Theme 2 - External Finance

Question 1

External finance definition

Answer 1

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

Question 2

What’s 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

What are the sources of finance ?

Answer 3

1. family and friends
2. banks
3. peer-to-peer funding
4. business angels
5. crowd funding
6. other businesses

Question 4

How does the family and friends source of finance work ?

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 and disadvantages of the family and friends source of finance ?

Answer 5

Advantages:

• 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

Disadvantages:

• 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 6

How does the bank source of finance work ?

Answer 6

• 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 7

What are the advantages and disadvantages of the bank source of finance ?

Answer 7

Advantages :
• 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)

Disadvantages:
• 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 8

How does the peer to peer funding source of finance work ?

Answer 8

• 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 9

What are the advantages and disadvantages of peer to peer funding source of finance ?

Answer 9

Advantages:
• 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%

Disadvantages:
• Peer to peer loans are classified as private business loans, so the money for the loan comes from several investors or small businesses.

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

Question 10

How does the business angel source of finance work?

Answer 10

• 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 11

What are the advantages and disadvantages of business angels ?

Answer 11

Advantages:
• 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

Disadvantages:
• Not suitable for investments below £10,000 or more than £500,000
• Owner needs to give up a share of the business

Question 12

What is crowd funding / how does it work (source of finance) ?

Answer 12

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 13

What are the advantages and disadvantages of crowd funding ?

Answer 13

Advantages :
• 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

Disadvantages :
• The business will need to show case their idea to investors and may need to put together a video and other promotional material to attract investors

Question 14

How could other businesses be a source of finance ?

Answer 14

• 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

• Usually IT or disruptive technology businesses will attract funding as they are likely to offer a larger % return on investment

Question 15

What are loans ( methods of finance ) ?

Answer 15

• Loaning money from a bank is like “renting” the money

• 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 16

What are the advantages and disadvantages of loans ?

Answer 16

Advantages:
• As the loan is fixed for a certain length of time the business owner can plan ahead and knows exactly what the repayments will be and when they will leave the bank account

• Banks will not ask for a % of the business or get involved in the running of the business

• Getting into a high street bank to apply for a business loan is a straightforward process

Disadvantages:
• A bank will charge interest on the loan

• Not very flexible, the business may incur a penalty if they decide to settle the loan early

• A bank will ask for security or collateral on a loan this may be a house or another asset that can be seized if the loan is not paid back

Question 17

What is share capital method of finance ?

Answer 17

• In a public limited company – plc - one that has been floated on the stock market - they can raise more finance to expand by having an ordinary share issue

• 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 18

What are the adv and dis of share capital method of finance ?

Answer 18

Advantages:
• Investors are often prepared to provide extra funding as the business grows
• More cost effective way to raise finance than a loan – no interest to pay back
• Finance is based on acquiring more equity rather getting further into debt

Disadvantages:
• Potential investors may require a great deal of background information before they buy the shares
• The more shares that are sold, the more the profits have to be divided up and paid out to investors as dividends
• Can be expensive and slow process to organise

Question 19

Who checks your credit details (credit score etc) to for e,g, apply for a loan?

Answer 19

Credit referencing agencies like Experian or Equifax

Question 20

What is the venture capital method of finance ?

Answer 20

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 e.g. 5 years

Question 21

What are the advantages and disadvantages of the venture capitalist method of finance ?

Answer 21

Advantages:
• Useful if the business is looking to raise a large amount of money in a short space of time e.g. £1 million
• The business gets all the skills of the venture capital business, their network and links may increase revenue streams
• Great for owners who have been refused a loan from a bank

Disadvantages:
• Venture capital firms look for a strong business plan, sound management and a proven track record, making it difficult for start-up firms
• Venture capital firms typically want 20-30% stake in the business

Question 22

What do you get when you buy shares of companies to prove that you own the shares ?

Answer 22

Share certificates - they prove that you are the owner of those shares

Question 23

What are overdrafts methods of finance ?

Answer 23

• 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
• Once its arranged (say £2,000) on an account a business can dip into it or pay it back as they see fit

Question 24

What are the advantages and disadvantages of overdrafts method of finance ?

Answer 24

Advantages:
• For a business owner this would idea as a quick fix method to tide the business over a difficult month of trading
• An overdraft can be arranged on the phone
• or online with an instant decision from the bank
• The business will only pay interest on the amount of money that they are overdrawn
• As soon as the business improves trading they can easily pay back the overdraft to the bank and the interest charges will stop

Disadvantages:
• If the business goes over this amount the overdraft will be “unauthorised” and the business will be charged heavily
• Very expensive source of finance, very high charges and interest rates
• Not suitable for large amounts over a long period of time

Question 25

What is trade credit method of finance ?

Answer 25

• When one business trades with another they will sometimes need to “buy” goods with trade credit
• The seller gives the buyer 30, 60, 90 days to pay
• The buyer then has time to sell the goods in their own shop before they have to pay for them
• The wholesaler may give the buyer a discount when they use cash instead

Question 26

What are the advantages and disadvantages of trade credit method of finance ?

Answer 26

Advantages:
• Business can sell the goods before the stock needs to be paid for, so can make a profit before the costs have to be paid
• No interest has to be paid on trade credit
• Businesses that pay regularly on time can build relationships with their suppliers and secure better deals

Disadvantages:
• Not all stock is available to buy using the trade credit method, so only applies to certain industries
• If the business does not pay in time they risk being refused further credit by the supplier in the future

Question 27

What are grants methods of finance ?

Answer 27

• The UK government provides financial help to businesses in some areas of the country, in an effort to overcome problems of unemployment.
• Government grants do not normally have to be repaid and owners keep full control of their business.

Question 28

What are the advantages and disadvantages of grants (method of finance) ?

Answer 28

Advantages:
• The business usually will not have to pay the grant back
• Unlike a loan there will be no interest to pay
• The business owner will get funds without any loss of control of the business

Disadvantages:
• A business will have to find a grant that suits their specific project, which can be difficult
• There’s a lot of competition for grants
• The business may be expected to match the funds they are awarded, eg a grant might cover part of the cost of a project
• Grants are usually awarded for proposed projects, not ones that have already started
• The application process can be very complex and time-consuming

Question 29

What is leasing method of finance ?

Answer 29

• 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
• Examples are photocopiers and vans

Question 30

What are the advantages and disadvantages of leasing (method of finance) ?

Answer 30

Advantages:
• This is a lower monthly costs for a business owner than a loan
• Often business leases can be arranged without any advanced fees being paid
• The leasing firm maintain the equipment, vans, cars etc. so the business will always have reliable working equipment

Disadvantages:
• Leasing is often over a fixed term, if the business changes its mind and wants to lease from a different company, contracts may be difficult to get out of