Chapter – 25
External Finance
Definitions
1. authorised share capital the maximum amount that can be legally raised.
2. bank overdraft an agreement between a business and a bank that means a
business can spend more money than it has in its account (going
'overdrawn'). The overdraft limit is agreed and interest is only charged when
the business goes overdrawn.
3. capital gain the profit made from selling a share for more than it was bought.
4. crowd funding where a large number of individuals (the crowd) invest in a
business or project on the Internet, avoiding the use of a bank.
5. debenture a long-term loan to a business.
6. equities another name for an ordinary share.
7. external finance money raised from outside the business.
8. issued share capital amount of current share capital arising from the sale of
shares.
9. lease a contract to acquire the use of resources such as property or
equipment.
[Link]-to-peer lending (P2PL) where individuals lend to other individuals
without prior knowledge of them, on the Internet.
[Link] capital share capital that is never repaid by the company.
[Link] loans a loan where the lender requires security, such as property, to
provide protection in case the borrower defaults.
[Link] capital money introduced into the business through the sale of shares.
[Link] loans a loan where there are no assets to which the lender has a
right if the borrower does not make repayments.
[Link] capitalists providers of funds for small- or medium- sized companies
that may be considered too risky for other investors.
EXTERNAL FINANCE
Few businesses can rely entirely on internal financing to fund all business activity.
Initially, external finance, which is finance from sources outside the business,
may not be available. This is because new businesses have no trading record and
present too much risk for many lenders. However, once a business has survived the
initial ‘uncertain’ stages of business development, external sources of finance are
likely to become a realistic option.
SOURCES OF FINANCE
There is quite a wide range of external sources that businesses can choose from.
Family and friends:
A common source of finance, particularly for small businesses, is family members
or close friends. This may be a cheap source because if the money is a loan,
interest charges may be low, or possibly zero. In some cases money might be gifted
to an entrepreneur.
Banks:
Commercial banks such as ANZ (Australia), State Bank of India, Commerzbank
(Germany) and HSBC provide a range of different external funding arrangements
for businesses. These include loans, overdrafts and mortgages. Most commercial
banks have specialist departments or staff that deal exclusively with businesses.
Banks will be involved in a business start-up because businesses need a bank
account to facilitate financial transactions with customers and suppliers. Banks
might also offer advisory services to businesses. These are often free. A formal
application is required to get finance from banks and it will probably be necessary
to provide a business plan.
Peer-to-peer lending:
Peer-to-peer lending (P2PL) involves people lending money to unrelated
individuals or ‘peers’ and therefore avoiding the use of a bank. Transactions are
undertaken online and are organized by specialists. Although this source of finance
can be used by a business, it is not exclusive to businesses. Anyone can apply for a
peer-to-peer loan.
The key features of peer-to-peer lending include the following.
All loans are unsecured, which means there is no protection for lenders.
Therefore, lenders might lose their money if a borrower is unable to repay
the loan.
The whole financial arrangement is conducted for profit.
All transactions take place online.
No previous knowledge or relationship between lenders and borrowers is
needed.
Lenders may choose which borrower to lend to. Peer-to-peer sites make a
charge - typically about 1 per cent.
Business angels:
Business angels are individuals who typically may invest between £10,000 and
£100,000+, often in exchange for a stake in a business. An angel might make one
or two investments in a 3-year period, either individually or together with a small
group of friends, relatives or business associates. Most investments are in business
start-ups or in early stages of expansion.
A problem with this source of finance for businesses is finding a suitable 'angel'.
As angels normally take a stake in the business, the angel and the current business
owners must have shared interests and a common vision for the future direction of
the firm.
Crowd funding:
Crowd funding is similar to peer-to-peer funding in that banks are excluded and
individuals can lend money to others without previous knowledge of them.
However, the fundraisers tend to be businesses or groups who are involved in a
particular venture such as putting on production, building a school or setting up a
community project. The lenders or investors will be large numbers of individuals
who collectively represent 'the crowd'. Transactions are conducted online.
Methods of finance
Businesses can use a variety of different methods to raise finance.
Loans: A loan is an arrangement where the amount borrowed must be returned over
a fixed period of time in regular equal payments. Loans tend to be inflexible and
interest will be added to the total. There are different sorts of loan capital.
Bank loans are probably the most common type of loan. They may be unsecured
loans. This means that the lender has no protection if the borrower fails to repay
the money owed. They can be used for long- term or short-term purposes
depending on the needs of the business. However, the use of unsecured bank loans
has probably diminished in recent years due to the high risk they carry for banks.
Mortgages are secured loans where the borrower has to provide some assets as
collateral to support the loan. This means that if the borrower defaults, the lender is
entitled to sell the assets and use the money from the sale to repay the outstanding
amount. Mortgages are long-term loans and are typically for 25 years or more.
They might be used by a business to fund the purchase of premises or a large item
of capital equipment. Mortgages are usually cheaper than unsecured loans because
there is less risk for the lender.
Debentures are a specialised method of loan finance. The holder of a debenture is a
creditor (someone to whom the business owes money) of a company, not an owner.
Debenture holders are entitled to a fixed rate of return, but have no voting rights.
They must also be repaid on a set date - when the term of the loan ends. Public
limited companies use this long-term source of finance.
Share capital: For a limited company share capital is likely to be the most
important source of finance. The sale of shares can raise very large amounts of
money. Issued share capital is the money raised from the sale of shares. Authorised
share capital is the maximum amount shareholders want to raise. Share capital is
often referred to as permanent capital. This is because it is not normally redeemed,
i.e. it is not repaid by the business. Once the share has been sold, the buyer is
entitled to a share in the profit of the company, i.e. a dividend. Dividends are not
always declared. Sometimes a business makes a loss or needs to retain profit to
help fund future business activities. A shareholder can make a capital gain by
selling the share at a higher price than it was originally bought for. Shares are not
normally sold back to the business. The shares of public limited companies are sold
in a special share market called the stock market or stock exchange. Shares in
private limited companies are transferred privately. Shareholders, because they are
part owners of the business, are entitled to a vote. One vote is allowed for each
share owned.
Ordinary shares. These are also called equities and are the most common type of
share issued. They are also the riskiest type of share since there is no guaranteed
dividend. The size of the dividend depends on how much profit is made and how
much the directors decide to retain in the business. All ordinary shareholders have
voting rights. When a share is first sold it has a nominal value shown on it - its
original value. Share prices will change as they are bought and sold again and
again.
Preference shares. The owners of these shares receive a fixed rate of return when a
dividend is declared. They carry less risk because shareholders are entitled to their
dividend before the holders of ordinary shares. Preference shareholders are not
strictly owners of the company. If the company is sold, their rights to dividends
and capital repayments are limited to fixed amounts. Some preference shares also
allow their holders to receive late-payment of dividends that were missed in years
when dividends were not declared. Some are also redeemable, which means that
they can be bought back by the company.
Deferred shares. These are not used often. They are usually held by the founders of
the company. Deferred shareholders only receive a dividend after the ordinary
shareholders have been paid a minimum amount.
Venture capital: Venture capitalists are specialists in the provision of funds for
small- and medium-sized businesses. Typically they invest in businesses after the
initial start-up and often prefer technology companies with high growth potential.
They prefer to take a stake in the company, which means they have some control
and are entitled to a share in the profit. Venture capitalists raise their funds from
institutional investors such as pension funds, insurance companies and wealthy
individuals. They are also likely to exit after about 5 years.
Bank overdraft: This is an important source of finance for a large number of
businesses. A bank overdraft means that a business can spend more money than it
has in its account. In other words they go 'overdrawn'. The bank and the business
will agree on an overdraft limit and interest is only charged when the account is
overdrawn. The amount by which a business goes overdrawn depends on its needs
at the time.
Leasing: A lease is a contract through which a business acquires the use of
resources, such as property, machinery or equipment, in return for regular
payments. In this type of finance, the ownership never passes to the business that is
using the resource.
Trade credit: It is common for business to buy raw materials, components and fuel,
and pay for them at a later date. Paying for goods and services using trade credit
seems to be an interest free way of raising finance. It is particularly profitable
during periods of inflation.
Grants: Some businesses might qualify for financial support in the form of a grant.
A list of grants available can be accessed using the government’s business finance
support finder tools. This allow firms to select specific funding options and search
for grants by business location, size and type of business activity.
Grants are usually available to small businesses providing they meet certain
criteria. Most grants do not have to be repaid, so this is a significant advantage of
this type of external finance.