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 and their benefits and drawbacks as a source of external finance?

Informal personal loans or gifts

Benefits:

- Often cheap with little to no interest, reducing financial burden and improving survival chances

- May have "no strings attached", with no expectation of equity or ownership and flexible terms of repayment, reducing pressure on the business in the early stages to allow focus on growth instead

Drawback:

- Risk of damaging personal relationships if funds are not repaid, reducing future support networks and causing long-term tension, creating conflict between personal and financial interests

- Finance available is usually small and dependent on the personal wealth of friends and family, limiting scale of funding compared to formal sources

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

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

Benefits:

- Wide range of structured financing options, with professional advice and repayment predictability, aiding financial planning

- Allow borrowing without giving up equity, so ownership remains with the entrepreneur, preserving strategic control

Drawbacks:

- Require detailed business plans and financial forecasts, which are time-consuming and create barriers for start-ups without trading history

- Loans carry interest and often require collateral, risking repossession of assets if repayments are missed, threatening survival

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

Individuals lend money via online platforms, offering unsecured loans directly to businesses and bypassing banks

Benefits:

- Quicker and less bureaucratic than banks as applications are online, improving liquidity and helping rapidly operate and respond to opportunities

- No equity given up as funding is debt-based, allowing entrepreneurs to retain control over decision-making

Drawbacks:

- Fees and interest are high to compensate for financial risk, making overall cost as high as banks, reducing net profit

- Loans are unsecured so lenders may avoid high-risk firms with low credit ratings, potentially restricting access to finance, making P2P funding unreliable

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

Wealthy individuals invest personal capital in start-ups

Benefits:

- Risk-tolerant so provide funding where others won’t, giving entrepreneurs a lifeline to allow growth

- Offer valuable advice and industry contacts alongside funds, improving business decision-making and accelerating development

- Investments are usually short-term, allowing owners to regain shares and control in the long-term

Drawbacks:

- Finding a suitable angel with relevant expertise requires time and strong networking, potentially delaying access to funds

- Often demand equity and decision-making influence, reducing owner's profit share and strategic control, which may cause conflicts

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

Many individuals contribute small amounts via online platforms to fund a business or project

Benefits:

- Provides both funding and publicity as marketing campaigns raise awareness and create a ready-made customer base, boosting sales potential

- Accessible for firms without trading history as credit checks are not required, removing barriers and widening opportunities for start-ups

Drawbacks:

- Requires a persuasive business plan and constant promotion to compete with others for attention, adding extra costs and effort

- Failure to meet funding targets publicly damages reputation and undermines credibility, deterring future investors or customers

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

Joint ventures or partnerships with suppliers/customers, sharing costs and resources

Benefits:

- Provides access to funding, expertise, and distribution channels, accelerating growth

- Risk-sharing reduces individual burden, making high-cost projects feasible for small firms

Drawbacks:

- Requires profit sharing, limiting financial gains for the original business

- Joint decision-making may slow down processes and reduce independence and flexibility

What are loans and the types of loans as a method of finance?

- Borrowed money repaid with interest in fixed instalments, offering predictability at the cost of flexibility

- Bank loans: Secured or unsecured with varied terms and rates, but hard to access for high-risk firms like start-ups, limiting reliability

- Mortgages: Long-term secured loans for property with low rates, but defaulting risks repossession of assets, threatening survival

- Debentures: Long-term PLC loans with predictable returns to support long-term financial planning, but are inflexible and defaulting risks investor confidence, damaging credibility

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

Benefits:

- Fixed rates and equal payments aid budgeting certainty, helping businesses manage cash flow effectively

- Enable major asset purchases without upfront capital without ceding control since no equity is sold

Drawbacks:

- Interest raises fixed costs, and high-risk firms like start-ups face expensive rates, reducing profitability

- Increase non-current liabilities on the balance sheet, damaging financial ratios and limiting borrowing capacity for future ventures

What is share capital as a method of finance?

Finance raised by selling company shares

Benefits:

- Raises large permanent funds without creating repayment obligations or debt, giving businesses financial stability and capacity for growth

- Particularly effective for PLCs as shares can be sold to the public, enabling access to massive pools of capital

Drawbacks:

- Shareholders are entitled to dividends and voting rights, reducing founders’ profit share and strategic control

- Share prices fluctuate on the stock market, so company valuation and market perception can be damaged by poor performance or external shocks

What are ordinary, preference, and deferred shares?

- Most common and riskiest share, with voting rights and dividends based on profits, so shareholders benefit in growth years but face uncertainty in weak years

- Less risky as fixed dividends are paid before ordinary, providing certainty, but often lack voting rights and may be bought back, limiting long-term influence and profitability

-Rare shares held by founders, paying dividends after all others, ensuring founder commitment but providing little immediate return

What are venture capitalists and their benefits and drawbacks as a method of finance?

Specialist investors providing funds to high-growth potential businesses

Benefits:

- Fund firms rejected by banks due to high risk, enabling ambitious projects to proceed, making them reliable

- Offer strategic guidance and management expertise, improving professionalism and boosts chances of growing successfully

Drawbacks:

- Require a significant equity stake and influence over decision-making, reducing owner’s profit share and strategic control

- Tendencies to exit within five years may conflict with the entrepreneur’s long-term vision, creating pressure to prioritize short-term returns over long-term gains

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

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

Benefits:

- Improve cash flow management during short-term shortages, with interest only charged on the amount used, reducing unnecessary costs

- Provide flexibility as businesses can increase spending without formal loan agreements, improving liquidity and helping rapidly operate and respond to opportunities

Drawbacks:

- Interest rates are typically higher than loans, making overdrafts an expensive long-term solution

- Banks can withdraw the facility at short notice, creating sudden liquidity problems that may disrupt operations

What is leasing and its benefits and drawbacks as a method of finance?

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

Benefits:

- Avoids large upfront capital expenditure, ensuring access to necessary assets while freeing cash flow for other investments

- Leasing firm often handles maintenance, reducing operational costs and enabling access to occasional or up-to-date equipment

Drawbacks:

- More expensive over time compared to outright purchase, raising long-term costs and reducing overall profitability

- Leased items cannot be used as collateral for further finance, limiting borrowing capacity for future ventures

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

Benefits:

- Provides interest-free finance in the short term, improving working capital and enabling firms to sell goods before payment is due

- Profitable during inflation by delaying payments since money owed loses value over time, reducing real costs

Drawbacks:

- Missing early payment discounts may increase costs compared to paying upfront, reducing cost-efficiency

- Delayed payments may also damage supplier relationships, risking stricter terms or refusal of future trade credit

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 sustainability, innovation or job creation

Benefits:

- Free funding without repayment obligations, improving financial stability and profitability without increasing liabilities

- Enhances business reputation by showcasing government approval, improving credibility with investors and customers

Drawbacks:

- Eligibility is highly restrictive and application processes are lengthy, delaying access to funds and delaying responses to opportunities

- Funds can only be used for approved purposes, reducing flexibility by limiting strategic choices