Sources of finance : overview

Internal sources of finance

Internal sources of finance are often the first to be exploited. But unless a business is cash-rich and extremely profitable, such finance may be insufficient for ambitious growth and development plans.

The main sources of internal finance are:

• Personal savings - Cash injected into a business by its owners can be paid back if the business succeeds, but there’s an obvious personal risk should the business fail.
• Working capital - That is, the finance available from current or short term assets, minus current liabilities. This could fund development, but may leave cash-flow tight.
• Retained profits - Any profit a business keeps as opposed to distributing to owners/shareholders. Balancing the interests of the business and its owners is important.
• Sale of assets - A business may sell assets such as property, equipment, or Intellectual Property. 

There may be risks associated with exploiting internal finance - such as putting personal savings in danger, crippling cash-flow, or frustrating equity holders through retention of profits. Of course, such risks need to be weighed up against the benefits - not least the fact that internal finance does not incur borrowing costs or require business owners to sell part of their business. Such risks and benefits should be considered within the context of a business’s own circumstances, and compared with the benefits of raising alternative, external sources of finance.

External sources of finance

The options for sourcing external finance can be divided into two groups: Ownership capital involves giving up ownership of and possibly some control over the business. Non-ownership capital does not involve such sacrifices, but can be a costly way to raise finance.

Ownership capital

• Sale of ordinary shares - Otherwise referred to as equity shares, this is a method of raising finance by selling part of a limited company. Ordinary shareholders share in the profits of a business (through dividends). Businesses choose whether to pay dividends, based on factors such as the profitability of the business or its strategic goals. 
• Sale of preference shares - Preference shareholders are usually entitled to fixed dividend payments, regardless of a business’s profitability, which should be paid before ordinary shareholder dividends. A business may retain the right to buy the shares back at a later date.
• Alliances or Partnerships - An individual or business may seek to ally or partner with other individuals or businesses to gain access to greater knowledge or skills, and of course increased financial resource. Sleeping partners may invest in a business but take no control over day-to-day operations. Often though, alliances or partnerships are strategic, i.e. the two entities working together offer ‘something greater than the sum of its parts’.

Non-ownership capital

• Bank overdrafts - Expensive in terms of interest charges and arrangement fees, but often easier to access than other sources of finance. Overdrafts may be offered for a limited time which (in addition to high interest costs) might make them unsuitable for funding longer term investment.
• Loans - Banks, building societies and other commercial money lenders offer loans on short-term or long-term bases, for a variety of different purposes. Eligibility for a loan or the amount offered may depend on a business’s financial track record, projections of future performance, or availability of security to borrow against. Interest rates vary but loans are not the cheapest way to acquire finance, and regular repayments must be budgeted for when considering cash flow. Schemes such as the Small Firms Loan Guarantee (SFLG) exist to help businesses that have been turned down for commercial loans, but selection criteria still apply, so the scheme is not available to all. Click here for more info on SFLG
• Grants - Considered by many to be the ideal source of finance, grants do not have to be paid back and no ownership rights are given up. Grants are not free money however, because a grant is often awarded upon condition of a business doing something in return for the money - such as to develop a new idea, concept or product, employ someone or work collaboratively with others. Grants recipients may also need to report back to grant givers on how effectively the money was spent. Grants are sometimes designed to help specific groups such as deprived areas or young people, so access to grant funding might depend on a business’s circumstances or goals.
• Debentures - Loans that are secured, where the lender has some kind of preferential rights. For example, a debenture loan may be secured for the purchase of a property, which the lender takes a legal interest in, similar to a domestic mortgage arrangement. Debenture holders may also have preferential rights to payment over and above other investors, such as shareholders, and may also have preferential rights to repayments should the business go into liquidation. Because of these preferential rights, debenture finance may impact ownership capital agreements, even though debenture lenders do not technically ‘own’ a portion of the business.
• Friends and family (and fools) - As the ‘and fools’ appendage suggests, sourcing finance from friends and family can be problematic. Problems could occur when the borrower makes unrealistic promises of success, or when the lender expects a bigger return on investment than they ultimately receive. Such issues can usually be addressed by managing expectations on both sides. (Such funding may also be sought in exchange for ownership rights such as ordinary shares, as detailed in the previous section.)

Choosing between ownership and non-ownership finance is tricky and the decision is subject to some unknowns. For example, an early stage business may be wary of borrowing because of exposure to interest charges and high monthly repayments. Instead, it may choose to sell part of its business. In the short-term this may be an attractive route to finance, but if the business turns out to be a huge success it may regret that decision - if it is forced to share a large portion of its profits or is left with insufficient equity to raise further rounds of finance.

Such an example demonstrates how no type of finance is typically better than another. The choice depends on a business’s current circumstances - and its future potential.  Any business looking to raise finance must therefore think extremely carefully about all the options available, and how their decisions may affect the business’s success in the short and long term.

Further resources

Find out more about government-backed guarantee for business loans: The Small Firms Loan Guarantee