External finance refers to money obtained from individuals or institutions outside of a business and is critical for funding growth, managing cash flow, and supporting operations.
What is external finance?
External finance involves the acquisition of funds from outside the business. This differs from internal finance, which comes from within, such as retained profits or the sale of assets. Businesses often require external finance when internal funds are insufficient to meet strategic goals or operational demands.
External finance can be categorised by time frame:
Short-term finance: Often used for managing day-to-day cash flow. Examples include overdrafts and trade credit.
Long-term finance: Suited for expansion, large purchases, or new projects. Examples include loans, share capital, and venture capital.
Businesses may also choose external finance based on the cost of finance, the degree of control they are willing to relinquish, and the specific needs of the enterprise at a given time.
Using external finance may involve legal agreements, repayment obligations, and often interest payments. However, it can enable businesses to grow faster than relying solely on internal sources.
Key sources of external finance
Family and friends
This is a common starting point for entrepreneurs, particularly in the early stages of a business. The funds usually come in the form of a loan or informal investment and are typically based on trust rather than formal contracts.
Characteristics:
Loans may come with low or zero interest.
Flexible repayment terms.
Quick and accessible compared to formal lenders.
Benefits:
Less red tape than banks or investors.
Trust-based arrangements can be more understanding in tough times.
Drawbacks:
Potential for personal relationship breakdowns.
Lack of formal agreements can lead to miscommunication or legal uncertainty.
Family and friends may lack business expertise, making them less useful as strategic partners.
Banks
Banks are one of the most traditional and widely used sources of external finance. They provide:
Business loans: Borrowed money with fixed repayments over an agreed term and interest.
Overdrafts: Short-term facility that allows firms to withdraw more than is in their account, usually at high interest.
Conditions:
Often require business plans, cash flow forecasts, and collateral.
Approval depends on the business’s creditworthiness and track record.
Advantages:
Can provide large sums if the business qualifies.
Professional structure and consistent terms.
Disadvantages:
Strict lending criteria.
Can be expensive, especially if defaulted or for businesses with poor credit ratings.
Loans need to be repaid regardless of business success.
Peer-to-peer (P2P) lending
Peer-to-peer lending platforms connect businesses directly with individual investors via online platforms like Funding Circle or Zopa.
Features:
Funds are often raised quickly.
Interest rates can be competitive but vary by risk rating of the borrower.
Advantages:
Alternative to traditional banking.
Faster decision-making process.
Suitable for small to medium-sized enterprises.
Disadvantages:
Limited amounts available.
Businesses need a strong credit profile to attract investors.
Not appropriate for very early-stage businesses with no financial history.
Business angels
These are private investors who invest their own money into start-ups or small businesses in return for a share of the company (equity).
Characteristics:
Often invest between £10,000 to £500,000.
Provide mentoring, industry knowledge, and contacts alongside capital.
Commonly found via angel networks or introductions.
Benefits:
Willing to invest in high-risk ventures.
Can offer valuable guidance and strategic advice.
Drawbacks:
May expect a significant share of ownership.
May want input into management decisions, affecting independence.
Not suitable for businesses unwilling to give up equity.
Crowdfunding
Crowdfunding involves raising small amounts of money from a large number of people, typically via a dedicated platform such as Kickstarter, Indiegogo, or Crowdcube.
Types:
Donation-based: No financial return expected.
Reward-based: Backers receive a product or perk.
Equity-based: Investors receive shares in the business.
Advantages:
Can raise substantial sums without going through traditional lenders.
Offers marketing exposure and early customer engagement.
May help validate a product idea.
Disadvantages:
Campaigns require significant time, effort, and marketing.
Success is not guaranteed.
In equity crowdfunding, there’s a loss of ownership and possible dilution.
Other businesses
Businesses may obtain finance from other companies, especially through:
Inter-company loans: Financial support from a parent company or partner firm.
Strategic investment: A larger business invests in a smaller business for a mutual benefit.
Pros:
Access to funding with potentially favourable terms.
May lead to collaboration opportunities or shared resources.
Cons:
Risk of loss of autonomy or dependence.
Agreements may be complex and involve commercial compromises.
Methods of finance and business applications
Loans
Loans are agreements to borrow a sum of money and repay it over a fixed period with interest. Loans are usually secured against assets or require a personal guarantee.
Ideal for:
Purchasing new machinery.
Expanding premises.
Long-term investment projects.
Benefits:
Fixed repayments assist with budgeting.
Available from a wide range of lenders.
Limitations:
Monthly repayments are mandatory even if profits fall.
May require collateral, increasing risk for the business owner.
Share capital
This involves selling shares in the company to raise funds. Only limited companies (Ltd or PLC) can issue shares.
Features:
No repayment or interest obligations.
Investors receive dividends and voting rights.
Benefits:
No monthly repayment pressures.
Access to substantial capital, especially via stock markets (for PLCs).
Drawbacks:
Dilution of ownership and control.
Dividends may reduce retained profit.
Venture capital
Venture capital firms provide finance to high-risk, high-potential businesses, often in exchange for significant equity and influence over business strategy.
Best for:
Start-ups with scalable business models.
Companies in technology or innovation sectors.
Pros:
Large sums of finance available.
Access to valuable strategic expertise.
Cons:
High expectations for return on investment.
Control may shift significantly to the investor.
Overdrafts
An overdraft allows businesses to temporarily exceed the funds in their current account up to an agreed limit.
Common uses:
Managing cash shortfalls between income and expenses.
Covering unexpected costs or delays in payment.
Advantages:
Flexible and quick to arrange.
Interest only paid on the amount used.
Disadvantages:
High interest rates and fees.
Can be withdrawn at short notice.
Leasing
Leasing allows a business to use an asset without owning it, with regular payments over an agreed term.
Used for:
Vehicles, machinery, IT equipment.
Benefits:
Spreads cost over time.
Avoids large initial outlays.
Some leases include maintenance.
Drawbacks:
Total cost over time may be higher than purchasing outright.
The business never owns the asset unless it opts to buy it later.
Trade credit
Suppliers allow businesses to buy now and pay later, often 30 to 90 days after delivery.
Advantages:
Improves cash flow.
Allows time to generate revenue from goods before paying.
Risks:
Late payments may damage supplier relationships.
Missing payment deadlines may incur penalties or interest.
Grants
Grants are non-repayable funds given by the government or other institutions to encourage certain activities or behaviours.
Examples:
Support for environmental improvements.
Innovation and technology development.
Regional development or job creation.
Advantages:
No repayment required.
Encourages socially or economically beneficial activities.
Limitations:
Highly competitive and complex application process.
Funds are often conditional and restricted to certain uses.
Suitability of finance types
By business stage
Start-ups:
Limited trading history restricts access to loans.
More suited to grants, crowdfunding, business angels, family and friends.
Growing businesses:
Require larger sums and can offer a track record.
More suited to loans, venture capital, leasing, share capital.
Mature firms:
Can access bank finance, share issues, P2P lending, and trade credit with ease.
By business size
Sole traders and partnerships:
Often rely on personal savings, overdrafts, family loans, or trade credit.
Less able to use equity finance.
Private limited companies (Ltds):
Can issue shares and attract venture capital.
Public limited companies (PLCs):
Can access the stock market, raise large sums quickly, and secure institutional investors.
By financial need
Short-term needs:
Overdrafts, trade credit, or credit cards are effective.
Long-term investment:
Loans, leasing, and share capital are more appropriate.
Cash flow gaps:
Overdrafts, trade credit, and factoring (not covered in this spec but relevant).
Key considerations
Cost: Consider the total repayment, interest, and any hidden fees.
Control: Equity finance dilutes control, while debt finance does not.
Flexibility: Some sources are more flexible than others in terms of repayment and use.
Risk appetite: Businesses must assess how much financial risk they are willing and able to take.
Practice Questions
Explain one advantage and one disadvantage of using crowdfunding as a method of external finance for a small business.
One advantage of using crowdfunding is that it provides access to a large pool of potential investors, allowing a small business to raise capital quickly without relying on traditional lenders. It can also help to generate publicity and early customer engagement. However, a disadvantage is that success depends heavily on the appeal of the campaign and effective marketing. If the funding target is not met, the business may receive no funds at all. Additionally, the process can be time-consuming and may distract the entrepreneur from core business operations.
Assess the suitability of venture capital as a source of finance for a fast-growing technology start-up.
Venture capital is highly suitable for fast-growing technology start-ups due to the large sums of finance it offers and the added benefit of business expertise and networking opportunities. These start-ups often carry high risk and lack collateral, making traditional finance difficult to obtain. Venture capitalists are willing to take risks in return for equity and control. However, this also means the business owner may lose decision-making power and significant ownership. If the start-up is keen to retain control or grows more slowly than expected, venture capital may become a constraint rather than a benefit.
FAQ
Equity finance involves raising money by selling shares in a business, while debt finance involves borrowing funds that must be repaid with interest. With equity finance, businesses do not incur debt or interest payments, which helps preserve cash flow. However, selling shares means giving up a portion of ownership and control. Shareholders may have voting rights and expect dividends, so the original owner could lose influence over strategic decisions. Equity finance is particularly common in limited companies and start-ups with high growth potential but limited collateral.
The decision between short-term and long-term finance depends on the duration and purpose of the funding required. Short-term finance is used to cover immediate, operational costs and cash flow gaps. Common methods include overdrafts, trade credit, and short-term loans. These are usually quicker to obtain, more flexible, and ideal for temporary financial needs such as paying suppliers, covering seasonal demand, or bridging delays in customer payments. However, they often carry higher interest rates and shorter repayment periods.
Long-term finance is used for major investments such as purchasing equipment, expanding operations, or developing new products. Suitable options include bank loans, leasing, share capital, and venture capital. These sources provide larger sums over extended periods with fixed or structured repayment plans. They are appropriate when the business expects a return on investment over several years. Therefore, the key is assessing whether the need is ongoing and strategic (long-term) or immediate and operational (short-term), as this determines the cost-effectiveness and suitability of each finance method.
Government initiatives in the UK play a vital role in improving access to external finance, especially for small and start-up businesses that may struggle to secure funding from traditional sources. One key example is the British Business Bank, which offers various schemes such as Start Up Loans, which provide fixed-interest loans with mentoring support to new businesses. These initiatives help reduce the risk perceived by lenders and investors by offering partial guarantees or co-investment opportunities.
Grants are another form of government support, often aimed at businesses involved in innovation, sustainability, or job creation. Schemes such as Innovate UK or local enterprise partnerships offer non-repayable grants for research and development, particularly in high-tech and green sectors. Additionally, the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) provide tax relief to investors who buy shares in small, high-risk companies, making equity finance more attractive.
These government initiatives help bridge the gap between early-stage businesses and private finance sources, encouraging entrepreneurship and innovation.
Convertible loans, also known as convertible notes, are a type of hybrid finance that begins as debt but can be converted into equity at a later date, usually during a future investment round. They are commonly used in start-up financing, particularly when the business is difficult to value in its early stages. Initially, the investor lends money with interest, but instead of repayment, the loan is converted into shares at a discounted rate during a future equity funding round.
Businesses use convertible loans for several reasons. They provide immediate funding without the need to set a valuation, which can be complex or premature in early stages. This avoids lengthy negotiations and speeds up the funding process. They also offer flexibility for both the business and investor, as the terms of conversion are often pre-agreed. Moreover, interest may be deferred until conversion, reducing short-term cash flow pressure. Convertible loans are particularly attractive in high-growth sectors where future valuation is expected to rise significantly.
Peer-to-peer (P2P) lending and bank loans both offer external finance to businesses, but they differ significantly in terms of accessibility, cost, and flexibility. P2P lending is conducted through online platforms where individual investors lend directly to businesses. This often results in quicker application processes, fewer bureaucratic hurdles, and a more streamlined approval system. Businesses with moderate credit ratings that may be rejected by banks often find P2P lending more accessible.
In terms of cost, P2P lending may offer competitive interest rates, especially for businesses with good creditworthiness, although rates can be higher than bank loans for riskier borrowers. Unlike banks, P2P platforms may not require collateral, making them more attractive to newer businesses with limited assets. However, there may be additional platform fees and less personal relationship management than traditional banking.
Flexibility is another benefit. P2P loans often come with customisable repayment terms and are suitable for both short-term and medium-term funding. However, they typically offer smaller sums than banks and may not suit businesses needing large-scale investment.
