The Advantages & Disadvantages of External Financing by George N. Root III

TL;DR - The pros and cons of raising outside capital for a startup

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Tags - pros and cons of external financing, outside capital, outside investment, venture capital

Questions answered:

  • What is external financing?
  • What are the advantages and disadvantages of external financing?

Summary:

  • External financing is any kind of business funding acquired from sources outside the company; examples include bank loans, outside investments, grants, equity, etc.
  • Advantages:
  • Preserving resources
    • External funding allows founders to use internal financial resources for other purposes.
  • Growth
    • External funding allows startups to finance growth projects that they could not fund on their own.
    • For example, if a startup is growing to the point that it needs additional manufacturing space/equipment to keep pace with demand, external financing can provide the fund necessary for the addition.
  • Advice and expertise
    • External organisations willing to finance startups can often be a useful source of expert advice and guidance (e.g. guidance on how to avoid pitfalls that created problems for other businesses they have funded).
  • Disadvantages:
  • Ownership
    • Some sources of external financing such as investors and shareholders often require founders to give up a portion of their ownership in their companies in exchange for their funding.
    • They often obtain the right to vote on company decisions, which might compromise founders’ visions for their companies.
  • Interest
    • Most sources of external financing require a return on their investment; banks add interest to business loans, and investors ask for a rate of return most of the time.
  • Lot of work
    • Identifying potential sources of external funding, preparing and presenting a business plan, and attending face-to-face meetings often take a lot of time and resources - and there is no guarantee that founders will get the funds.

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