Sources of Finance - Long Term Sources of Finance

An activity that looks at sources of finance for Level 2.

Long Term Sources of Finance

Long term sources of finance are those that are needed over a longer period of time - generally over a year. The reasons for needing long term finance are generally different to those relating to short term finance.

Long term finance may be needed to fund expansion projects - maybe a firm is considering setting up new offices in a European capital, maybe they want to buy new premises in another part of the UK, maybe they have a new product that they want to develop and maybe they want to buy another company. The methods of financing these types of projects will generally be quite complex and can involve billions of pounds.

A large industrial plant

Large-scale development of plant and equipment may cost millions of pounds. Long term finance is needed for this type of development. Copyright: Alfonso Lima, from stock.xchng.

It is important to remember that in most cases, a firm will not use just one source of finance but a number of sources. There might be a dominant source of funds but when you are raising hundreds of millions of pounds it is unlikely to come from just one source.

Shares

A share is a part ownership of a company. Shares relate to companies set up as private limited companies or public limited companies (plcs). There are many small firms who decide to set themselves up as private limited companies; there are advantages and disadvantages of doing so. It is possible, therefore, that a small business might start up and have just two shareholders in the business.

If the business wants to expand, they can issue more shares but there are limitations on who they can sell shares to - any share issue has to have the full backing of the existing shareholders. PLCs are different. They sell shares to the general public. This means that anyone could buy the shares in the business.

A Merrill Lynch office

Merrill Lynch: a merchant bank that engages in large-scale deals to acquire sources of finance.

Some firms might have started out as a private limited company and have expanded over time. There might come a time when they cannot issue any more shares to friends or family and need more funds to continue expanding. They might then decide to become a public limited company. This is called 'floating the business'. It means that the business will have to go through a number of administrative and legal procedures to allow it to be able to offer shares to the general public.

It might be that a business wants to raise £300 million to finance its expansion plans. It might issue 300 million £1 shares in the company. The offering of these shares has to be accompanied by a prospectus which lays out details of the business - what it is involved in, how it is structured, how it will be managed and so on. This is so that prospective investors, people or institutions who might want to buy the shares, can get information about the company before committing to buying shares.

Often a business will employ the services of a merchant bank to help with a share issue. These institutions specialise in arranging large financial deals of this sort. Examples of such institutions are Morgan Stanley, Merrill Lynch, Rothschilds and Goldman Sachs. These institutions may agree to underwrite the share issue. What this means is that if all the shares are not sold, the institution will still provide all the money to the firm issuing the shares.

Once the shares are sold, share owners can buy and sell their shares through the stock exchange. Such buying and selling does not affect the business concerned directly and is one of the main advantages of the stock exchange. You can get more details of how the stock exchange works through our resource on the London Stock Exchange.

There may be times in the development of a plc when it needs to raise more funds. In this case it can issue more shares. Many firms will do this through what is called a 'rights issue'. This occurs where new shares are issued but existing shareholders get the right to purchase new additional shares at a reduced price. If the business is doing well and the new finance is needed for expansion, this can be an attractive proposition for existing shareholders. For the business it is a relatively quick and cheap way of raising new funds.

Task

Follow this link to Morgan Stanley's United Kingdom Transactions. (http://www.morganstanley.com/about/offices/uk-transactions.html)

Select three of the transactions from the list. Try and work out who was trying to raise finance, how much they wanted to raise and then think about what they might have wanted to raise this money for. For example, one of the entries for March read:

March - Transport for London - £200 million Euro market public issue, 25-year fixed-rate note.

In this case, the business trying to raise money was Transport for London. They wanted to raise £200 million and did so through borrowing money over a 25 year period. The people lending the money would have received a fixed rate of interest for the period that they choose to hold the loan. (These notes can be bought and sold as well!). Why did Transport for London want to raise the money? Well, that is for you to think about.

Venture Capital

Venture capital is becoming an increasingly important source of finance for growing companies. Venture capitalists are groups of (generally very wealthy) individuals or companies specifically set up to invest in developing companies. Venture capitalists are on the look out for companies with potential. They are prepared to offer capital (money) to help the business grow. In return the venture capitalist gets some say in the running of the company as well as a share in the profits made.

Venture capitalists are often prepared to take on projects that might be seen as high risk which some banks might not want to get involved in. The advantages of this might be outweighed by the possibility of the business losing some of its independence in decision making.

Examples of venture capitalists (who are also called private equity firms) are Advantage Capital Limited, Braveheart Ventures, Permira and Hermes Private Equity.

Task

Go to the BVCA Web site. (http://www.bvca.co.uk/index.html)

The site contains a list of members - all firms providing capital for businesses! It also contains some case studies of how private equity firms have helped entrepreneurs. To find this, go to 'Entrepreneurs', 'Entrepreneurs - case studies' and open the pdf file. You can get some interesting information on the work of venture capitalists here.

Now go to Permira's page on the Gala Coral Group (http://www.permira.com/permira/en/dealdetail.jsp?id=50530) and read the information.

  • How much money did Permira invest in Coral?
  • In October 2005, Gala bought Coral Eurobet. How much did they pay to buy this company?
  • What do Permira plan to do to help the business grow in the future?
  • Why do you think that Permira believes the investment in the Gala group is a good one?

Government Grant

Interior shot of an Eden Project 'bubble'

The Eden Project near St Austell in Cornwall. The cost of the project was £133.6 million. Some of thefunding came from the National Lottery and some came from the EU. Copyright: Simon Nicholson, from stock.xchng.

Some firms might be eligible to get funds from the government. This could be the local authority, the national government or the European Union. These grants are often linked to incentives to firms to set up in areas that are in need of economic development. In Cornwall, for example, there have been a number of initiatives to encourage new businesses to locate there.

Cornwall has the lowest gross domestic product (GDP) per head of the population in the UK. The average wage in Cornwall is 28% below the UK average. As a result, the area attracts funding from the EU and the government. Firms looking to set up in Cornwall might be able to apply for some help in starting or moving a business to the area. One of the disadvantages of this type of funding is that it involves large amounts of paperwork and administration. This can add to costs and in some cases might not make the project worthwhile.

One famous example of how a business project can be developed using European Union funding was the Eden Project. The EU was not the only source of finance to help set up the project but was an important partner in helping to realise this important tourist destination for a deprived part of Cornwall.

Bank Loans

As with short term finance, banks are an important source of longer term finance. Banks may lend sums over long periods of time - possibly up to 25 years or even more in some cases. The loans have a rate of interest attached to them. This can vary according to the way in which the Bank of England sets interest rates. For businesses, using bank loans might be relatively easy but the cost of servicing the loan (paying the money and interest back) can be high. If interest rates rise then it can add to a businesses costs and this has to be taken into account in the planning stage before the loan is taken out.

Mortgage

A mortgage is a loan specifically for the purchase of property. Some businesses might buy property through a mortgage. In many cases, mortgages are used as a security for a loan. This tends to occur with smaller businesses. A sole trader, for example, running a florists shop might want to move to larger premises. They find a new shop with a price of £200,000. To raise this sort of money, the bank will want some sort of security - a guarantee that if the borrower cannot pay the money back the bank will be able to get their money back somehow.

The borrower can use their own property as security for the loan - it is often called taking out a second mortgage. If the business does not work out and the borrower could not pay the bank the loan then the bank has the right to take the home of the borrower and sell it to recover their money. Using a mortgage in this way is a very popular way of raising finance for small businesses but as you can see carries with it a big risk.

A large street-side flower stall

There may be a need to move to larger premises but the risks could be great if using your home as security for a loan. Copyright: Sue Anne Joe, from stock.xchng.

Owner's Capital

Some people are in a fortunate position of having some money which they can use to help set up their business. The money may be the result of savings, money left to them by a relative in a will or money received as the result of a redundancy payment. This has the advantage that it does not carry with it any interest. It might not, however, be a large enough sum to finance the business fully but will be one of the contributions to the overall finance of the business.

Retained Profit

This is a source of finance that would only be available to a business that was already in existence. Profits from a business can be used by the owners for their own personal use (shareholders in plcs receive a share of the company profits in the form of a dividend - usually expressed as Xp per share) or can be used to put back into the business. This is often called 'ploughing back the profits'.

The owners of a business will have to decide what the best option for their particular business is. In the early stages of business growth, it may be necessary to put back a lot of the profits into the business. This finance can be used to buy new equipment and machinery as well as more stock or raw materials and hopefully make the business more efficient and profitable in the future.

Selling Assets

As firms grow they build up assets. These assets could be in the form of property, machinery, equipment, other companies or even logos. In some cases it may be appropriate for a business to sell off some of these assets to finance other projects.

Thomson Learning EMEA home page

Biz/ed is owned by Thomson Learning. Thomson Learning, in turn, is part of the Thomson Corporation. The Thomson Corporation consists of a variety of different businesses, of which Thomson Learning is one.

In October 2006, the Thomson Corporation announced that it would be selling Thomson Learning. Part of the reasoning was that the learning part of the business was different to other parts of the corporation and that it did not fit into the strategic direction which the corporation as a whole wanted to go in. Selling Thomson Learning will help to raise valuable funds for the rest of the corporation to be able to develop. It is estimated that Thomson Learning will be worth something in the region of £5 billion!

Lottery Funding

In the UK the National Lottery might be a possible source of funds for some types of business. These businesses will mostly be charities or charitable trusts. The Eden Project, referred to earlier, received some funding from the Lottery. The company that run the Eden Project are a not for profit business so any surplus they make is put back into the business to help develop and improve it.

Close-up of a lottery ticket

The lottery is a source of funding for business but businesses making use of lottery finding tend to be registered charities rather than businesses looking to make a profit for shareholders. Copyright: Uffe Nielsen, from stock.xchng.

Task

Liverpool Football Club will have to raise over £200 million to build the new stadium.

  • Identify and explain some possible sources of finance that the club might use to raise the money to start the project. You can get some help on this by looking at the page on their Web site detailing their new stadium. (http://www.liverpoolfc.tv/newstadium/)
  • (If you live in the United States and are using this article, you might want to look at task from the perspective of the plans for the development of the New York Yankees baseball stadium. In which case, look at this page to help you.(http://www.mlb.com/NASApp/mlb/emailArticleServlet?aid=1262599)

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