Raising Finance (Edexcel A-Level Business): Revision Notes

External Finance

When businesses need funding, they cannot always rely on internal resources generated from within the company. External finance refers to funding obtained from sources outside the business. This type of financing becomes particularly important as businesses grow and develop, though it can be challenging to access in the early stages.

However, once a business has survived the initial uncertain phases of development and demonstrated its ability to operate successfully, external sources of finance become much more accessible and realistic options for future growth.

Sources of finance

Businesses can obtain external finance from several different sources, each with distinct characteristics and suitability for different situations.

Family and friends

Many small businesses, particularly in their early stages, turn to family members or close friends for financial support. This source offers several potential benefits for entrepreneurs. If the money is provided as a loan, interest charges may be significantly lower than commercial rates, or possibly zero. In some cases, family members may gift money to help an entrepreneur get started, such as a parent or grandparent providing capital as a present to their child or grandchild.

Another advantage of finance from friends or family is that they may not demand a stake in the business ownership. This means they will not have the right to interfere in business decisions or operations, allowing the entrepreneur to maintain full control.

Banks

Commercial banks represent one of the most traditional and widely-used sources of external finance for businesses. Major banks such as Barclays, NatWest, Lloyds and HSBC provide various funding arrangements including loans, overdrafts and mortgages. Most commercial banks maintain specialist departments or staff members who deal exclusively with business clients, understanding their specific needs and challenges.

Banks become involved with businesses from the very beginning, as all businesses need a bank account to facilitate financial transactions with customers and suppliers. Beyond providing finance, banks often offer advisory services to businesses, frequently at no charge.

Peer-to-peer lending

Peer-to-peer lending (P2PL) represents a modern alternative to traditional bank financing. This approach involves people lending money directly to unrelated individuals or 'peers', completely bypassing banks as intermediaries. All transactions are conducted online and are organised by specialist platforms such as Zopa, Funding Circle, Lending Works and RateSetter. While businesses can use this source of finance, it is not exclusive to them - any individual can apply for a peer-to-peer loan.

Several key features characterise peer-to-peer lending:

• All loans are unsecured, meaning there is no protection for lenders through collateral
• Lenders risk losing their money entirely if a borrower defaults on repayment
• The entire financial arrangement is conducted for profit, with all transactions taking place online
• No previous knowledge or relationship between lenders and borrowers is required
• Lenders have the freedom to choose which borrowers they wish to support
• Peer-to-peer platforms typically charge about one per cent of the transaction value for facilitating the arrangement

The main attraction of P2PL for both parties is that interest rates are generally more favourable than those offered by traditional banks. Borrowers pay less interest while lenders earn better returns on their money. The process is also very convenient, as everything can be completed online relatively quickly.

Business angels

Business angels are wealthy individuals who invest their personal funds in businesses, typically providing between £10,000 and £100,000 or more, often in exchange for an equity stake. An angel investor might make one or two investments over a three-year period, either individually or together with a small group of friends, relatives or business associates. Most investments target business start-ups or companies in early stages of expansion when other funding sources may be reluctant to invest.

People become business angels for various reasons:

• Many enjoy the excitement and challenge of the risk involved in supporting new ventures
• Others are attracted by the tax relief offered by the government to encourage this type of investment
• Some angels are looking for productive investment opportunities for their unused income, seeking better returns than traditional savings accounts offer

Business angels are often demanding individuals with considerable pressures on their time. They may be overwhelmed by business propositions and spend significant time carefully selecting suitable targets for investment. Business owners must therefore present a compelling business proposition concisely and succinctly. They must highlight the positive aspects of their venture while honestly addressing the risks involved. Business owners must also be comfortable with sharing profits with the angel for as long as they remain involved in the business.

Crowd funding

Crowd funding shares similarities with peer-to-peer lending in that banks are excluded and individuals can lend money to others without any previous knowledge of them. However, the fundraisers in crowd funding tend to be businesses or groups involved in specific ventures such as staging a production, building a school or setting up a community project. The lenders or investors are large numbers of individuals who collectively represent 'the crowd', hence the name.

Transactions are conducted entirely online and administered by crowd funding specialists such as Crowdcube, Kickstarter and Crowdfunder. These platforms allow those seeking finance to publish detailed information about their business idea or project, including how much cash they need, how they plan to use it, and how investors stand to profit (if at all) in the future. Some platforms carry out checks on fundraisers before allowing them to list their projects, but not all of them do. In most cases, investors who can usually subscribe as little as £10 per venture are offered shares in the business as a return for their investment.

Other businesses

Another external source of finance can come from other businesses. For example, a company might set up a fully-funded subsidiary. This often occurs when a manufacturer establishes a separate business specifically to supply it with components, ensuring a reliable supply chain while maintaining some operational separation. Some businesses establish joint ventures, where two or more companies share the finance, costs and profits of a specific venture. This allows them to pursue opportunities that might be too large or risky for a single business to undertake alone.

Some public limited companies buy shares in other companies. This might be done to earn dividend income, particularly if they have surplus cash available for investment. Alternatively, PLCs might buy shares in other companies to gradually build a controlling stake, perhaps with a long-term view to acquiring the entire company in the future.

Methods of finance

Beyond identifying sources of finance, businesses need to understand the different methods or instruments available for raising funds. Each method has specific characteristics that make it more or less suitable for different business needs.

Loans

A loan is a financing arrangement where the borrower receives a sum of money that must be repaid over a clearly stated period of time through regular instalments. Loans tend to be rigid arrangements, meaning the repayment schedule is fixed and must be adhered to. Interest will be added to the principal amount borrowed, increasing the total amount to be repaid. There are several different types of loan capital available to businesses.

Bank loans represent probably the most common type of loan. These may be unsecured loans, meaning 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 specific 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, especially following the financial crisis when many borrowers defaulted.

Mortgages are secured loans where the borrower must provide assets as collateral to support the loan. This means that if the borrower defaults on repayments, the lender is legally entitled to sell the assets and use the proceeds to repay the outstanding amount. Mortgages are long-term loans, typically lasting for 25 years or more. Businesses might use mortgages to fund the purchase of premises or large items of capital equipment. Mortgages are usually cheaper than unsecured loans because the collateral reduces the risk for the lender.

Debentures represent a specialised method of loan finance used by larger companies. The holder of a debenture is a creditor of a company, not an owner. This is an important distinction. Debenture holders are entitled to a fixed rate of return, but they have no voting rights in company decisions. They must also be repaid on a set date when the debenture matures. Public limited companies typically use this long-term source of finance as an alternative to issuing shares.

Share capital

For limited companies, share capital represents likely the most important source of finance. The sale of shares can raise very large amounts of money, making it particularly valuable for significant expansion or major projects. Issued share capital is the money actually raised from the sale of shares to investors. Authorised share capital is the maximum amount that shareholders want to raise, setting an upper limit on share issues.

However, dividends are not always declared. Sometimes a business makes a loss, or the directors decide to retain profit within the business to help fund future business activities rather than distributing it to shareholders.

Shareholders can make a capital gain by selling their shares at a higher price than they originally paid. The shares of public limited companies are bought and sold in a special share market called the stock market or stock exchange, where prices fluctuate based on supply and demand. Shares in private limited companies are transferred privately between buyers and sellers. Shareholders, because they are part-owners of the business, are entitled to vote on major company decisions. One vote is typically allowed for each share owned. Voting takes place annually at general meetings, where shareholders vote either to re-elect the existing board of directors or replace them.

Different types of shares can be issued, each with distinct characteristics:

Ordinary shares, also called equities, are the most common type of share issued by companies. They are also the riskiest type of share for investors because there is no guaranteed dividend. The size of any dividend depends on how much profit the company makes and how much the directors decide to retain within the business for reinvestment. All ordinary shareholders have voting rights, giving them a say in major company decisions. When a share is first sold, it has a nominal value shown on it, representing its original value. However, share prices will change as they are bought and sold repeatedly on the stock market.

Preference shares offer different characteristics that reduce risk for investors. The owners of these shares receive a fixed rate of return whenever a dividend is declared by the company. They carry less risk than ordinary shares because shareholders are entitled to receive their dividend before the holders of ordinary shares receive anything. However, preference shareholders are not strictly full owners of the company. If the company is sold or liquidated, their rights to dividends and capital repayments are limited to fixed amounts specified when the shares were issued. Some preference shares are cumulative, entitling the holder to dividend arrears from years when dividends were not declared. Some are also redeemable, which means they can be bought back by the company at a predetermined price.

Deferred shares are not used often in modern business. They are usually held by the founders of the company as a form of founder's stock. Deferred shareholders only receive a dividend after ordinary shareholders have been paid a minimum amount. This makes them the riskiest type of share, but they may receive very large dividends if the company performs exceptionally well after other shareholders have been satisfied.

Venture capital

Venture capitalists are specialists in providing funds specifically for small and medium-sized businesses. They typically invest in businesses after the initial start-up phase has been completed and often prefer technology companies with high growth potential. Rather than providing loans, they prefer to take an equity stake in the company, which gives them some control over decisions and entitles them to a share in the profits. This aligns their interests with the business's success.

Venture capitalists raise their funds from institutional investors such as pension funds, insurance companies and wealthy individuals who are looking for high-return investments. They typically plan to exit their investment after approximately five years, either through selling their stake to other investors or when the company is sold or listed on the stock market. Examples of venture capital firms include MMC Ventures, Index Ventures and AXM Venture Capital. Businesses may turn to venture capitalists for funding when they have been refused by other sources, as venture capitalists specialise in higher-risk investments in exchange for potentially higher returns.

Bank overdraft

Bank overdrafts represent an important source of finance for a large number of businesses, particularly for managing day-to-day cash flow. A bank overdraft allows a business to spend more money than it currently has in its account. In other words, businesses can go 'overdrawn' up to an agreed limit. The bank and the business will negotiate and agree on an overdraft limit, and interest is only charged when the account is actually overdrawn. The amount by which a business goes overdrawn can vary from day to day depending on its needs at the time.

This flexibility makes bank overdrafts particularly valuable for businesses with fluctuating cash flows. A business might be overdrawn by $5,000 one week and back in credit the next, only paying interest for the period when overdrawn.

Leasing

A lease is a contractual arrangement in which a business acquires the use of resources such as property, machinery or equipment in return for regular payments. This is fundamentally different from purchasing assets outright. In leasing arrangements, ownership never passes to the business that is using the resource - the leasing company retains ownership throughout. With a finance lease, the arrangement typically lasts for three years or longer, and at the end of the period, the business is often given the option to purchase the resource at a reduced price.

However, leasing has important disadvantages. Over a long period of time, leasing typically costs more than the outright purchase of plant and machinery because the business is essentially paying for the convenience and flexibility. Additionally, loans cannot be secured on assets which are leased because the business doesn't own them, potentially limiting access to other forms of finance.

Trade credit

Trade credit represents a very common method of finance in business-to-business transactions. Businesses routinely buy raw materials, components and fuel, and pay for them at a later date, usually within 30 to 90 days. This delay in payment effectively provides the purchasing business with interest-free credit during that period. The supplier essentially finances the buyer's operations for the credit period.

Paying for goods and services using trade credit appears to be an interest-free way of raising finance, and it can be particularly profitable during periods of inflation when the real value of money decreases over time.

Grants

Some businesses might qualify for financial support in the form of grants from various sources. Both central and local government back a wide range of grant schemes designed to support business development, job creation, innovation, or regional development. A comprehensive list of available grants can be accessed using the government's 'business finance support finder' tool, which allows firms to select specific funding options and search for grants by business location, size and type of business activity.

Beyond government sources, other organisations such as trusts and industry specialists also provide funding through grant programmes. For example, the Building Enhancement Programme provides grants to Swansea city-centre businesses to help build new shop fronts or improve their facades, encouraging urban regeneration. Fuse Fund provides grants for investment projects that will stimulate growth and create jobs in Lancashire, including support for machinery acquisition and property improvements.

Grants are usually available to small businesses providing they meet specific criteria established by the grant provider. These criteria might relate to location, industry sector, business age, employment creation, or innovation. Most grants do not have to be repaid, which represents a significant advantage compared to all other types of external finance. However, the application process can be time-consuming and competitive, and businesses must typically demonstrate how their project meets the grant's objectives.