BS25. External Finance

What is external finance?

- Finance sourced from outside the business when internal funds are insufficient

- Which startups struggle to access due to their lack of trading history posing a risk for lenders and investors

What are family and friends as a source of external finance and what are their benefits and drawbacks?

Informal personal loans or gifts, typically cheap and flexible

Benefit: Cheap, flexible funding without ownership share or interference, easing start-up costs

Drawback: Risk of damaging personal relationships if the business cannot repay the funds

What are banks and their benefits as a source of external finance?

Provide loans, overdrafts, and mortgages for both short- and long-term needs

- Offer a wide range of financing options, providing advice and allowing businesses to borrow without giving up equity

- Small unsecured loans may be available, making it accessible to newer or smaller firms

What are the drawbacks of banks as a source of external finance?

- Require detailed business plans for new firms, making applications time-consuming

- Interest is charged, and larger loans need collateral, increasing business risk if repayments are missed

What is peer-to-peer funding as a source of external finance and what are its benefits and drawbacks?

Individuals lend money via online platforms, offering unsecured loans to businesses

Benefit: Quick access to funds than banks, without giving up ownership or control

Drawback: Borrowers pay fees and interest, and lenders expect compensation for providing funds, making it similar in cost to bank loans

What are business angels and their benefits as a source of external finance?

Wealthy individuals invest capital in start-ups, often providing advice alongside funding

- More risk-tolerant than banks and offer valuable advice and contacts, improving business prospects

- Investments are usually short-term, allowing owners to regain shares and control later

What are the drawbacks of business angels as a source of external finance?

- Finding a suitable angel with relevant expertise is difficult and requires strong networking

- Investors may seek involvement in decision-making and a share of profits, reducing owner autonomy

What is crowdfunding and its benefits as a source of external finance?

Many people contribute small amounts online to fund a business or project

- Creates a ready-made organic customer base and provides free marketing through publicity on the platform

- No credit rating needed, giving new firms without trading history a chance to raise capital

What are the drawbacks of crowdfunding as a source of external finance?

- Requires a persuasive business plan and competes with many other projects for attention

- Public failure to secure sufficient crowdfunding capital can harm the business's reputation and deter future investors

What are other businesses as a source of external finance and what are their benefits and drawbacks?

Joint ventures or partnerships with suppliers or customers, sharing resources and risk

Benefit: Can offer expertise, market access, and large funding, accelerating growth

Drawback: Requires profit sharing and joint decision-making, potentially reducing business independence

What are loans as a method of finance?

Borrowed money repaid with interest in fixed payment over an agreed period, offering predictability at the cost of inflexibility

What are the types of loans?

- Bank loans: Secured or unsecured, varying in term and interest rates, though harder for risky firms to access

- Mortgages: Long-term, secured loans for property, offering lower rates but risking repossession if unpaid

- Debentures: Long-term loans for PLCs, providing fixed returns to lenders without granting control

What are the benefits of loans as a method of finance?

- Fixed rates aid budgeting, and equal repayments improve cash flow management

- Enables asset purchases without large capital outlay while retaining business control

- Debentures offer predictable costs, supporting long-term financial planning

What are the drawbacks of loans as a method of finance?

- Interest rates depend on credit rating, raising costs for risky firms

- Increases non-current liabilities, affecting the balance sheet and borrowing capacity

- Missing mortgage payments risks asset loss, and failure to repay debentures can damage investor confidence

What is share capital as a method of finance?

- Share capital is finance raised by selling company shares

- Issued share capital is the amount of share capital raised through the sale of shares

- Authorised share capital is the maximum amount shareholders can legally raise

What are the benefits and drawbacks of share capital as a method of finance?

Benefits:

- Raises large permanent funds, especially for PLCs, without creating repayment obligations or increasing debt

Drawbacks:

- Shareholders are entitled to voting rights and dividends, reducing owners’ control and share of profits

- Share values can fluctuate as they’re traded, affecting company valuation and market perception

What are ordinary shares/equities?

The most common and riskiest type of share, with variable dividends based on profits and voting rights for shareholders

What are preference shares?

Less risky as preference shareholders are paid dividends before ordinary shareholders, at a fixed rate, but often lack full ownership rights so may be bought back by the company

What are deferred shares?

Rare shares held by founders, offering low dividend priority and payments only after other shareholders are paid

Who are venture capitalists as a method finance and what are their benefits and drawbacks?

Specialist investors providing funds to high-growth potential businesses, usually exiting within five years after achieving returns

Benefit: Fund businesses rejected by traditional lenders, accepting higher risk for potentially large returns

Drawback: Often demand a stake and control over key decisions, reducing founders' autonomy

What are bank overdrafts as a method of finance and what are their benefits and drawbacks?

A flexible facility allowing firms to spend beyond their bank balance up to a set limit, repaid on demand

Benefit: Short-term finance improving cash flow, with interest charged only when used

Drawback: The bank can withdraw the facility anytime, risking liquidity issues if not carefully managed

What is leasing?

A contract allowing firms to use property or equipment in exchange for regular payments, where ownership remains with the leasing firm

What are the benefits of leasing as a method of finance?

- No large upfront cost, and maintenance is often handled by the leasing firm, easing cash flow

- Useful for firms needing occasional or up-to-date equipment, and easier for new businesses to access as assets remain with the leasing firm

What are the drawbacks of leasing as a method of finance?

- Over time, leasing is often more expensive than outright purchase, increasing long-term costs

- Leased items can't be used as security for other loans, limiting financing options

What is trade credit as a method of finance and what are its benefits and drawbacks?

Allows businesses to buy goods or services and pay later, usually within 30–90 days, improving short-term liquidity

Benefit:

- Interest-free with no immediate cash outflow, aiding working capital management

- Profitable during inflation as businesses use others' money to pay later

Drawback:

- Delayed payment loses out on early payment discounts and may harm supplier relationships

What are grants as a method of finance and what are its benefits and drawbacks?

Financial support from governments for businesses meeting certain criteria, usually for innovation or job creation

Benefit: Free funding with no repayment obligation, improving financial stability

Drawback: Can only be used for approved purposes, and eligibility is often restrictive and application processes lengthy