penalties or damaged relationships if they fail to make payments on time.

Grants

Grants are sums of money provided by government bodies, non-profit organisations, or other institutions, often for specific purposes, such as research, development, or environmental sustainability.

Advantages:

• Non-repayable: Grants do not need to be repaid, making them an attractive option for businesses.
• Support for specific purposes: Grants often come with fewer restrictions on how they can be used.

Disadvantages:

• Competitive process: Obtaining a grant can be highly competitive, and there may be stringent eligibility criteria.
• Time-consuming application process: Applying for grants can require significant effort and documentation.

Summary

External finance offers various options for businesses to raise the capital necessary for growth and expansion. The choice of source and method of external finance will depend on the business’s needs, the stage of growth, and the level of control the business owner is willing to give up. Each source and method has its advantages and disadvantages, and businesses must carefully evaluate their options to ensure they select the most appropriate form of finance.