The Disadvantages of External Sources of Finance

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External sources of financing can be broken down into two basic categories: debt or equity. Both of these types of external financing can come at a cost beyond just a monetary one. Working capital is important, but a business should carefully consider the disadvantages of external financing before it is undertaken.

Loss of Ownership

  • For a corporation, external financing may come from the issuance of new stock. This can decrease the owner's equity and means a loss of ownership. Other business types may be forced to sell an interest in the business as a means of raising capital. Venture capitalists are often relied upon for external financing in exchange for a share in the business. The distinct disadvantage in ownership loss is the possibility of giving up untold shares of future profits for a bit of working capital in the present.

Loss of Control

  • Debt based external financing normally means control of a company is secure. If a default were to take place, legal proceedings may force a loss of control if a judge appoints someone to oversee operations. Equity based financing almost always means a loss of control. Shareholders or other investors usually will have a vote or representation at annual meetings and can influence many corporate decisions. Proxy voting fights or attempts at hostile takeovers are two potential types of control loss. A company that relies too heavily on external financing may find itself being manipulated by outsiders. This loss of control is difficult to regain.

Cost

  • The cost of external financing is a major factor. Debt financing has associated interest payments and a struggling company may be forced to accept high interest rates on a loan or be forced to issue bonds with a higher than anticipated interest rate. Equity financing can mean fewer future profits are kept within the company as investors and shareholders claim profits or dividends. A fast growing company needs to make careful profit projections and understand that future profits lost to outside ownership interests may be the biggest cost of external equity financing.

Cash flow

  • The future of any company depends on working capital. Cash flow can be greatly affected by external financing. Payments for principal and interest for debt financing or dividends for equity financing can limit a company's ability to invest in expansion, research and development, marketing, or advertising. This loss of working capital may make it impossible for a company to continue operations without taking on more financing.

References

  • Photo Credit Thomas Northcut/Digital Vision/Getty Images
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