EXTERNAL FINANCE

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 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 entrepreneur. Another possible advantage of finance from family or friends is that they
may not want to share in the ownership of the business. Consequently, they will not be
able to interfere in the running of the business. However, serious problems could arise if
a loan cannot repaid or the terms of the arrangement are unclear. This could lead to the
loss of friendship or a breakdown in family relations.
 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. Banka 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 such as Lendbox in India, Zopa in the
UK and Pandai in China. 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 transaction take place online.
 No previous knowledge or relationship between lenders and borrowers is needed.
 Lenders may choose which borrower to lead to.
COURSE INSTRUCTOR: ABU NAYEEM MOHAMMED SUYEEB
CONTACT: +8801752408560
EMAIL: suyeebnayeem@gmail.com Page 1
  Peer-to-peer sites make a charge typically about 1 percent.

The main attraction of P2PL is that interest rates are better for both borrowers and lenders than
those offered by bank. P2PL is also very convenient because it can be completed online fairly
quickly. However, the main disadvantage is that in most countries there may be lack government
protection for lenders.

 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 years 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. There are several reasons why people become
business angels. Many like the excitement of the risk involved, or being part of a new or
developing business. Others are attracted by the tax relief offered by the government.
Some are looking for investment opportunities for their surplus income. A problem with
this source of finance for businesses is finding a suitable ‘angels’. As angels normally
take a stake in the business, the angel and a common vision for the future direction of
the firms.
 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. They are
administered by a crowd funding specialist such as Ulele, Kickstarter and Tumblebug.
These websites allow those seeking finance to publish details of their business idea or
project, including how much cash they need, how they will use it and how investors
stand to profit in future. Some of the sites carry out checks on the fundraisers but not all
of them. In most cases the investors, who can usually pay as little as £10 towards
ventures, are offered shares in the business.
 Other businesses: Another external sources of finance might be provided by other
businesses. Some businesses set up joint ventures, where the businesses share the
finance, cost profits of a specific venture. Some plcs buy shares in other companies.
This might be to earn an income, if they have surplus cash for example. Alternatively,
plc might buy shares in other companies to build a controlling stake, perhaps with a
view to taking them over in the future.

COURSE INSTRUCTOR: ABU NAYEEM MOHAMMED SUYEEB

CONTACT: +8801752408560
EMAIL: suyeebnayeem@gmail.com Page 2
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 reply the outstanding amount. Mortgages
are long-term loans and are typically for 25 years or more. They might be used by the
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 specialized method of loan finance. The holder of a debenture is a
creditor of a company, not an owner. Debenture holders are entitled to a fixed rate of
returns, but have no voting rights. They must also repaid on a set date-when the terms of
the loans 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 of shareholders want to raise. Share capital is of ten 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 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. Voting takes place annually and shareholders vote
either to re-elect the existing board of directors re replace them. Different types of shares
can be issued.
 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
COURSE INSTRUCTOR: ABU NAYEEM MOHAMMED SUYEEB
CONTACT: +8801752408560
EMAIL: suyeebnayeem@gmail.com Page 3
 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 normal value shown on 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 in declared. They carry less risk because shareholders entitled to their dividend
before the holders of ordinary share. 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 brought 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 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. This means that bank overdrafts provide a flexible source of
funding to businesses. However, a bank has the legal right to call in the money owed at any point
in time. This will happen if the bank suspects that the business is struggling and unlikely to repay
what is owed.

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. With a finance lease, the
arrangement is often for 3 years or longer and at the end of the period, the business is given the
option of then buying the resource. There are some advantages of leasing.

 No large sums of money are needed to buy the use of equipment.

 Maintenance and repair costs are not the responsibility of the user.
 Hire companies can offer the most up-to-date equipment.

COURSE INSTRUCTOR: ABU NAYEEM MOHAMMED SUYEEB

CONTACT: +8801752408560
EMAIL: suyeebnayeem@gmail.com Page 4
  Leasing is useful when equipment is only required occasionally.
 A leasing agreement is generally easier for a new company to obtain than forms of
loan finance. This is because the assets remain the property of the leasing company.

However:

 Over a long period of time leasing is more expensive than the purchase of
equipment and machinery.
 Loans cannot be secured on assets that are leased.

Trade credit: It is common for businesses to buy raw materials, components and fuel and pay
for them at a later date, usually within 30-90 days. 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. However, many companies encourage early payment by offering discounts.
The cost of goods is often higher if the firm does not pay early. Delaying the payment of bills
can also result in poor business relations with suppliers.

Grants: Some businesses might qualify for financial support in the form of a grant. Both central
and local government in most countries around the world back a wide range of schemes. A list of
grants available can be accessed using the government’s business finance support finder’ tool.
This allows firms to select specific funding options and search for grants by business location,
size and type of business activity. Grants are usually 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.

COURSE INSTRUCTOR: ABU NAYEEM MOHAMMED SUYEEB

CONTACT: +8801752408560
EMAIL: suyeebnayeem@gmail.com Page 5