Sources of Finance

The need for finance

No business can start-up without some source of finance. There is no business that can start to function without finance (also called “capital” in one sense of “capital”).

Very often, when individuals start a small business, they do so with their savings. This illustrates how risky business can be, and how people who want to be in business are prepared to take those risks.

Once a company is up and running, and even if it is profitable, it may require further finance — in order to grow, for example. That finance may be generated either internally or externally.

Sources of finance

Internally generated

There is only one source of internally generated finance and that is retained profits. Profits are made when all the costs of production, including management overheads, and everything, are subtracted from all the sales revenue. Once profits are made tax has to be paid on them. After the tax is deducted the business can decide to two either of two things with them: (1) distribute them to the owners of the business, or (2) retain them for the future use of the business. It is these retained profits that provide the internal source of finance.

Externally generated

The company can basically either (1) sell shares; or (2) borrow finance from banks and/or other financial institutions.

There are other ways in which externally generated finance can be obtained, but these are the two principle methods, and the fundamental choice facing the owners of the business.

Shares are as the sound — a “share” in the business. When an investor buys a share he/she pays over a sum of money that does not every have to be given back by the business in return for a share in the ownership of the company. The obvious advantage of share capital is that it is “non-redeemable” — in other words, as a source of finance it is permanent and never has to be returned. The disadvantage is that in issuing shares the original owners of the business have to accept that other people will own part of their company, and the loss of control that this entails. Of course, if the other partners also bring in other expertise, the loss of control may be a bonus, but partnership is a tricky thing, and it is possible to choose the wrong partner, with woeful consequences.

Bank loans and loans from financial institutions are injections of capital, but this capital does have to be paid back, and at interest. The company does not lose control of the direction of the business, but must generate revenues and profits sufficient to pay off the loan and the interest. If the interest rate is variable, the company could expose itself to changes in interest rates, with increasing costs and a resultant profit squeeze or loss.

This is the basic choice facing the directors or owners of any company that seeks further finance. However, there are a number of variations on these themes.

(1) Director's loans

The directors of the company, who are its shareholders, may make a loan into the company. This is not strictly share capital and will have to be paid back, but the loan is made on the understanding that it will only be paid back as and when the company can afford to do so, so really it is part and parcel of the process of obtaining share capital.

(2) Debentures

Debentures are a form of certificate that can be traded almost as if they were shares. However, they are not shares but actually a legal for of fixed finance, that is to say, a form of borrowing at a fixed or variable rate of interest from a finance house or possibly another company or wealthy individual.

(3) Property and mortgages

Often a loan is sought from a bank for the specific purpose of purchasing a property, and the company pays the bank a mortgage. This is just a form of bank finance on which interest is charged, but the bank usually secures the loan against the property and this provides both them and the business with some degree of security in the case of business failure.

(4) Hire purchase agreements

Companies can choose to buy equipment by means of hire purchase. This means that they do not have to find all the capital for the equipment in one go, but they pay for it as they use it. They are using expected future profits to pay for the capital equipment. The finance is created because creditors are willing to extend credit to the business in the faith that the business will make a profit, so it is a form of loan.

Short term finance

In the short term companies can provide themselves with cash by some or all of the following:

1		Overdraft facility — this is a form of bank loan; the bank allows the company to be overdrawn up to an agreed limit.
2		Trade credit. Companies from which one purchases raw materials, goods and/or services are prepared to extend credit to you.
3		Factoring. Companies often have slow payers and long-term debtors. In order to obtain the cash from these debts immediately, they can sell the debt to a debt collection agency at a discount. That is, they agree to receive, for example, 90% of the debt now in return for the debt collection agency collecting the debt.

Issuing of Shares

A private limited company is one whose shares are not quoted on the stock market. But large companies can sell shares directly to the public through the stock market.

The Stock Exchange in fact involves two related markets. The primary market is a market for issues of new shares; the secondary market is for the buying and selling of existing shares.

A public company (plc — public limited company) is one that is listed on the Stock Exchange. To be listed on the London Stock Exchange a company requires (1) a minimum market capitalization of at least £500,000. (2) That 25% of the shares should be owned by the general public; (3) That the company complies with rules established by the stock exchange.

Public companies can issue shares in the following ways:

1		By offer of sale. The company sells shares to an issuing house or merchant bank, which then offers them to the public at a higher price.
2		By public issue. The offer to the public is made directly to the public rather than through an issuing house. In order to make the offer, it is usual for the company to issue a prospectus, which is an account of the firm's legal structure, voting rights and an explanation of the reasons for the share offer and the expected returns. It is usual for the company to have the issue underwritten by a financial institution. This institution guarantees to purchase all shares not subscribed to by the public in return for a risk premium. Since having a share issue underwritten is very costly, public share issues are usually only involved when large sums of capital are sought.
3		In placing shares are sold privately to clients of the issuing house.
4		In a tender shares are offered to the public on the basis of bids, and the shares are sold to the highest bidder.
5		In a rights issue existing shareholders are given the option to buy additional shares at reduced prices, so as to be able to maintain their equity holding in the company.
6		In a bonus issue shares are issued free to existing shareholders. This does not raise funds for the company, and is used by companies when their assets are substantially greater than the value of the shares, which makes them vulnerable to takeover.

Franchise

One way to start a business is to buy a franchise. This can also act as a source of finance.

The franchisor sells the right to trade with an existing company name, and use the business format of that company. They do this in return for a fixed sum and/or a percentage royalty. The franchisee is likely to be a locally based firm or individual who may be making their first venture in business. The franchisor generally provides the structure for a successful business, and may provide training and other back-up services. The franchisee accepts conditions on the use of the name regarding quality and the purchase and/or use of equipment.

Businesses starting-up on the basis of a franchise have a lower rate of failure than businesses that start-up afresh. The franchisor benefits from being able to expand their business more rapidly. The franchisee is able to purchase a successful business format. The franchisee provides most of the finance for the new business.

Venture Capital

Venture capitalists are people (or oganisations) with access to capital, seeking higher profits. They look for small firms with the potential to expand and invest in them in return for higher rates of return. Since the firms are small and not fully-established, this kind of investment carries with it greater risks; hence, venture capitalists are prepared to accept high levels of risk in return for higher rates of return.