2.1.2 External finance

Define external finance

Finance sourced from outside of the business

What are common sources of external finance?

Family and friends, banks, peer-to-peer funding, business angels, crowdfunding, and other businesses.

Define family and friends as a source of finance

Small business owners approach close acquaintances to invest in or lend money to a business

Benefits and drawbacks of family and friends as a source of finance

BENEFITS

• Usually a very cheap source of funds

• May have ‘no strings attached (e.g. a share of the business) and can be provided to the business on very flexible terms

DRAWBACKS

• Relationships may be damaged if the finance is not repaid

Benefits of drawbacks of using banks as a source of finance

BENEFITS

• May offer both short term finance (e.g. overdrafts) and long term finance (e.g. loans or mortgages) if a business qualifies

• Banks are often keen to provide free advice and guidance to businesses that use their services

DRAWBACKS

• A business plan is usually required to access bank finance

• Banks can be cautious about lending to new, untested businesses

• Interest (and often an arrangement fee) is payable

• Businesses must be customers of the bank (i.e. hold a banking account) to access some loans

• For larger amounts, businesses may need to provide security to be granted a loan

Define peer to peer funding

Individuals lend money directly to businesses (or other individuals) via online platforms,

Benefits of drawbacks of using peer to peer funding as a source of finance

BENEFITS

• Loans can usually be made available to businesses very quickly

• Usually has ‘no strings attached (e.g. a share of the business)

DRAWBACKS

• Borrowers are charged a small fee to access finance in this way and have to pay interest in the same way as a bank loan

  • The individuals who made the money available in the first place receive some of this interest as compensation

Define business angels

Wealthy individuals who invest their own money into new or growing businesses in exchange for equity (ownership).

Benefits of drawbacks of using business angels as a source of finance

BENEFITS

• Business angels tend to be more willing to take a risk than banks

• Angels often offer advice and guidance to the businesses in which they invest

• Investment is usually for a determined period of time so owners regain shares in the future

DRAWBACKS

• Finding the ‘right’ business angel (e.g. with appropriate experience, expertise or interest) can be challenging

  • Networking is vital when entrepreneurs seek this kind of investment

• As business angels own a stake in the business, they may be involved in decision-making and will receive a share of business profits

Define crowdfunding

Finance provided by a large number of small investors on online platforms

Benefits of drawbacks of using crowdfunding as a source of finance

BENEFITS

• Free marketing – the platform promotes your idea publicly

• No credit check – good for startups with no financial history

• Creates a customer base – backers often become early users/fans

DRAWBACKS

• Businesses need to provide a persuasive business plan to convince individuals to invest in their product as they will be competing with many other projects online

• Bad PR risk – public failure can damage brand image - The potential for negative publicity if the project is not successful in attracting enough crowdfunding capital

What is meant by using other businesses as a source of external finance?

A business may access finance through a joint venture, strategic partnership, or by another business buying shares (e.g. for investment or takeover purposes).

Benefits of drawbacks of using other businesses as a source of finance

BENEFITS

• May provide access to business processes and market knowledge alongside finance

• Can access large amounts of finance

DRAWBACKS

• Profits need to be shared between businesses

• Decisions will usually need to be agreed by all businesses

What are common methods of external finance?

Loans, share capital, venture capital, overdrafts, leasing, trade credit and grants

Define venture capital

Investment from a firm or individual into a high-risk business (often a start-up) in exchange for equity (ownership).

Benefits and drawbacks of venture capital

✅ Benefits:

• Good for start-ups with potential

• Investors bring expertise, contacts, advice

• No regular repayments

❌ Drawbacks:

• Lose a stake in your business

• Often comes with loss of independence/control

• Expectation of high growth and return

Define loan

A sum of money is borrowed and repaid (with interest) over a determined period of time

Define overdrafts

An overdraft is a short-term source of finance where a business can spend more money than it has in its bank account, up to an agreed limit.

Benefits and drawbacks of an overdraft

✅ Benefits:

• A short-term source of finance that offers significant flexibility and aids cash flow (quick and easy)

❌ Drawbacks:

1. High interest rates
   → More expensive than a bank loan if used often

2. Can be “called in” at any time
   → The bank can demand full repayment with little warning

Define share capital

Finance raised from the sale of shares in a limited company (plc or ltd)

Benefits and drawbacks of share capital

✅ Benefits of Share Capital:

1. No repayment or interest like a loan
   → It’s not debt — it's investment

2. Can raise large amounts (especially for PLCs on stock exchange)
   → Great for expansion

3. Spreads risk — more people invested in the success of the business

4. Improves liquidity — boosts the company’s available cash without increasing debt

❌ Drawbacks of Share Capital:

1. Loss of ownership/control
   → Shareholders have voting rights (e.g. at AGMs)

2. Must share profits via dividends
   → Not all profit goes back into the business

3. Risk of hostile takeovers (for PLCs) if too many shares are bought

Define leasing

An asset such as a piece of machinery or a vehicle used by the business in return for regular payments

Define trade credit

An agreement is made with suppliers to buy raw materials, components and stock which are paid for at a later date

Benefits and drawbacks of trade credit

✅ Benefits of Trade Credit:

• Interest-free (if paid on time)
  → Cheaper than a loan or overdraft

❌ Drawbacks of Trade Credit:

• Discounts for early payment will not be available

• Penalties or fees if you pay late
  → Could damage reputation with suppliers

Define grants

A grant is a sum of money given to a business (usually by the government, charities, or local authorities) that doesn’t have to be repaid.

Benefits and drawbacks of grants

✅ Benefits of Grants:

1. Free money 💸
   → No repayment and no interest = very low risk

2. Doesn’t dilute ownership
   → Unlike share capital, you keep full control

3. Encourages investment in social, green, or regional development projects

❌ Drawbacks of Grants:

1. Very competitive
   → Lots of businesses apply, only a few get it

2. Strict criteria
   → Must meet specific rules (e.g. location, type of business, what the money is used for)

3. Time-consuming to apply
   → Lots of paperwork, planning, and waiting

4. Often only small amounts available
   → Not always enough for big projects