External finance

Question 1

Define external finance.

Answer 1

investment for the business that is obtained from; banks, investors and lenders outside of the business.

Question 2

What is the difference between a source of finance and a method of finance?

Answer 2

Source of finance: This is where the finance has come from e.g. a bank

Method of finance: This is the use of a finance – or what use it would be suitable for e.g. loan to buy computer equipment for the business

Question 3

List some sources of finance.

Answer 3

family and friends
banks
peer-to-peer funding
business angels
crowd funding
other businesses

Question 4

Explain family and friends as a source of finance.

Answer 4

Private limited companies are able to raise finance by selling shares to friends and family.

A sole trader or partnership may also find that their family may want to contribute to the business. This may be for interest, a share of the profits or maybe even an interest free loan amongst family.

Question 5

What are the advantages of friends and family as a source of finance?

Answer 5

Loans from friends and family will probably be offered without the need for security and at lower rates and over longer terms than traditional lenders.

They are also unlikely to need a business plan which means the owner may not need to write one.

Question 6

What are the disadvantages of friends and family as a source of finance?

Answer 6

Downside is that it may cause tension and problems if the finance is not repaid or the business does not flourish.

They may also demand their money back at short notice

Question 7

Explain banks as a source of finance.

Answer 7

Banks may lend a loan to a business to start-up or when a business wants to grow and expand.

Banks may also provide a business with an overdraft to help when they have cash flow problems.

All the high street banks have business departments that will deal with commercial loans

Question 8

What are the advantages of using banks as a source of finance?

Answer 8

Banks will lend to businesses without asking for a % of the ownership

Banks will allow the business owner to continue running the business their own way, and not interfere, so the owner retains control of the business (unlike business angels)

Question 9

What are the disadvantages of using banks as a source of finance?

Answer 9

Bank loans can be expensive compared to other sources of finance and interest must be paid back on time

It may be hard for a new business owner to obtain a loan as they have no historical sales data to show the bank

The owner may need to use their own assets as security for the loan e.g. their own house

Question 10

Explain peer to peer funding as a source of finance.

Answer 10

Lending marketplaces such as Funding Circle have gained the trust of consumers by offering lower rates than banks to business owners who want to borrow money

Peer-to-peer funding matches businesses that need finance with investors who are looking for a good return on their investment

Question 11

What are the advantages of using peer to peer funding as a source of finance?

Answer 11

Businesses can get access to funding within a week once approved

Business owners can apply online

Investors can expect returns of 6-7% whereas a savings account might only give them 3%

Question 12

What are the disadvantages of using peer to peer funding as a source of finance?

Answer 12

It’s harder for the funding service when they have to find several investors / businesses to put money up for the loan.

If there are not enough individuals/small businesses interested or willing to invest in your loan, you may not be able to acquire the entire amount that the business needs.

Question 13

Explain business angels as a source of finance.

Answer 13

An Angel investor offers to lend their personal disposable finance

The angel would normally take shares in the business in return for providing finance

Angels normally seek to not only provide the business with money to grow, but also bring their experience and knowledge to help the company achieve success

Angel Investors seek to have a return on their investment over a period of 3-8 years

Usually smaller loan amounts than a venture capitalist

Question 14

What are the advantages of business angels as a source of finance?

Answer 14

Angels are free to make investment decisions quickly

The owner gets access to your investor’s sector knowledge and contacts

The owner gets access to angels mentoring or management skills

The owner will have no repayments or interest on the money lent

Question 15

What are the disadvantages of business angels as a source of finance?

Answer 15

Not suitable for investments below £10,000 or more than £500,000

Owner needs to give up a share of the business

Question 16

Explain crowd funding as a source of finance.

Answer 16

Crowd funding is where a large number of people fund a project over the internet making small investments each, 3 ways to fund:

Donate: no money back, but rewards like tickets or a newsletter

Lend: get money back with interest and satisfaction of contributing to success of a small business

Invest: Invest in a business in exchange for equity or shares which may increase in value

Question 17

What are the advantages of using crowd funding as a source of finance?

Answer 17

Good alternative to loans for small business owners

Finance can be obtained without paying upfront fees

The business can generate funds and also promote the business at the same time

Question 18

What are the disadvantages of using crowd funding as a source of finance?

Answer 18

The business will need to showcase their idea to investors and may need to put together a video and other promotional material to attract investors

Question 19

Explain other businesses as a source of finance.

Answer 19

Other businesses may wish to invest in start-ups

A business may have surplus profit and view this as a way to get a good return on their investment

Question 20

List some different methods of finance.

Answer 20

loans
share capital
venture capital
overdrafts
leasing
trade credit
grants

Question 21

Explain share capital as a method of finance.

Answer 21

In a public limited company – plc - one that has been floated on the stock market - they can raise more finance to expand by selling more shares.

This is an external and long term method of finance but would only apply to a large business with a plc after its name

Question 22

Explain loans as a method of finance.

Answer 22

Banks will lend to small business but may not lend when they first start-up as there is no track record or history of them making money.

Loans are quick to set up

Loans are affected by interest rates – if they go up the cost of borrowing will go up too and the business may have to pay more interest back to the bank

Question 23

Explain venture capital as a method of finance.

Answer 23

Venture capitalists (VCs) will invest large sums of other people’s money in a business in return for shares in the company.

Typically, VCs will invest at least £50 000 in a small regional business although this can rise into millions of pounds.

The VC will look for a high rate of return in a specific time period.

Question 24

Explain overdrafts as a method of finance.

Answer 24

Some months a business may need extra cash to tide it over until a better month. A loan is over many years so is not suitable.

An overdraft may be organised by the bank which is short term lending of smaller amounts of money

Question 25

Explain leasing as a method of finance.

Answer 25

As a business grows it may decide that it needs some more vehicles or equipment

They may decide to lease so that the equipment can be updated regularly and spread the cost

They will never own the equipment but will get the option to change it when it wears out