Business Finance - Sources » External Sources - Loan Capital and Share Capital

What you'll learn this session

Study time: 30 minutes

Understand the difference between loan capital and share capital
Learn about various types of loans available to businesses
Explore different types of shares and their characteristics
Analyse the advantages and disadvantages of each financing method
Examine real-world examples of businesses using external finance
Understand the impact of external finance on business ownership and control

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Introduction to External Sources of Finance

When businesses need money to grow, start up, or solve cash flow problems, they often look outside the company for help. External sources of finance come from people or organisations that aren't part of the business. The two main types are loan capital (borrowed money that must be paid back) and share capital (money from selling ownership stakes in the business).

Key Definitions:

External Finance: Money obtained from sources outside the business, such as banks, investors, or the government.
Loan Capital: Money borrowed from external sources that must be repaid with interest over a specific period.
Share Capital: Money raised by selling shares (ownership stakes) in the business to external investors.
Interest: The cost of borrowing money, usually expressed as a percentage of the loan amount.
Collateral: Assets that can be seized by lenders if loan repayments aren't made.

💲 Loan Capital

Borrowed money that creates a debt for the business. The business keeps full ownership but must repay the money plus interest, regardless of whether the business makes a profit.

📈 Share Capital

Money raised by selling ownership stakes in the business. Investors become part-owners and share in profits, but the original owners give up some control of their business.

Loan Capital - Types and Characteristics

Loan capital comes in many forms, each designed for different business needs and situations. Understanding these options helps businesses choose the right type of borrowing for their circumstances.

Bank Loans

Traditional bank loans are the most common form of loan capital. Banks lend money for a fixed period at an agreed interest rate. The business receives the full amount upfront and repays it in regular instalments.

✅ Advantages

• Predictable monthly payments
• Keep full ownership
• Interest may be tax-deductible
• Build credit history

❌ Disadvantages

• Must repay regardless of profits
• Interest charges increase costs
• May require collateral
• Strict application process

🎯 Best For

• Purchasing equipment
• Expanding premises
• Large one-off investments
• Established businesses

Case Study: Local Restaurant Expansion

Sarah's Café wanted to open a second location. She applied for a £50,000 bank loan over 5 years at 6% interest. The predictable monthly payments of £966 helped her budget effectively. However, during the COVID-19 pandemic, when her restaurants were closed, she still had to make loan payments, putting financial strain on the business.

Overdrafts

An overdraft allows businesses to spend more money than they have in their bank account, up to an agreed limit. It's like a safety net for short-term cash flow problems.

⚡ Quick Access

Money is available immediately when needed, making overdrafts perfect for unexpected expenses or seasonal cash flow dips.

💰 Flexible Repayment

Only pay interest on the amount actually used and repay when cash flow improves without fixed monthly payments.

Mortgages

Business mortgages are long-term loans (typically 15-25 years) used to purchase commercial property. The property itself serves as collateral, meaning the lender can repossess it if payments aren't made.

Key Features:

Lower interest rates than other loans due to property security
Very long repayment periods spread the cost
Business builds equity in valuable property
Risk of losing the property if payments are missed

Share Capital - Ownership and Investment

Share capital involves selling pieces of ownership in the business to raise money. This fundamentally changes the business structure and gives investors rights and potential rewards.

Ordinary Shares

Ordinary shares represent basic ownership in a company. Shareholders have voting rights on important decisions and receive dividends when the company makes profits.

💳 Shareholder Rights

• Vote on major decisions
• Receive dividend payments
• Share in company growth
• Attend annual meetings

📊 For the Business

• No repayment required
• Access to investor expertise
• Shared financial risk
• Potential for large amounts

⚠ Considerations

• Diluted ownership control
• Pressure for profits
• Complex legal requirements
• Dividend expectations

Case Study: Tech Startup Growth

GreenTech Solutions needed £200,000 to develop their solar panel app. Rather than taking a loan they couldn't afford to repay, they sold 25% of their company to an investor for £200,000. The investor brought not just money but also valuable contacts in the renewable energy industry. However, the founders now had to consult the investor on major decisions and share 25% of all future profits.

Preference Shares

Preference shares are a hybrid between ordinary shares and loans. They typically don't carry voting rights but give shareholders priority for dividend payments and asset distribution if the company closes down.

⬆ Priority Treatment

Preference shareholders receive dividends before ordinary shareholders and have first claim on assets if the business fails.

🔒 Fixed Returns

Usually offer fixed dividend rates, providing predictable returns for investors and predictable costs for businesses.

Comparing Loan Capital vs Share Capital

Choosing between loan capital and share capital depends on the business's situation, growth plans and the owners' willingness to share control.

Impact on Business Control

This is often the deciding factor for business owners. Loans maintain full ownership control, while shares dilute it.

👑 Loan Capital Control

Owners keep 100% control of all business decisions. Lenders have no say in how the business operates, as long as loan payments are made on time.

🤝 Share Capital Control

Control is shared with new shareholders. Major decisions may require shareholder approval and profits must be shared through dividends.

Financial Risk and Reward

The financial implications of each option affect both immediate cash flow and long-term business strategy.

Loan Capital Risks:

Fixed repayment obligations regardless of business performance
Interest payments increase total cost of finance
Risk of asset seizure if payments are missed
May limit future borrowing capacity

Share Capital Risks:

Permanent loss of ownership percentage
Pressure to pay dividends when profitable
Potential conflicts with investor goals
Complex legal and regulatory requirements

Real-World Example: Choosing Finance Types

When Innocent Drinks needed £250,000 to expand, they initially considered a bank loan. However, they realised they needed more than just money – they needed business expertise and connections. They sold shares to experienced investors who helped them secure deals with major supermarkets. This decision to choose share capital over loan capital was crucial to their eventual success and £100 million sale to Coca-Cola.

Factors Influencing Finance Choice

Businesses must consider multiple factors when choosing between loan capital and share capital, as the decision affects their future flexibility and growth potential.

Business Stage and Size

Start-ups often struggle to get loans due to lack of trading history and collateral, making share capital more accessible. Established businesses with steady cash flows find loans easier to obtain and may prefer to keep full ownership.

🚀 Start-up Businesses

• Limited credit history
• High risk profile
• Need investor expertise
• Share capital often preferred

🏢 Established Businesses

• Proven track record
• Assets for collateral
• Predictable cash flows
• Loans often preferred

Purpose of Finance

The intended use of money influences the best financing method. Different business needs suit different types of external finance.

Best Uses for Loan Capital:

Purchasing specific assets (equipment, vehicles, property)
Short-term cash flow management
Expansion with predictable returns
When owners want to maintain full control

Best Uses for Share Capital:

High-risk, high-reward ventures
Research and development projects
Rapid expansion plans
When expertise is needed alongside money

Modern Trends in External Finance

The finance landscape continues to evolve, with new options emerging that blur the lines between traditional loan and share capital.

Alternative Lending

Online platforms and peer-to-peer lending have created new opportunities for businesses to access loan capital with faster approval processes and more flexible terms than traditional banks.

Crowdfunding

Platforms like Kickstarter allow businesses to raise money from many small investors, combining elements of both loan capital (if rewards are promised) and share capital (if equity is offered).

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