The New York Stock Exchange, Wall Street, New York City

Share capital (also known as equity capital) is finance raised through the issuing of shares via a stock exchange (or stock market). It is a long-term source of finance for limited liability companies, obtained by selling shares in the company. When a limited liability company sells its shares for the very first time on a public stock exchange, this is called an initial public offering (IPO).

A stock exchange is a well-organized and highly regulated marketplace where individuals and businesses can buy and sell shares in public limited companies. Shares in private limited company cannot be traded on a stock exchange, as their shares are not sold to the public.

The main functions of a stock exchange are to:

• enable existing companies to raise share capital (through a share issue)

• oversees the initial public offering (IPO) of new public limited companies

• to provide a market for trading of second-hand shares (and government bonds, although this isn’t covered in the IB syllabus).

 Advantages of share capital

• It is permanent capital as it does not need to be repaid (shareholders sell their shareholdings to other buyers via the stock exchange)

• There are no interest payments made to shareholders, thus this reduces the expenses of the company

• Unlike loan capital, share capital does not involve debt or incur interest repayments.

• Any public limited liability company can raise further finance by selling additional shares (a process known as a share issue).

 Disadvantages of share capital

• Shareholders need to (at some point) be paid dividends if the company earns a profit.

• Although share capital can raise a lot of money for a company, the ownership and control of the organization may be diluted.

• Only public limited companies can trade their shares using the stock market.

To find out more about the stock market, watch this Netflix documentary. Many thanks to IB educator Gema Quintanilla for recommending this.

Loan capital, also known as debt capital, refers to borrowed funds from financial lenders, such as commercial banks. It is typically a long-term source of external finance, and is usually for the purchase of non-current assets (sometimes referred to as fixed assets). Hence, loan capital appears as part of non-current assets in the balance sheet.

 Advantages of loan capital

• It enables the borrower to repay in regular instalments, making loan capital more accessible and affordable for many businesses as it is not burdened by having to pay a large lump sum of money.

• Large businesses are often able to negotiate a lower rate of interest on their loans (financial economies of scale).

• Loan capital is suitable if the owners need to raise finance but do not want to dilute their ownership or potentially lose control through issuing shares.

 Disadvantages of loan capital

• Interest is charged on the amount of borrowed funds. The interest rate can be a fixed or variable rate.

• In many cases, businesses have to offer collateral (security) before loans can be approved. Failure to repay the loan can lead to the lender being able to legally seize the firm’s assets to pay for the outstanding amount borrowed.

• Firms that borrow loan capital on variable interest rates may suffer from liquidity problems if the rate of interest increases, because their debt repayment burden will increase.

An overdraft is a banking service that enables customers (personal and business customers) to withdraw more money from their account than exists in the account. This can help businesses to meet their short-term liquidity needs, especially in emergency situations. The overdraft has to be pre-approved to avoid expensive bank charges, as does the maximum amount that can be overdrawn.

 Advantages of overdrafts

• Overdrafts are quite easy to obtain, so are an important source of external finance for small businesses in particular.

• Overdrafts provide businesses with emergency funds to finance their operations, such as making payment to suppliers or paying wages to staff, during times when liquidity is a problem.

• It provides great flexibility for businesses as overdrafts are only used as and when needed.

• Interest is charged on the amount overdrawn, usually at rates higher than those charged for ordinary bank loans.

• Banks usually only lend a small amount of money, in order to keep a business operation; it is not a suitable source of finance for purchasing fixed assets, for example.

• Banks can ask for overdrafts to be repaid at very short notice.

• It is essentially a high cost, short-term loan for businesses.

Whilst individual customers may use credit cards to pay for their purchases, business organizations use trade credit. Trade credit enables a customer to purchase and obtain goods and services but to pay for these at a later date. The supplier provides the trade credit to the customer (another business organization), which helps the purchaser’s cash flow as they can obtain supplies without having to pay for these immediately.

The typical trade credit period is between 30 to 90 days, depending on the industry in question. This means that it is possible to sell the goods bought before actually having to pay for them! Hence, trade credit can be an important external source of finance for businesses struggling with cash flow. Buying goods and services on trade credit does not incur any interest charges if the amount owed is paid in full within the trade credit period. This makes trade credit relatively attractive compared to overdrafts.

Leasing involves the business or customer (known as the lessee) drawing up a contract with the leasing company (known as the lessor) to use particular fixed assets for an agreed fee. Example of leased fixed assets included: machinery, tools, equipment, photocopiers, computers, vehicles or premises. It is a common option for businesses to access fixed assets without the high costs of capital expenditure.

Leasing enables a business to use these assets without having to purchase them outright (which may be unnecessary or too expensive for some businesses). In many cases, the lessor allows a long-term lessee (usually lasting three or more years) the option to buy the asset at the end of the lease agreement.

The lessor is responsible for maintaining leased equipment

 Advantages of leasing

• The lessor does not have to purchase the expensive equipment, machinery, vehicles or other type of capital. Instead, its money can be used for revenue expenditure purposes.

• The lessor takes responsibility for the maintenance of the capital equipment and other leased property. This helps to cut the operating costs of the lessee.

• Leasing is particularly advantageous if the business only needs to use the fixed capital for a short period of time, or if it does not want to deal with the hassles and costs of repairs and maintenance.

 Disadvantages of leasing

• With leasing, the lessee never owns the asset. Ownership remains with the lessor (the leasing company) before, during and after the leasing contract.

• Over a long period of time, leasing can be more expensive than buying the asset outright due to the accumulated costs of leasing the asset over time.

Microfinance has helped female entrepreneurs in Vietnam

Microfinance providers are for-profit social enterprises that offer a financial service to those without a job or on very low incomes. These members of society would not ordinarily be able to secure bank loans. The concept of microfinance was developed by Nobel Prize winner Muhammad Yunus (http://www.muhammadyunus.org/) in 2006, in association with the Grameen Bank.

The aim of providing microfinance is to help entrepreneurs, especially women, struggling to finance their business start-ups to gain access to loans of a small amount. Microfinance can give these people the opportunity to become self-sufficient and empower them to run their businesses. As with the majority of loans, interest is charged on the amount borrowed, although these are typically lower than what commercial banks would charge.

 Advantages of microfinance providers

The advantages of establishing a business as a microfinance provider as a form of for-profit social enterprise include:

• Microfinance can help many people to get out of poverty by making them become financially independent.
• Around half of the world’s people live on less than $2 a day, (with the vast majority of these living in low-income countries or highly indebted poor countries) so microfinance can help to provide poverty relief.
• They help to empower entrepreneurs of small businesses, especially women and the underprivileged working and living in low-income countries.
• Microfinance can create benefits for the wider community, such as improved healthcare, education and employment opportunities.
• Microfinance providers act in a socially responsible way by helping the poorest and most vulnerable adults in society.
• Microfinance can help to build and foster a culture of entrepreneurialship and economic independence.

 Disadvantages of microfinance providers

However, there are potential drawbacks of establishing a business as a microfinance provider. These limitations include the following points:

• Some people regard the practice of microfinance providers as being unethical as they earn profits from low-income individuals and households.

• Microfinance only provides finance on a small scale, so is unlikely to be sufficient to make a real difference to society as a whole.

• Microfinance loans incur interest charges, so can be rather expensive for small business owners who find it difficult to earn enough revenue to keep up with their loan repayments.

• Microfinance increases the debts of entrepreneurs who may subsequently struggle in their business venture.

• Due to relatively low profitability, microfinance providers may struggle to attract and/or retain employees and managers, given that their remuneration packages are unlikely to be matched by larger for-profit financial companies such as commercial banks and insurance companies.

Business angels (or angel investors) are wealthy and successful private individuals who risk their own money in a business venture that has high growth potential. The finance from business angels is their own (personal investors). This external source of finance represents a high degree of risk.

 Advantages of business angels

• Business angels provide an essential source of finance for start-ups and small businesses that are unable to secure finance from conventional providers of finance, such as commercial banks and other financial institutions.

• The business can benefit from the expertise and experiences of the business angels, who are likely to provide their input in order to secure a significant return on their investment (ROI).

• It is particularly useful for small businesses and inexperienced entrepreneurs who are unable to raise sufficient finance on their own, such as those which are unable to secure loan capital or those that are not permitted to sell shares on a public stock exchange.

 Disadvantages of business angels

• For the business angels, such business ventures are extremely high risk, especially as they risk losing their personal money. Hence, the amount of finance available is often not easily available for start-ups and small businesses.

• This also means that there are no guarantees than angel investors will earn a satisfactory ROI, despite the high potential returns.

• Such finance is difficult to come by, not only due to the risks involved but also due to the large number of entrepreneurs competing for such funds. You only have to watch an episode of Dragon’s Den or Shark Tank to realise this.

• The use of business angels will dilute the firm’s control and ownership as the angel investors will want a share and say in the organization.

• Business angels are wealthy and successful private individuals who risk their own money in a business venture that has high growth potential.

• Crowdfunding is an external source of finance that involves raising small amounts of money from a large number of people to fund a particular business project or venture, typically via online platforms.

• External sources of finance are those that come from outside the organization, usually with the help of a third party provider.

• An initial public offering (IPO) occurs when a limited liability company sells its shares for the very first time on a public stock exchange.

• The interest rate is the price of money over a period of time. It can refer to the cost of borrowing money or the reward for saving money, expressed as a percentage figure.

• Leasing involves the business or customer drawing up a contract with the leasing company to use particular fixed assets for an agreed fee.

• Loan capital (or debt capital) refers to borrowed funds from financial lenders, such as commercial banks, usually for the purchase of fixed assets.

• Microfinance providers are for-profit social enterprises that offer a financial service to those without a job or on very low incomes.

• An overdraft is a banking service that enables customers (personal and business customers) to withdraw more money from their account than exists in the account.

• Share capital (or equity capital) is finance raised through the issuing of shares via a public stock exchange.

• Trade credit is an external source of finance that enables customers to purchase and obtain products but to pay for these at a later date.

 Exam Practice Question - Venturing in the beauty industry

According to Forbes, the the global hair wigs and extensions market size has been valued at $5.8 billion in 2021 and it expected to skyrocket to reach $13.3 billion by 2026. The readily available supply of high-quality wigs and the growth in average disposable incomes, as well as the increase in hair loss rates and the popularity of personal grooming and beauty products, have driven growth in the industry.

The growth prospects for the industry has attracted a large number of business angels to invest in the market for the long-term. According to data from the Centre for Venture Research at the University of New Hampshire, the number of female angel investors has increased nearly eightfold, from over 11,000 to almost 94,000 in 2019.

Source: adapted from Forbes

 Teacher only box

Answers

(a)  Define the term market size.  [2 marks]

Market size refers to the total number of individual customers or the value of total sales revenue in a certain market. The size of a market can be measured in a number of ways, but usually refers to the number of people in a certain market who are potential customers of a product or service.

Award [1 mark] for a vague definition that shows some understanding of market share.

Award [2 marks] for an accurate definition that shows good understanding of the term market share, similar to the example above.

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(b)  Calculate the forecasted percentage increase in the value of the global hair wigs market.  [2 marks]

• Percentage change = ($13.3bn – $5.8bn) / $5.8bn = 129.31%
• Accept answers that show 130%

Award [1 mark] for the correct answer, and [1 mark] for showing appropriate working out.

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(c)    Define the term business angels.    [2 marks]

Business angels are wealthy and successful private investors who risk their own money in start-up firms and/or small but expanding business ventures that have significant growth potential. In return, they gain part-ownership of such businesses.

Award [1 mark] for a vague definition that shows some understanding.

Award [2 marks] for an accurate definition that shows good understanding, similar to the example above.

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(d)  Explain one reason for and one reason against the use business angels to generate long-term investment in the beauty industry.  [4 marks]

The use of business angels can be an effective way for businesses to generate much-needed start-up capital and possibly a long-term investment. A business angel is a high net worth individual who looks to take an equity stake in a commercial business that seems to have growth potential, such as those in the hair wigs and extension market that is expected to grow by around 130% within the 5 years up to 2026.

Although the financial rewards can be high for venture capitalists, investments such as these are extremely risky and so the businesses receiving the funds from angel investors may have to give up a very high proportion of their business in return.

Mark as a 2 + 2.

Award [1 mark] for identifying a relevant advantage (and disadvantage), and [1 mark] for the explanation, written in the context of the case study, up to the maximum of [4 marks].

Review your understanding of external sources of finance by answering the questions below.