sources of finance

• Factors Influencing the Choice and Amount of Finance Required

  • What is the finance required for?

  • The cost of the finance

  • The flexibility of the finance

  • The business organisational structure
• Internal sources of finance

  Founder finance (various personal sources of the entrepreneur) Retained profits

  Friends & family
• External Sources of finance

  Business angels

  Loans & grants

  Crowdfunding

  Bank loan

  Bank overdraft
• Founder finance

  • Cash and investments

  • Redundancy payments

  • Inheritances

  • Personal credit cards

  • Re-mortgaging

  • Putting time into the business for free
• Internal Sources of Finance for Established Businesses

  Retained profits

  Working capital

  Asset disposals
• External Sources of Finance for Established Businesses

  Share issues

  Bank loans and overdrafts

  Peer-to-peer lending

  Debentures

  Venture capital

  Supplier finance
• Benefits of Retained Profits

  • Cheap (though not free)

  • The “cost ” of retained profits is the opportunity cost for shareholders of leaving profits in the business

  • Very flexible - management control how they are reinvested

  • Shareholders control the proportion retained

  • Do not dilute the ownership of the company - unlike the issue of new share capital
• Drawbacks of Retained Profits

  • A danger of hoarding cash

  • Shareholders may prefer dividends if the business is not achieving sufficiently high returns on investment

  • High profits and cash flows would suggest the business could afford debt (higher gearing)
• Working Capital

  • Cash inflow arise from reducing working capital – This is a one-off source of finance – However, the question is can it be sustained?

  • Finance often wasted in excess stocks and trade debtors

  • Look for very low inventory turnover ratio or high debtor days – for businesses that ought to be able to release cash tied up in working capital
• Asset Disposals

  • Potentially another one-off boost to finance

  • Good examples: spare land, surplus equipment

  • Note – not all businesses have spare assets

  • Often occurs after acquisitions
• Benefits of Share Issues

  Able to raise substantial funds if the business has good prospects

  Broader base of shareholders

  Equity rather than debt = lower risk finance structure
• Drawbacks of Share Issues

  Can be costly and time-consuming (particularly flotations)

  Existing shareholders’ holdings may be diluted

  Equity has a cost of capital that is higher than debt
• Bank loans

  • Medium or long-term finance (depending on the term of the loan) – Loan provided over fixed period – Rate of interest either fixed or variable – Timing and amount of repayments are set

  • Good for financing investment in fixed assets

  • Generally at a lower rate of interest that a bank overdraft

  • However, bank loans don’t provide much flexibility
• Bank overdrafts

  • An overdraft is really a loan facility – the bank lets the business “owe it money” when the bank balance goes below zero, in return for charging a high rate of interest

  • A flexible source of finance, in the sense that it is only used when needed

  • Bank overdrafts are excellent for helping a business handle seasonal fluctuations in cash flow or when the business runs into short-term cash flow problems (e.g. a major customer fails to pay on time)
• Bank Overdraft Advantages

  Relatively easy to arrange

  Flexible – use as cash flow requires

  Interest – only paid on the amount borrowed under the facility

  Not secured on assets of business
• Bank Overdraft Disadvantages

  Can be withdrawn at short notice

  Interest charge varies with changes in interest rate

  Higher interest rate than a bank loan
• Bank Loan Advantages

  Greater certainty of funding, provided terms of loan complied with

  Lower interest rate than a bank overdraft

  Appropriate method of financing fixed assets
• Bank Loan Disadvantages

  Requires security (collateral)

  Interest paid on full amount outstanding

  Harder to arrange
• Debentures

  • Long-term: often 10-20 years

  • Issued by the company (not a bank)

  • Fixed rate of interest

  • Usually secured against the assets of the company (provides some protection for debenture holders)

  • Can be traded
• Venture Capital (also known as Private Equity)

  • Specialist investors in private companies

  • Often back management buy-outs (MBOs)

  • They manage investment funds designed to achieve high rates of returns

  • Tend to focus on larger investments (>£1m) than business angels

  • Will seek a large share of the share capital (equity) + representation on the Board
• Advantages of Venture Capital

  Can raise substantial amounts

  Business benefits from specialist investor support

  Brings better discipline to business management & strategy

  Helps original business owners realise their investment
• Disadvantages of Venture Capital

  Venture capitalist requires a high rate of return

  Investment often supported by a high level of bank debt in business

  Not a long-term investment – venture capitalist will aim to sell within 5-7 years

  Loss of control
• Supplier Finance

  • Suppliers provide goods and services in advance of payment = trade creditors

  • As a business expands, the amount owed to suppliers at any one time also grows

  • If a business has a strong relationship with its suppliers, then it may be able to obtain better (i.e. longer) payment terms