Introduction: Why External Finance?
Welcome to your study notes on External Finance! In the last chapter, you looked at internal finance (money the business finds from within, like personal savings). However, most businesses eventually reach a point where they need more "fuel" to grow than they have in their own tank. That is where External Finance comes in.
Think of it like this: Internal finance is using your own pocket money to buy a bike. External finance is asking a bank or a friend for a loan so you can buy a car. In this chapter, we will explore who provides this money (sources) and how they provide it (methods).
Section 1: Sources of External Finance
A "source" is simply the person or organisation that provides the money. Don't worry if these sound like jargon; we will break them down into everyday terms!
1. Family and Friends
This is often the first place a new entrepreneur looks.
Why? It is usually flexible, and they might not charge much (or any) interest.
The Risk: If the business fails, you might lose more than just money—you could lose a relationship!
2. Banks
The most traditional source. Banks provide professional financial services. They are reliable but very strict about seeing a business plan before they hand over any cash.
3. Peer-to-Peer (P2P) Funding
Analogy: It is like a "dating site" for money.
Online platforms match people who have money to lend with businesses that need to borrow. It cuts out the "middleman" (the traditional bank), which can sometimes mean better rates for everyone.
4. Business Angels
These are wealthy individuals who invest their own money into exciting new businesses.
The "Plus": They often provide mentorship and advice because they want your business to succeed.
The "Minus": They will want a share (equity) in your business in return.
5. Crowdfunding
This involves getting small amounts of money from a large number of people, usually via the internet (e.g., Kickstarter).
Did you know? Crowdfunding is also a great way to test if people actually like your product before you fully launch it!
6. Other Businesses
Sometimes, a business might invest in another business to build a partnership or help a supplier stay afloat.
Quick Review: Sources
• Family/Friends: Emotional but flexible.
• Banks: Professional and structured.
• Business Angels: Money + Expertise + Shared Ownership.
• Crowdfunding: "The Power of the People."
Section 2: Methods of External Finance
While the "source" is who gives the money, the "method" is how the money is given and the rules for paying it back.
1. Loans
A fixed amount of money borrowed for a specific time.
Key Feature: You must pay back the "principal" amount plus Interest.
Memory Aid: Think of a loan as "Rent for Money." You pay the bank a fee (interest) to use their cash for a while.
2. Share Capital
This is only for Limited Companies (Ltd or PLC). You sell "bits" of the business to investors.
Advantage: You don't have to pay the money back.
Disadvantage: You lose some control, and you have to share your future profits (dividends).
3. Venture Capital
This is a "high-stakes" method. Venture capitalists provide large sums of money to businesses with massive growth potential. They take a big risk, so they expect a big share of the business and a say in how it is run.
4. Overdrafts
Analogy: An emergency parachute.
A bank lets you spend more money than you actually have in your account, up to a certain limit.
Best used for: Short-term cash flow problems (e.g., paying a bill today when your customer won't pay you until next week).
Warning: Interest rates on overdrafts are usually very high!
5. Leasing
Instead of buying a piece of equipment (like a van or a printer) for £20,000, you "rent" it for a monthly fee.
Why do this? It keeps cash in the business for other things, and the leasing company is usually responsible for repairs.
6. Trade Credit
This is when a supplier lets you "buy now, pay later" (usually in 30, 60, or 90 days).
Simple trick: It’s like a credit card for business supplies. It helps you sell the goods before you even have to pay for them!
7. Grants
Money given by the government or charities.
The best part: You don't have to pay it back!
The catch: They are very hard to get and often come with "strings attached" (e.g., you must create 10 new jobs in a specific area).
Key Takeaway:
Choose Short-term methods (Overdraft, Trade Credit) for day-to-day bills.
Choose Long-term methods (Loans, Share Capital) for big purchases like buildings or machinery.
Section 3: Choosing the Right Finance
In your exam, you will often be asked which method is "best" for a specific business. Here is how to decide:
1. The Legal Structure
A Sole Trader cannot use Share Capital because they don't have "shares" to sell. They would likely look at a bank loan or personal savings.
2. The Amount Needed
If you need £500 for a new desk, you wouldn't look for a Venture Capitalist. You might use an Overdraft or Trade Credit. If you need £5 million for a factory, you need a Loan or Share Capital.
3. Risk and Control
If the owner wants to keep 100% control, they should avoid Business Angels and Share Capital. They should use Debt Finance (Loans) instead.
Common Mistake to Avoid:
Students often say "the business should get a grant" for every problem. Remember: Grants are rare and very specific! Only suggest them if the business is doing something for the community or environment.
Quick Summary Table
Method: Loan
Cost: Interest
Control: Owner keeps control
Method: Share Capital
Cost: Dividends
Control: Owner loses some control
Method: Overdraft
Cost: High Interest
Control: Owner keeps control
Final Top Tip for Success
Whenever you talk about External Finance, always mention the Cost (interest or dividends) and the Risk (losing the business if you can't pay it back). Linking these together will help you get those higher marks!