Sources of capital

Capital is the money or finance an enterprise needs to start up or expand. At start-up, capital pays for what the business needs before it makes sales — for example a deposit on a market stall, a card reader, a first batch of materials and some launch advertising. Later, an enterprise may need capital again to grow, such as renting a second workshop bay, buying extra equipment or paying for a part-time assistant.

An enterprise can need capital more than once. The same sources of capital can be considered at either stage, so a new business choosing how to fund its launch works through the same list of options as an established business planning growth.

Internal or external?

An internal source is the owner's own money: for a start-up, that means the owner's own savings. An external source comes from outside the enterprise: a loan from a bank or another financial provider, crowdfunding, a grant, a business angel, or a gift or loan from friends and family. Friends and family support is external even when it is informal, because the money comes from outside the enterprise.

More checks outside

External sources usually involve more paperwork, checks and formalities than using own savings or informal family support. A bank loan needs an application and credit checks; a grant needs an application and eligibility checks; a business angel may want a formal agreement about shares. These steps can take time, so the source chosen affects how soon the money can be used as well as where it comes from.

For example, a mobile bike repair service needs £800 for tools, a work stand and a first batch of parts. The owner's savings could be paid in straight away; a bank loan could raise more, but the application and credit checks mean waiting before the tools can be bought.

Own savings are money the owner has already saved and chooses to put into the enterprise. They are an internal source of capital, because the money comes from the owner rather than from an outside lender or investor.

Any owner can use their savings: a sole trader, a partner putting money into a partnership, or a director putting money into a limited company. For example, Priya has £3,000 saved from a Saturday job and uses £1,600 of it to buy a second-hand sewing machine, fabric and a card reader to start selling made-to-measure dance costumes online.

Advantages

Own savings are cheap and quick. No interest or fees are payable, so the owner keeps more of the money the business earns. The money does not have to be repaid as a debt, unlike a loan. There are also no application forms or credit checks, so the cash can be in the business almost immediately.

Disadvantages

The amount available is limited to what the person has saved, so it may not cover everything needed to start up or expand. Using savings can also leave the owner with little or nothing set aside for other events or emergencies, such as a car repair or a sudden bill. If the money is lost, the owner carries the loss personally, which can cause real strain because it was their own money rather than someone else's.

Friends and family finance is capital given to an enterprise by people the owner already knows, such as a parent, a grandparent or a close friend. The money comes from outside the enterprise, so it is an external source of capital, even though the arrangement is usually informal.

Gift or loan?

Supporters can hand money over in one of two forms, and the difference matters:

• A gift is money given to the owner. It does not have to be repaid and normally involves no interest or fees.
• A loan must be repaid and may involve interest, even when the arrangement is informal and nothing is written down.

For example, Sam runs a weekend business printing custom phone cases to sell at craft markets. His sister gives him £120 as a gift towards blank cases and ink, while his godmother lends him £250 for a market pitch and a display stand, to be repaid at £25 a month. The £120 is Sam's to keep, so nothing comes out of his takings, but the £250 is a debt he must budget for every month — even one where he sells very little.

Why it can be quick

Friends and family can be a fast source of finance because the owner asks people they already know and may get an answer the same day. There may be little formal paperwork — perhaps no application form, credit checks or security — so it can be quicker and simpler than a bank loan. Even so, writing down the amount, the repayment date and any interest is sensible, so both sides remember the same terms later.

Friends and family finance is capital from people you already know, given as a gift, which does not need to be repaid, or a loan, which does. It is an external source of capital.

Advantages

• Flexible repayment terms. You and your supporter can agree the schedule between you, so repayments can start small or pause until sales are steady — helpful when the enterprise's income is uneven.
• Free or low cost. A gift carries no interest or fees, so all the money goes into the enterprise. A loan from a relative may be interest-free or charged at a very low rate.
• Lower interest than a formal lender. The rate charged may be lower than a bank's, and because the arrangement is informal it may not affect your credit score.

Disadvantages

• Lack of clarity. With nothing written down, people remember the deal differently, which causes awkwardness and arguments if something goes wrong.
• The supporter may ask for the money back. They might need it early, perhaps to cover their own bills. If it has already been spent on stock or equipment, the enterprise is left short of cash and the relationship is strained.
• A sense of entitlement. Having provided the money, the supporter may expect a say in decisions, such as which supplier to use, which can pull you away from your own plan.
• A limited amount. Friends and family have their own commitments, so the sum available may be small and may not cover everything the enterprise needs.

For example, a learner starting a weekend bike repair service needs £420 for tools and a repair stand. An aunt lends £300 interest-free, repaid at £40 a month once repairs begin: cheap and flexible. But she also expects to decide which jobs he takes on, and asks for £100 back early when her car needs fixing — leaving too little for the stand and straining both the enterprise and the relationship.

A loan is a lump sum of money from a bank or other financial provider. The enterprise receives the full amount up front, then repays it in instalments over a set period. Each instalment pays back part of the amount borrowed plus interest, which is the lender's charge for providing the money.

For example, a mobile bike repair enterprise borrows £7,000 to buy a van and tools. The lender sets a three-year term, so the owner makes one payment each month rather than repaying the whole £7,000 in one go.

Advantages

• Fixed interest rate: the rate may be fixed for the whole term. The repayments then stay the same each month, so the enterprise can plan ahead without worrying that payments will rise.
• Known repayment amount: because the instalments are set out in advance, the owner knows exactly what must be paid and when. This makes budgeting easier, as the loan payment can be treated as a regular cost.

Disadvantages

• High interest: interest rates may be high, so the enterprise may pay back considerably more than it borrowed. The extra cost reduces the money available for other things.
• Security: the lender may require security — an asset such as property or equipment. If repayments are not made, the lender can take ownership of that asset and sell it to recover the money owed.

A loan from a financial provider is not a gift: it must be repaid, and the interest charged means it costs more than the amount borrowed. This is true even if the enterprise does less well than expected. The lender is still entitled to its instalments, so a loan adds a regular commitment that continues even if sales are lower than planned.

Crowdfunding is an online appeal for investment where many people each contribute a small amount towards a funding target. The enterprise sets a target amount and a deadline on a crowdfunding platform. Members of the public then pledge money, often in return for a reward, a product or a share of the business or its profits.

How a campaign works

Suppose you want £5,000 to make a new card game. You set a £5,000 target and a 30-day deadline. Supporters might pledge £15 to receive a copy of the game when it is made. On an all-or-nothing campaign, funding is only released if pledges reach £5,000 before the deadline.

Advantages

• It can raise finance quickly from a large pool of investors, instead of relying on one bank or one investor.
• It may involve no interest payments and sometimes no fees, because supporters are not lending money that must be repaid with interest.
• It can be an alternative source when banks refuse finance, for example if the enterprise is new and has little trading history.

Disadvantages

• When pledges fall short of the target, no money is released and supporters are refunded. All the effort can therefore produce no finance at all.
• The business idea may be copied if it is not protected by copyright or a patent, because the campaign is public and anyone can see it.
• Time and money are needed to launch and run the campaign. Reputation may also be damaged if the target is missed in public.

A grant is a cash injection from a government or a charity, given to support particular types of investment or enterprise. It is not lent by a bank and it is not bought by an investor — it is awarded to help pay for something specific.

Grants exist to achieve an aim, so they are usually linked to public benefit or economic stimulus. A fund might offer money to create jobs in a town with high unemployment, to pay for staff training, to help businesses buy greener equipment, or to support a rural community bus service. The funder wants a result for its money, even though the business never repays it.

Why a grant is attractive

A grant usually does not need to be repaid and is often free of interest and fees, so it is much cheaper than borrowing the same amount as a loan. For example, a small climbing centre wants to fit energy-saving LED lighting. A green energy charity offers £3,000 towards the equipment because it wants to cut electricity waste. That £3,000 is never repaid, so the owner only has to find the rest of the cost.

Why a grant is not always the answer

• Eligibility — only certain businesses, in certain places or industries, can apply, so you may find nothing suitable. A fund for staff training is no help if you need new tools.
• Conditions — money comes with rules, such as how it must be spent, where you must be based, how many jobs you must create or how long you must stay open. Break them and you may have to repay the grant.
• Time and competition — applying means forms and evidence such as quotes and a business plan, so it can take weeks or months. When demand is high and funds are limited, there are more applicants than money, so even a strong application may be turned down.

A business angel is an individual who invests their own money in a business in return for a share of the enterprise (part-ownership) and a slice of its profits. They are usually experienced business people who back start-ups and small businesses.

Advantages for the owner

• Advice and mentoring: the owner gains guidance from someone with business experience, as well as the money.
• Quick finance with no repayments: the money can arrive quickly, and because the angel is buying a share there is no interest or repayment schedule to meet. A large amount may be available.
• Backing for risky ideas: an angel may fund a risky business that other sources, such as a bank, would refuse.

For example, a small mobile bike repair service needs £8,000 for tools, a van and a website. A business angel could provide the money quickly and also advise on pricing and finding customers. The service may look risky because it is new, but an angel may still invest.

Disadvantages for the owner

• Less control: the angel now has a say, so the owner may lose control over core decision-making.
• A share of the profits: the owner has to hand over part-ownership and a slice of future profits.
• Possible conflict: differing visions may cause conflict, because the angel expects input into how the enterprise is run and may want it to go in a different direction.

An angel's money is never a gift or a loan: it is an investment bought with part-ownership, and that is where these drawbacks come from. If the angel wants a second repair van in a nearby town while the owner prefers to stay small, the two visions can clash.

When you choose a source of capital, you compare the finance options available to an enterprise rather than taking the first one offered. The right source depends on the enterprise’s stage, how much it needs and what it can afford to give up.

Comparing sources means naming one and weighing it against another using these points for that enterprise.

For example, a mobile bike repair service needs £5,000 for a van, tools and insurance, and has £2,000 in savings. A bank loan of £3,000 could arrive in time for spring, when repairs are busiest, but interest makes it cost more and the van may be used as security. Crowdfunding might raise a larger sum, but it takes time to prepare and depends on reaching a target. The owner might choose the bank loan because it could arrive in time and repayments can be planned from repair income, even though it is not the cheapest option. A different enterprise could choose differently: savings are quick and free but limited, while a loan gives a larger sum but adds interest and security.