Sources of finance for a new business - internal and external, debt and equity (owner equity, retained profits, loans, overdraft, trade credit, leasing, venture capital, government grants) - and the matching of finance source to purpose, cost, risk and control

What this dot point is asking

QCAA wants you to identify the sources of finance available to a new business, classify them as internal or external and as debt or equity, and explain how an owner chooses between them based on purpose, cost, risk and control. Unit 1 assessment commonly asks you to recommend a finance mix for a stimulus venture, so the marks are in the justification, not just the list.

The answer

Two ways to classify finance

Every source of finance can be classified on two dimensions.

Internal sources

• Owner equity (owner's capital). Money the owner contributes from personal savings. This is the foundation of finance for almost every new business, because lenders and investors expect the owner to have "skin in the game".
• Retained profits. Profit kept in the business rather than taken out. A new business usually has little or no retained profit in its first year, so this matters more once the business is established.

External debt sources

• Bank loan (term loan). A lump sum repaid over a fixed term with interest. Suited to large, long-life purchases such as equipment or a fit-out. Often secured against an asset, and a new operator may need a personal guarantee.
• Bank overdraft. A facility that lets the account go into negative balance up to a limit. Suited to short-term working-capital gaps, not long-term assets. Interest applies only to the amount used.
• Trade credit. A supplier allows the business to buy now and pay later (commonly 30 days). Effectively an interest-free short-term loan that eases early cash flow.
• Leasing. The business pays to use an asset (vehicle, equipment) without owning it. Conserves upfront cash and the payments are an operating expense.

External equity sources

• New owners or partners. Bringing in a partner or shareholder who contributes capital.
• Venture capital. Professional investors fund high-growth potential businesses in exchange for equity. Relevant to scalable startups rather than a typical small business.
• Equity crowdfunding. Many small investors contribute capital online in exchange for shares, regulated in Australia under the Crowd-Sourced Funding regime.

Government grants and assistance

Governments offer grants and concessional support that do not need to be repaid and do not dilute ownership, such as small-business start-up grants and industry-specific incentives. These are situational rather than guaranteed, so they should supplement, not replace, a finance plan.

The matching principle

The core decision rule is to match the term of the finance to the life of what it funds.

• Long-life assets (equipment, fit-out, vehicles) should be funded by long-term finance (a term loan, lease or equity), so repayments are spread over the period the asset earns income.
• Short-term needs (stock, seasonal cash gaps) should be funded by short-term finance (overdraft, trade credit), so the business is not locked into long repayments for a temporary need.

Cost, risk and control trade-offs

• Cost. Debt has an explicit interest cost; equity has an implicit cost because investors expect a higher return than a lender. Trade credit and grants can be effectively free.
• Risk. Debt increases financial risk because repayments are compulsory in good times and bad. Equity carries no repayment obligation, so it is lower risk for cash flow.
• Control. Debt preserves the owner's full control and ownership. External equity dilutes both.

Examples in context

Example 1. Owner equity plus secured debt - a regional Queensland cafe. A new operator opens a cafe in Toowoomba. She contributes $50,000 of her own savings (internal equity) for the deposit and signs a$45,000 secured bank loan (external debt) over five years for the fit-out and coffee machine, which matches the long-life assets to long-term finance. Daily milk and produce are bought on 14-day supplier trade credit (external debt, effectively interest-free), and a $10,000 overdraft facility covers quiet-week cash gaps. She avoids outside equity to keep full ownership and control.

Example 2. Equity-funded scalable startup - the Atlassian path. Atlassian famously bootstrapped from founder equity and retained profits in its early years, deliberately avoiding outside investment for a long time to keep control. When it eventually raised external equity (a 2010 investment from Accel), it traded some ownership for capital and credibility to accelerate growth. This shows the control trade-off: equity brings money and partners but dilutes the founders' ownership.

Try this

Q1. Classify each of the following as internal or external, and as debt or equity: owner's savings, a bank term loan, retained profits, trade credit, a venture-capital investment. [3 marks]

• Cue. Owner's savings = internal equity; bank term loan = external debt; retained profits = internal equity; trade credit = external debt; venture capital = external equity.

Q2. Explain the matching principle and give one example of applying it. [3 marks]

• Cue. Match the term of finance to the life of what it funds: long-term finance (loan, lease, equity) for long-life assets such as equipment; short-term finance (overdraft, trade credit) for short-term needs such as stock or seasonal cash gaps.

Q3. A new business owner is choosing between a $50,000 bank loan and bringing in an equity partner who will contribute$50,000 for a 30 percent share. Recommend an option and justify it using cost, risk and control. [4 marks]

• Cue. Loan keeps full ownership and control and interest is tax-deductible, but adds compulsory repayments and financial risk; equity partner removes repayment pressure and shares risk but dilutes ownership and future profit. Recommend based on the owner's cash-flow certainty and how much control they want to keep.