Internal and external sources of business financing

What it is?

Finance is the total amount of funds that ensure all the activities of the company: from solvency to suppliers and lessors in the present to the possibility of expanding the scope of interests in the future.
Unfortunately, from time to time, reasons may arise that prevent the smooth and uninterrupted operation of an enterprise. Among them may be:

• funds from the sale of products arrive later than the time comes to pay off debt obligations,
• inflation depreciates the income received so that it is impossible to purchase raw materials for the production of the next batch of goods,
• expansion of the company or opening of a branch.

In all of the above situations, the company has to look for internal and external sources of financing.

Source of financing is a donor resource that provides a permanent or temporary influx of material and intangible funds. The more stable a company's business is, the higher its liquidity in the economic market, so the main headache for an entrepreneur is finding the best source of financing.

Definition of seed funding

The central element of the entire process of attracting external sources of financing is the business plan, which is provided to investors for consideration. We will not dwell in detail on drawing up a business plan, but will simply list the key elements.

A business plan is a complete overview of your business, both inside and out. The inside of a business includes you and your team, your product and services, your strengths and weaknesses, your strategy and your ambitions. The external part of the business is the market you are in, what your customers need, what problems they have and what you are going to solve. In addition, who are your competitors and what do they offer to solve these problems?

An important part of your business plan is the executive summary. This is a document of up to two pages that is well written and summarizes all the key elements of your business and, more importantly, makes an investor want to invest in your project. Investors typically review executive summaries first before requesting a full business plan.

As you raise capital, you will constantly be faced with the valuation of your company. This is a critical element of raising capital, especially when you are raising funds using shares of a company.

A company valuation is needed so that you know how many shares you need to sell to get the amount you need. In this case, you negotiate with the investor or appraisal company about the value of your business, divide the value by 100 to find out the price of one percent of the shares. After this, you already know how many percent of shares you should give to the investor for the amount of money you need.

Classification by sources of formation

Based on the place of origin, the financial resources of an enterprise are classified into:

• internal financing;
• external financing.

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Internal financing involves the use of those financial resources, the sources of which are generated in the process of the financial and economic activities of the organization. Examples of such sources include net profit, depreciation, accounts payable, reserves for future expenses and payments, and deferred income.

External financing uses funds that come to the organization from the outside world. Sources of external financing can be founders, citizens, the state, financial and credit organizations, and non-financial organizations.

The grouping of financial resources of organizations by sources of their formation is presented in the figure below.

An organization's financial resources, unlike material and labor resources, are interchangeable and susceptible to inflation and devaluation.

Currently, an urgent problem for domestic industrial enterprises is the condition of fixed production assets, the deterioration of which has reached 70%. In this case, we are talking not only about physical, but also about moral wear and tear. There is an urgent need to re-equip Russian enterprises with new high-tech equipment. In this case, the choice of source of financing for this re-equipment is important.

The following sources of funding are distinguished:

• Internal sources of the enterprise (net profit, depreciation, sale or rental of unused assets).
• Raised funds (foreign investments).
• Borrowed funds (loan, leasing, bills).
• Mixed (complex, combined) financing.

Domestic

This is the totality of all the organization’s own tangible and intangible assets that were obtained as a result of the company’s work. They are expressed not only in money, but also in intellectual, technical and innovative resources.

These include:

• income in cash equivalent,
• depreciation deductions,
• issued loans,
• withholding wages,
• factoring,
• sale of assets,
• reserve profit,
• redistribution of funds.

Net profit of the enterprise

Among the advantages of this source it should be noted:

• reducing the tax burden on business;
• no interest burden on the use of net profit for investment.

The disadvantage is that the more profits are used for financing, the lower the share of dividends, while the main goal of the enterprise is to increase the dividends of its owners.

There are 3 directions of the enterprise policy:

• the final amount of dividends does not affect the market value of the enterprise, as a result of which the investment interests of the enterprise are more important than the interests of shareholders;
• the amount of dividends has a direct impact on the price of shares;
• optimization of income tax, regardless of how dividends and investments are distributed.

Depreciation charges and loans issued

This is the name of a certain amount set aside in reserve in case of breakdown or wear and tear of equipment. It should be enough to buy new equipment without the risk of getting into other sources and assets. They can be used as an investment in a new idea.

Loans issued are those funds that have been issued to customers on a credit basis. If necessary, they can be claimed.

Salary deduction

The employee has the right to receive payment for the work done. However, if you need to invest additionally in a new project, you can refrain from paying for a month or two, having previously agreed with the staff. This method is fraught with great risk, as it increases the company's debt and provokes workers to strike.

Accounts payable management

When accounts payable increases, the company has the opportunity to take advantage of the following advantages:

• increasing the share of free money supply;
• economical analogue of a loan.

At the same time, experts also highlight disadvantages:

• financial stability is weakening;
• an increase in purchasing prices is likely.

It is recommended to determine the economic benefit for each contract and select the most profitable option.

When using accounts payable, certain risks arise. Examples: the business reputation of the enterprise has deteriorated, the counterparty has suspended the supply of products due to late payment (in the latter case, the counterparty, according to the Civil Code of the Russian Federation, has the right to demand the repayment of fines and penalties forcibly).

Reserves for future expenses and future income

Such reserves are formed against planned future obligations. If a plan for managing reserves is developed correctly, the company will have the opportunity to use the balance of funds, unencumbered by obligations, to finance the business within a certain period of time.

Note! Thanks to reserves for future expenses, an economically feasible and uniform distribution of costs over time is achieved.

The disadvantages are the following:

• limiting the amounts that can be defined as reserves at the legislative level;
• strict control by inspection authorities.

The disadvantage of deferred income is that it is not available to many companies. Basically, deferred income is represented by targeted financing (both government and non-government), security payments and prepayments.

Classification of funding sources

Basic

sources of business financing are divided into the following types:

• creditors;
• investors;
• own finances.

Companies that have established a work process in accordance with their business plan can afford to finance entrepreneurship on their own. In most cases, the entrepreneur receives support from other external sources. It should be remembered that the use of third-party capital increases costs through deductions.

Internal sources

When a business can finance itself, without outside help, the owner has complete control over the business.

Examples of internal sources of financing:

1. Net profit. Investing most of the funds in further development allows you to ensure a successful existence and reduce the risk of ruin.
2. Depreciation deductions. That monetary asset that could be spent on repairs and maintenance of equipment.
3. Accounts payable. It assumes deferment of bank payments with an increase in their size in the future. Can be used as a temporary measure.
4. Withholding wages from company employees. According to financial documents, wages are calculated and accrued, which are not actually paid. The delay may be a short-term measure.
5. Factoring. This source implies a deferred payment by agreement with the supplier company or manufacturer of the necessary components.
6. Asset reset. In the case where an enterprise has a direction with unprofitable, zero or low profitability, you can get rid of such a line in favor of another.
7. Reserve fund. Funds intended for unexpected financial expenses.
8. Process optimization. Distribution of financing to the most profitable production or creation of a new additional source of income.

Government funding

Support programs for start-up entrepreneurs are posted on the website of the Ministry of Finance. To receive assistance from the state, it is necessary to draw up a business plan with a mandatory indication of the payback period.

The finished project can be provided to employees at the Employment Center, and then to the tax office. Here you have to register as an entrepreneur. After which you need to register with the labor exchange.

It is important to consider that to obtain finance, approval of a business plan is not enough; you must have your own resources. The state partially covers the entrepreneur’s expenses, depending on the type of assistance. Or becomes a customer of the goods and services produced.

Interbudgetary government relations

In 2020, the following types of government support are provided:

• free consultation on legal and other issues;
• payment for education necessary to implement a business idea;
• assistance in acquiring production capacity at the lowest cost;
• monetary assistance in the process of production (partially) and rental of government premises;
• financing 20% ​​of the cost of purchased raw materials;
• partial repayment of loans;
• grants;
• subsidies;
• preferential participation in events such as exhibitions or fairs;
• business incubator (profitable rental of government premises);
• guaranteeing the entrepreneur's obligations to the bank.

State support for small and medium-sized businesses in Russia is discussed in detail in a video taken from the Active Finance Group channel.

Subsidies

Subsidies imply one-time assistance from the state. The amount of assistance is regulated by the Budget Code of the Russian Federation. The Accounts Chamber will definitely monitor the movement of allocated finances. If they are wasted on needs other than those specified in the business plan, the state will not help in the future and cover the costs. As a rule, subsidies are allocated to entrepreneurs who produce goods that are included in the consumer basket or that benefit the region. Mainly it is agriculture.

Tax benefits

Law of the Russian Federation No. 477-F3 talks about the possibility of temporary relief for entrepreneurs. Subject to certain conditions, an entrepreneur may be exempt from paying taxes for a period of 2 years. To receive benefits, you must have the first registration with a simplified taxation system (STS) or a patent (PSN).

Screenshot of the main page of the Unified Register

Tax holidays

What taxes must be paid if there is a subsidy?

Timing of tax holidays

Lending

A loan from the state comes in several forms:

• allocation of funds;
• guaranteeing a bank loan;
• export assistance.

Interest on loan funds will be lower than at a bank. When you receive money to repay the loan, you can get a deferment on payments.

Bank lending

It is possible to obtain a bank loan secured by property or working capital. Banks provide different lending programs for small and medium-sized businesses. As a rule, the amount does not exceed 1 billion rubles and is issued for a period of up to 3 years. The loan rate is 10-11% per annum and cannot be higher. Funds are allocated for the purchase of equipment or for other purposes specified in the contract. At the same time, the bank providing the loan becomes a business partner. This gives him the right to control the financial condition of the entrepreneur until the loan and the interest rate on it are fully repaid.

There are a number of industries that lenders prefer:

• Agriculture;
• construction;
• transportation;
• food production;
• communication services.

Leasing

Leasing involves long-term rental of property, equipment and/or tax benefits. In the latter case, when it comes to renting premises or production facilities by an entrepreneur, a subsidy can also be provided to the lessor.

Leasing involves the opportunity to purchase leased assets:

• company;
• land plot;
• structure;
• vehicle;
• property.

The advantage of this lending method is that you do not need to provide collateral. If an entrepreneur buys out assets, he pays their real actual cost - without a markup. But when applying for a loan, you must pay up to 30% of the appraised value of the assets.

In Russia, not all types of activities are leased. It depends on the form of taxation.

The amount of loan payments is included in the enterprise's cost fund and VAT is charged on it.

Trade loans

These relationships involve the provision of deferred payments from companies with which the entrepreneur cooperates. This applies to the field of trade when goods from another supplier are sold. A form of relationship in the form of exchange is possible. The product is changed to another product or service.

Equity financing

This type of assistance involves attracting an investor who becomes a co-owner of the business. He makes a one-time contribution to the authorized capital with possible further investments. Sometimes investing concerns one of the areas.

Bonds

Bonds are a loan with interest. The entrepreneur pays it to the investor.

The following options are possible:

1. Coupon. The loan is repaid 2 times within 12 months. Conditions may be different, for example 3-4 times. This is stated in the bonds. The interest rate (annual) is broken down accordingly.
2. Discount. In this case, the interest rate is floating.

Type of bond depending on the timing of issue:

• short-term - 1-2 years;
• medium-term - 5-7 years;
• long-term - from 7 years.

Overdraft

Overdraft is a bank lending by opening a credit account linked to the main account of the entrepreneur. The maximum size of this type of loan is 50% of the average monthly turnover of the enterprise. The loan guarantees the provision of payments for any needs of the company, if at a particular moment the company’s personal funds are insufficient. The bank charges a fee for servicing the main account and charges credit interest when the entrepreneur does not repay the debt within the agreed time frame. Such repayment occurs by synchronizing with the main account and automatically transferring money.

External

External financing represents funds raised from external counterparties, which can include both individuals and companies, as well as the state. Sources of external financing include:

• special-purpose financing;
• lending;
• investment funds;
• government injections;
• private funds;
• partner funds;
• income from the sale of securities.

The most common form of external financing is lending . When attracting borrowed capital, an enterprise receives freedom to use financial resources, except in cases with special conditions.

Use of venture capital

Unlike other forms of external financing, venture capital investors are actively involved in the management of the companies in which they invest. Venture capital is a risky business, and at every stage of the process, venture capitalists will do everything possible to maximize the potential for success. VC firm members are appointed to the company and sit on the board of directors, participating in the management of the business, reviewing strategic projects and providing advice on important decisions as well as some day-to-day ones.

When a firm investing in your company brings significant experience in your field, it can be a big advantage as you gain a good mentor as well as access to the firm's network and possibly new clients.

Remember that raising venture capital to invest in your business will be expensive and you will have to give away a significant portion of your shares. Therefore, the venture capitalist will have a say in the decisions you make. Of course, it's good that everyone will be working towards success, but unlike angel investors who will remain outside of your day-to-day business activities, venture capitalists will become true business partners not just because they want to, but because they thereby protecting their investments.

When working with venture capital firms, it is very important to consider how they will exit your business. As we already wrote, the venture capital company becomes the holders of your shares, which means the stage will come when they will sell them all, because This is the specifics of venture capital work. Here they can use two directions:

1. mergers and acquisitions, when two companies decide to combine to form one company or when a company decides to acquire another;
2. sale of shares through IPO. IPO stands for initial public offering and refers to a company that is traded on the stock market.

These are two ways for venture capital firms to exchange their company shares and make a profit. But they can also sell their shares to another venture capital firm if there is an additional round of funding.

Venture capital firms usually invest in companies that offer new products and services, but they must correctly distinguish between an idea that will not succeed, one that is unlikely to succeed, and one that will truly change the rules of the game in the market. To do this, they will examine every aspect of their work to reduce their risks as much as possible in hopes of increasing their chances of making a profit.

In short, the venture capitalists you meet will be interested in issues that matter to them:

• Does your product or service solve most people's problems? How innovative is your product or service?
• Do you have a strong team? Practice shows that a team makes a company successful or, conversely, destroys it. It is people who are able to solve problems and turn them into opportunities.

When working with venture capital firms, you will have to demonstrate your ability to at least tenfold the value of your company within five years of making the investment. Last but not least, you must be clear about the VC's exit strategy from your business and how it will turn its shares in your company into huge profits.

Conclusion

Attracting external sources of financing is quite a difficult task, especially if it needs to be done with minimal losses. The main thing is to correctly calculate the amount of investment your business needs. If you need from 20 to 70 thousand dollars, try to limit yourself to your own funds, the funds of your loved ones or a loan. The main goal here is to maintain complete control over your company.

If your project needs more investment, and you are considering the option of turning to business angels, then calculate the amount of funds that is needed at some stage of your program, where you will already begin to make a profit. Remember that staged financing will save you more money and more control over the company.

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Indirect

The company may also be interested in sources that are called indirect. There are three main types of such sources: leasing, franchising and factoring. Since leasing was discussed above, let’s move on to the remaining two.

Franchising is the transfer of intellectual property from the copyright holder to an enterprise for a nominal fee. This form of indirect investment has allowed many companies to strengthen their positions in the market. The most striking example in the Russian economy is the McDonalds chain. A large restaurant chain transfers the rights to use its trademarks through a franchising scheme and thus invests in the Russian economy.

Factoring is a more complex scheme for selling an enterprise’s receivables. In this case, we are talking about the actual sale of receivables to the factor company.

Indirect sources of investment financing do not have a critical impact on the financial performance of the enterprise and RVP in the macroeconomic sense, but are still important factors that must be taken into account when analyzing certain companies that can be successful without attracting large external sources of investment, but taking into account the use of indirect sources of investment and competent management of internal resources.

Leasing: definition, conditions and characteristics

Leasing is a complex of various forms of entrepreneurial techniques that are beneficial for the lessor and the lessee, as they allow the former to expand the boundaries of its activities, and the latter to update the composition of fixed assets.

The terms of the leasing agreement are more liberal compared to lending, since they allow the business owner to count on deferred payments and implement a large-scale project without large financial investments.

Leasing does not affect the balance of own and borrowed funds, that is, it does not violate the ratio characterizing the external/internal financing of the enterprise. For this reason, it does not become an obstacle to obtaining a loan.

It is interesting that when purchasing equipment under the terms of a leasing agreement, the company has the right not to put it on its balance sheet during the entire period of validity of the document. Thus, the manager has the opportunity to save on taxes because assets do not increase.

Borrowed and attracted investments - main characteristics

Attracted investments in the form of money received through the redemption of shares by the population or other commercial structures have certain economic characteristics:

• the difficulty of selling securities on the stock exchange;
• mandatory full payment of the authorized capital;
• Only closed and open joint-stock companies issue shares;
• dividends must be paid.

Debt investments may be more attractive to businesses that have a strong financial position. For these companies, borrowed capital will be cheaper than attracted capital in the long term. The characteristics of borrowed investments include:

• the need to provide collateral for a loan;
• only companies with good financial performance have the opportunity to obtain leasing or credit;
• the need to pay discounts on bonds and interest on loans.

The critical difference between the two groups of investments can be called the difference in working conditions with one or another source. Any company can use borrowed funds, but only joint-stock companies can raise funds from outside directly into fixed capital. For some companies this is a definite plus; for others, increasing the number of shareholders does not seem like the most profitable prospect.

External funds

Successful entrepreneurship is not only about generating your own profit in sufficient quantities to satisfy all your needs, but also about the ability to attract partners and investors. One of the main and successful capital expansion schemes is the merger of several companies experiencing similar difficulties or lack of resources. The effect of economies of size and scale manifests itself in an increase in financial reserves.

External sources of financing are conventionally divided into 2 groups: attracted and borrowed. The first include all the funds that the enterprise receives from the state or other structures that are ready to invest. The second group consists of bank loans, loans from individuals and legal entities.

Examples of external reserves include:

• overdraft;
• leasing;
• lending;
• bonds;
• trade loans;
• equity financing;
• sale of shares;
• state sponsorship.

The big advantage of providing loans is the opportunity to receive a large amount on favorable terms. Commercial banks are happy to provide interest-bearing loans to successful and steadily growing companies. As a rule, financial institutions are willing to enter into agreements with entrepreneurs who already have one profitable business and intend to expand their scope of activity or open another business.

One of the forms of lending is leasing. Its peculiarity is that the applicant receives not funds, but equipment and machinery. Using them directly in the production process, the organization pays its value gradually to the rightful owner. You can lease various types of resources: land, buildings, transport and special equipment, real estate and an entire business.

When concluding an overdraft agreement, the bank becomes an invisible permanent partner of the company, since the credit account is linked to the main one. Money is reflected and written off automatically both to repay the loan and, conversely, to receive it. However, if there is a delay, the company will be charged interest and a fine.

A bank loan is an expensive paid loan, unlike government sponsorship. This is a free form of credit that is available only to a limited number of organizations, usually within the scope of government interests.

Advantages and disadvantages

Owners of enterprises who decide to place securities on the stock market conduct their business in such a way as to minimize possible losses from dilution of their own stake and not lose the opportunity to manage the organization. Many large shareholders manage to retain a controlling stake after a public offering of securities.

In general, today it is more convenient and profitable for enterprises to attract external loans for financing, as cheaper, simpler and more effective ways to raise capital.

Borrowing from friends and family

One of the first ways people typically raise funds is by reaching out to their friends and family. This often sounds like a great idea because these people are easily accessible and want to see you happy and successful. But the nature of the relationship itself and the fact that these people are so close to you makes this one of the most dangerous methods for fundraising.

When you raise funds through professional investors, everyone knows what the stakes are, what the growth potential is and, of course, the reality that 80 percent of all startups ultimately fail, and that there is a very real risk of losing all capital.

It's different with friends and family. Their desire to invest in your business is actually because they want you to succeed or to prove that they believe in you and want to support you in your entrepreneurial endeavors. They can't offer their critical opinions without demotivating you or making you feel like they don't support you.

The question is, what happens if your company runs into difficulties and you are unable to repay the loan? Will this be a problem for them? If your company files for bankruptcy, do you expect to repay the loan anyway? These are all questions that need to be answered up front.

When you deal with an institution, all the answers to these questions are specified in the contract. You know who is responsible for the loan, what happens if you miss a payment, and all the consequences of not being able to repay the loan. With your friends and family, you should have the same level of rigor in the borrowing process and document every situation. This will help avoid jeopardizing your friendships or family relationships, since all issues will be discussed in advance.

For example, if you are experiencing temporary difficulties, you need to determine how you will solve them. Will you stop your monthly payments for a while until your financial situation improves? Is the lender willing to not receive payments from you for a while? If your company declares bankruptcy, will you repay the loan or not, and will it be okay if your lender waits until you have a new source of income to repay the loan? Will they accept a lower monthly payment over a longer period of time?

Even if you agree on all the issues above, you should remember that your friends and family may have their own opinions about how you use your money if the situation in your business goes unfavorably. For example, they may agree to reduce your monthly burden and take it on themselves to allow you to repay the loan over a longer period of time, but they will not be understanding if you go on vacation instead of paying them quickly . They may feel like they are funding your vacation. This is something you should consider when borrowing money from friends and family.

So what's the best way to borrow money from friends and family? You must treat them as strangers at the time of drawing up the contract or receipt. Don't fall into the trap of believing that verbal agreements are enough simply because you know each other. You must describe all possible consequences and how you will solve it in the event of a negative outcome of your business activity.

Let's consider what lending options you can get from your loved ones. To do this, we will take a direct and convertible loan.

A direct loan is a regular loan that people commonly use. The money you borrow must be repaid within a certain period of time or at the end of the period at a certain interest rate. This is a great way to easily obtain capital if your company has a certain level of revenue and is looking for capital to launch a new product or enter a new market.

A convertible loan differs from a direct loan only in that the contract has an additional clause that states that the lender can either return his money with interest or an equivalent amount in company shares at a certain point in time. You receive the money and do not pay a monthly payment and at the end of the loan period, say three years or five years, you either pay back the entire amount due, including interest, or give up shares for a total amount equal to the amount owed.

The way it works is that the loan typically lasts until you move to your next investment round or maturity level. At this time, the lender may receive all the money plus interest or the same amount of stock plus a discount to compensate the lender for the risk it took.

For example, if you sign a convertible loan for $100,000, you may have a seven percent interest rate on that loan that the lender will agree to. Or, conversely, the debt is converted into equity, he will receive $100,000 worth of stock in your company plus a 15% discount.

Remember, for convertible debt to work, you must be able to move on to another round of financing or to the next milestone that you have agreed upon. If your company doesn't reach this milestone, then technically the lender can ask you to repay the loan and force you into bankruptcy if you can't pay it back.

So why are you interested in using convertible loans to raise funds?

• Firstly, because it is much simpler than conventional investment vehicles. For regular funding rounds, you need to value your company to determine how many shares investors will get for their money. In the case of convertible debt, this discussion is postponed until a later time.
• The second reason, related to the first, is that because you delay discussing valuation, you tend to get a better deal and give away fewer shares. When you start a business, it is very difficult to determine the value of the company.

When you give up shares early in exchange for cash, you can never be sure that you are getting a good deal because... In any case, you need funds. But in the future, when you see how successful your company is and you have all the tools you need to properly evaluate the company, you will have a definitive answer to the question of whether it was a good deal or not.