Introduction: Welcome to External Finance!
In the previous chapter, we looked at how businesses can raise money from within their own four walls (Internal Finance). But sometimes, a business has big dreams that their own piggy bank just can't cover. That is where External Finance comes in!
External finance is money raised from outside the business. Whether it’s a small café asking a bank for a loan or a tech startup selling shares to a millionaire, knowing which source to pick can make or break a business. Let’s dive in and see how businesses get the cash they need to grow!
Part 1: Sources of Finance (The "Who")
Before we look at the type of money, we need to know who is providing it. Think of this as the "Who's Who" of the financial world.
1. Family and Friends
Often the first port of call for new entrepreneurs. This involves borrowing money from people you know personally.
Pros: Often interest-free or very low interest; usually no need for complicated paperwork.
Cons: Can lead to awkward Sunday dinners if the business fails and you can't pay them back! It can ruin personal relationships.
2. Banks
The traditional "high street" source. Banks provide various financial products to businesses they deem "safe."
Pros: Reliable and professional.
Cons: Banks are very cautious. They often require a detailed Business Plan and might ask for collateral (an asset like a house that they can take if you don't pay).
3. Peer-to-Peer (P2P) Funding
This is a modern way of borrowing. Instead of a bank, an online platform matches people who have spare cash with businesses that need it.
Analogy: Think of it like a "dating app" for money. The platform matches lenders with borrowers.
4. Business Angels
These are wealthy individuals (like the ones you see on Dragon's Den) who invest their own money into exciting new businesses.
Pros: They bring expertise and contacts, not just cash.
Cons: They will want a portion of your business (shares) and a say in how you run it.
5. Crowd Funding
Raising small amounts of money from a large number of people, usually via the internet (e.g., Kickstarter). Investors might get the product early or own a tiny "slice" of the company.
Did you know? The Oculus Rift VR headset started as a crowdfunding project before being bought by Facebook for billions!
6. Other Businesses
Sometimes, a large business might invest in a smaller one, perhaps because they want to use the smaller company's technology in the future.
Quick Review: The "Who" Mnemonic
Try "Big Cats Purr For Other Friends" to remember the sources:
Banks, Crowd funding, Peer-to-Peer, Business Angels, Other businesses, Family & Friends.
Part 2: Methods of Finance (The "How")
Now that we know who gives the money, we need to understand the different methods or "contracts" used to get it.
1. Loans
A set amount of money borrowed for a specific period, paid back in installments with interest added on.
Key Point: The formula for the total amount repaid is usually:
\( Total Repayment = Original Loan + Interest \)
2. Share Capital
This is only for Limited Companies. You sell a "piece" of the business to investors. In return, they get a share of the profits (called dividends).
Crucial Tip: With shares, you don't "pay back" the money like a loan, but you lose some control over your business.
3. Venture Capital
A mix of a loan and share capital, usually for high-risk, high-reward startups. Venture capitalists provide large sums of money in exchange for a big stake in the company.
4. Overdrafts
A very short-term "safety net" where the bank lets you spend more money than you actually have in your account.
Relatable Example: It’s like having a £0 balance but being able to buy a £20 pizza anyway because the bank allows you to go into "minus" figures.
5. Leasing
Instead of buying an expensive piece of equipment (like a delivery van or a printer), you "rent" it from a leasing company. You pay a monthly fee, but you never actually own the item.
6. Trade Credit
Buying supplies now and paying for them later (usually 30, 60, or 90 days later).
Benefit: It helps with cash flow because you can sell the product to customers before you have to pay your own suppliers!
7. Grants
Essentially "free money" from the government or charities. They are usually given to businesses that help the community or create jobs in poor areas.
The Catch: You usually have to meet very strict conditions to get one and keep it.
Part 3: Making the Right Choice
Don't worry if this seems like a lot of options! In the exam, you'll often be asked to recommend the best one. Here is how to decide:
Common Mistakes to Avoid:
1. Matching the length: Don't use a long-term loan to buy daily milk (stock). Use trade credit or an overdraft. Conversely, don't use an overdraft to buy a factory! Use a long-term loan or shares.
2. The "Cost" of Shares: Students often think shares are "free." They aren't! You are giving away future profits forever. That can be much more expensive than a bank loan in the long run.
Summary Table: Debt vs. Equity
This is a great way to simplify the "Methods" section for your revision:
Debt (Loans/Overdrafts):
- Must be paid back.
- Interest is charged.
- No loss of control.
Equity (Shares/Venture Capital):
- Never "paid back" in the traditional sense.
- Investors want a say in decisions.
- You have to share your profits (dividends).
Key Takeaway
External finance is about trade-offs. If you want to keep total control, you take on Debt (and the stress of repayments). If you want to avoid debt, you give away Equity (and lose some control). The "best" source depends on the size of the business, its legal status (sole trader vs. PLC), and what the money is being used for.