3.2.2 External Sources of Finance Notes

External Sources of Finance

1. When your business needs funds to expand, purchase equipment, or manage cash flow.
2. Where do you turn if internal resources aren't enough?
3. This is where external sources of finance come into play.

Share Capital: Selling Ownership in the Business

1. Shareholders become part-owners and may receive dividends as a return on their investment.
2. This is often referred to as having "equity" in the company.

When Is Share Capital Suitable?

1. Long-term investments: Ideal for funding major projects like expansion or research and development.
2. Limited companies: Only available to private or public limited companies, not sole traders or partnerships.

Types of Companies Using Share Capital

1. Privately Held Companies: Shares are not traded publicly, ownership is typically held by a small group.
2. Publicly Held Companies: Shares are traded on stock exchanges, allowing wider access to investors.

Pros and Cons of Share Capital

Loan Capital: Borrowing with Interest

1. Common forms include bank loans, mortgages, and debentures.
2. These types of financing are essential for businesses requiring significant amounts of money for investments or operational growth.

1. Bank Loans

1. Bank loans are typically repaid over terms ranging from 2 to 20 years, with regular repayment schedules.
2. The interest rate on a bank loan can be either fixed (unchanging) or variable (fluctuating with market conditions).
3. Banks often require collateral, such as property or equipment, to secure the loan.
4. This collateral can be seized if the borrower defaults on payments.
5. Bank loans are usually easier to secure for businesses with a strong credit history and financial stability.
6. Once agreed, the repayment terms are relatively inflexible, requiring businesses to commit to regular payments.

2. Mortgages

1. Mortgages can last for up to 50 years, making them ideal for financing large assets such as land or buildings.
2. The interest rate can be fixed or variable, allowing businesses to select repayment terms that suit their financial stability.
3. The purchased property acts as security, which means it can be seized if the borrower fails to make payments.
4. Remortgaging allows businesses to refinance their property to release additional funds, which can be particularly helpful for expanding operations.
5. Mortgages are often used by businesses that want to own fixed assets instead of renting.

3. Debenture

1. Interest rates on debentures are fixed, providing businesses and lenders with predictable financial terms.
2. The repayment term for a debenture usually ranges from 10 to 15 years, although some debentures are irredeemable (no repayment date).
3. Debentures are secured using non-current assets like property or equipment as collateral.
4. Unlike equity financing, debentures do not give lenders any ownership rights in the business, meaning no dilution of control.
5. Debentures are often used by businesses that need large-scale, long-term financing without offering shares in the company.

Pros and Cons of Loan Capital

Overdrafts: Flexible Short-Term Borrowing

When Are Overdrafts Useful?

1. Managing cash flow: Ideal for covering short-term expenses like payroll or inventory.
2. Flexibility: Borrow only what you need, when you need it.

Pros and Cons of Overdrafts

Trade Credit: Delayed Payment to Suppliers

Benefits of Trade Credit

1. Improves liquidity: Frees up cash for other expenses.
2. Interest-free: Unlike loans or overdrafts, no interest is charged.

Pros and Cons of Trade Credit

Crowdfunding: A Modern Source of Business Finance

Types of Crowdfunding

1. Donation-based: Supporters contribute without expecting a return.
2. Reward-based: Contributors receive perks or products.
3. Equity-based: Investors receive shares in the business.

Why Crowdfunding Has Grown in Popularity

1. Bank Lending Challenges:
   1. Following the financial crisis of 2007–2009, banks became more cautious, making it harder for small and medium-sized enterprises (SMEs) to secure loans.
2. Low Interest Rates for Savers:
   1. Interest rates on traditional savings accounts have often been lower than inflation.
   2. This has led savers to look for alternative ways to grow their money.
3. Internet Platforms Bridging the Gap:
   1. Entrepreneurs have developed online platforms that connect businesses seeking funding with individuals willing to lend or invest.
   2. These platforms simplify the process for both parties.

Pros and Cons of Crowdfunding

Leasing: Renting Instead of Buying

Why Choose Leasing?

1. Preserves capital: No large upfront payment required.
2. Access to latest technology: Easily upgrade assets at the end of the lease term.

Pros and Cons of Leasing

Microfinance Providers: Small Loans for Big Impact

Why Microfinance Matters

1. Empowers small businesses: Provides capital to those without access to traditional banking.
2. Promotes economic development: Supports entrepreneurship in low-income communities.

Pros and Cons of Microfinance

Business Angels: Investing More Than Money

What Do Business Angels Offer?

1. Capital: Investments typically range from €15,000 to €750,000.
2. Mentorship: Angels often provide guidance and industry expertise.

Pros and Cons of Business Angels

Venture Capital: A Strategic Source of Business Finance

1. Venture capital focuses on businesses that may face challenges in securing funding through traditional means due to their high-risk profile.
2. It typically involves a mix of loan financing and equity investment, where the investor acquires partial ownership of the business.

Choosing the Right Source of Finance

1. Selecting the appropriate source of finance depends on several factors:
   1. Timeframe: Short-term needs (e.g., overdrafts) vs. long-term investments (e.g., share capital).
   2. Cost: Interest rates, fees, and opportunity costs.
   3. Control: Will the source dilute ownership or influence decision-making?
   4. Business Structure: Not all sources are available to every type of business.