2.1.2 external finance

1. Debt Finance (Loans and Borrowing):

Debt finance involves borrowing money that must be paid back over time, usually with interest. The primary forms of debt finance are:

a. Bank Loans:

• Definition: A business borrows a fixed sum of money from a bank or financial institution, which is paid back in installments over an agreed period, typically with interest.

• Advantages:

  • Large Sums: Businesses can borrow significant amounts for investment or expansion.

  • Predictable Repayments: Loan repayments are fixed, so businesses can plan for regular expenses.

• Disadvantages:

  • Interest Payments: The business has to pay interest on the loan, which adds to the overall cost.

  • Risk of Default: If the business cannot repay the loan, it may face legal action or lose assets (in the case of secured loans).

b. Overdrafts:

• Definition: A short-term borrowing facility that allows a business to withdraw more money than it has in its account, up to an agreed limit.

• Advantages:

  • Flexible: Ideal for managing short-term cash flow issues.

  • Quick Access: Can be accessed quickly when needed.

• Disadvantages:

  • High-Interest Rates: Overdrafts tend to have higher interest rates compared to loans.

  • Risk of Debt Accumulation: If not managed carefully, overdrafts can lead to accumulating debt.

c. Bonds:

• Definition: A business can issue bonds, which are essentially loans from investors that the company agrees to repay with interest over a fixed period.

• Advantages:

  • Larger Amounts: Suitable for large-scale financing, such as funding major capital expenditures.

  • Fixed Terms: Clear repayment terms help with planning.

• Disadvantages:

  • Interest Costs: Bonds incur regular interest payments, which can be a financial burden.

  • Reputation Risk: Issuing bonds can signal financial distress or the need for funding, which might affect investor confidence.

2. Equity Finance (Shares and Investment):

Equity finance involves raising capital by selling shares or ownership stakes in the company. Investors, in return for their investment, receive a share of the business's profits or future growth.

a. Issuing Shares (for Public or Private Companies):

• Definition: A business sells shares of stock in exchange for investment capital. Shareholders become partial owners of the business.

• Advantages:

  • No Repayment: Unlike loans, equity finance does not need to be repaid, and there is no interest.

  • Attracts Long-Term Investors: Shareholders are often more patient and may provide long-term support.

• Disadvantages:

  • Loss of Control: Issuing shares means giving away a portion of ownership and decision-making power to shareholders.

  • Dividends: Shareholders may expect dividends, meaning a portion of profits must be paid out.

  • Dilution of Ownership: Issuing more shares reduces the control of existing shareholders over the business.

b. Venture Capital:

• Definition: Venture capital involves external investors providing funding to start-ups or early-stage companies in exchange for equity, often accompanied by mentorship or strategic support.

• Advantages:

  • High Growth Potential: Venture capitalists typically invest in high-growth businesses that can scale quickly.

  • Expert Guidance: Along with funding, venture capitalists often offer valuable business advice and networks.

• Disadvantages:

  • Loss of Control: Venture capitalists may want a say in the business’s strategy or management decisions.

  • High Expectations: They often expect high returns on their investment and may push for rapid growth.

c. Business Angels:

• Definition: Business angels are wealthy individuals who invest their personal funds into start-ups or small businesses in exchange for equity or debt. They may also offer mentoring.

• Advantages:

  • Mentorship: In addition to funds, angels often bring experience, expertise, and business connections.

  • Flexible Terms: Business angels may offer more flexible terms than traditional investors or banks.

• Disadvantages:

  • Partial Control: Similar to venture capital, business angels may want influence over the business’s decisions.

3. Grants and Subsidies:

Grants and subsidies are non-repayable funds provided by governments, organizations, or foundations to support businesses, typically those involved in research and development, environmental projects, or community welfare.

• Advantages:

  • No Repayment: Grants do not need to be repaid, unlike loans.

  • Encouragement for Innovation: Often targeted at businesses working on innovative, sustainable, or socially beneficial projects.

• Disadvantages:

  • Competitive: Grants are often highly competitive, and businesses must meet strict criteria.

  • Conditions: Some grants come with specific conditions or limitations on how the funds can be used.

4. Crowdfunding:

Crowdfunding involves raising small amounts of money from a large number of people, typically via online platforms. Investors may receive rewards, products, or equity in return for their investment.

• Advantages:

  • Access to Large Pools of Investors: Small businesses or start-ups can raise capital from a wide range of people.

  • Marketing: Crowdfunding can also act as a marketing tool, as it generates interest in the product or service.

• Disadvantages:

  • Not Guaranteed: There’s no certainty that the funding target will be met.

  • Time-Consuming: It can take significant time and effort to create and promote a crowdfunding campaign.

5. Trade Credit:

Trade credit is when a business purchases goods or services from a supplier and agrees to pay for them at a later date (typically 30, 60, or 90 days after delivery).

• Advantages:

  • Improves Cash Flow: It allows the business to delay payments, improving short-term cash flow.

  • No Interest: Trade credit is usually interest-free if paid within the agreed period.

• Disadvantages:

  • Late Fees or Penalties: If the business does not pay on time, it may face late fees or damage to its relationship with suppliers.

  • Limited to Certain Suppliers: Trade credit may only be available from specific suppliers and for certain products.

Advantages of External Finance:

1. Larger Funding: External finance allows businesses to raise larger amounts of capital compared to internal finance.

2. No Immediate Repayment (for equity finance): Unlike debt finance, equity finance does not require regular repayments.

3. Access to Expertise: Investors, especially venture capitalists or business angels, bring valuable experience, networks, and strategic support.

4. Support for Growth: External finance can provide the necessary funds for business expansion, acquisitions, or innovation projects.

Disadvantages of External Finance:

1. Repayment Obligations (for debt): Debt financing must be repaid with interest, which can strain cash flow.

2. Loss of Control (for equity): Issuing shares or taking investment means giving up partial ownership and control.

3. Time-Consuming: Securing external finance can be a lengthy process, involving negotiations, legal paperwork, and approvals.

4. Costly: External finance, particularly loans and bonds, often comes with interest rates, fees, and other costs.