Summary
- Internal financing uses capital already held by the business, including retained earnings and working capital management, avoiding share dilution and borrower obligations, but requires adequate reserves that many early-stage startups have not yet built.
- Internal financing is not a free source of capital: the returns generated from deploying retained earnings must exceed the startup’s weighted average cost of capital, just as they would under any external financing arrangement.
- The pecking order theory, which prioritises retained earnings over debt and equity, is less applicable to startups, where equity financing is often the primary and most practical source of growth capital at early stages.
- This article is a plain-English guide to internal and external financing options for startup founders, written by LegalVision’s business lawyers.
- LegalVision specialises in advising clients on startup financing, equity structures and commercial growth strategy.
Tips for Businesses
Before drawing on retained earnings, calculate whether the expected return on that deployment exceeds your weighted average cost of capital. If you are considering external financing, understand the trade-offs between equity dilution and debt obligations before committing to a structure. Early-stage founders should not dismiss equity financing simply because it dilutes ownership, as the right investor brings more than just capital.
Internal financing is a funding method that allows a company to deploy its own capital reserves, rather than seeking funds from outside investors or lenders, under the general principles of corporate financial management recognised across Australian, New Zealand and UK commercial practice. For startups, it typically means drawing on retained earnings or managing working capital more actively. Unlike equity financing, which the Corporations Act 2001 governs in Australia and ASIC oversees, internal financing carries no regulatory approval requirements, though it still carries a real cost of capital that founders often underestimate. This article will explain the difference between external and internal sources of financing so that you can ensure you are deploying your startup’s capital most efficiently.
What is Internal Financing?
As the name suggests, internal financing refers to the funds available to the company without resorting to external sources. You can break down internal financing into long-term and short-term internal financing.
Long-term financing essentially describes your startup’s retained earnings. This is all the aggregate profits your business has generated but has not been distributed to shareholders as dividends.
Short-term internal financing describes managing your working capital to allow you to repurpose the funds for certain purposes. In particular, you can change how you manage your credit controls, inventory levels and trade payables.
How Working Capital Management Releases Cash
Working capital is the cash tied up in your day-to-day operations. Managing it well can free up funds without needing to raise external capital.
There are three main levers:
- Debtors: Invoice customers promptly and follow up on late payments. The faster clients pay, the more cash you have available.
- Creditors: Negotiate longer payment terms with suppliers where possible. Paying on day 45 instead of day 14 keeps cash in your business longer.
- Inventory: Avoid holding more stock than you need. Excess inventory ties up cash that could be deployed elsewhere.
For early-stage startups with limited retained earnings, improving working capital management is often the most accessible form of internal financing. It does not require profits to exist. It simply requires tighter operational discipline around how cash moves through the business.
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How is Internal Financing Different from External Financing?
The difference between the two forms of financing is quite straightforward. Internal financing refers to capital that is already in possession of your startup. You do not need to go to prospective equity or debt investors to access the cash. Assuming you have adequate internal financing sources, internal financing is often preferable to external financing. This is because the authority to access the capital remains with your company.
In turn, you do not need to worry about the dilution of shares in accessing internal financing as you would under equity financing. Nor do you need to incur onerous borrower obligations common under debt financing.
However, internal financing usually requires you to have adequate capital reserves in the form of retained earnings. Many startups, especially early-stage ones, lack ample reserves because they have yet to generate sales at a profit.
External financing also has many of its own benefits. For example, investors often bring opportunities for your startup to establish industry connections and experience mentorship. Additionally, securing external financing can enhance the credibility of your business, and you may have avenues for starting partnerships. Most importantly, external financing alleviates the cash flow constraints on your business that may come with internal financing options.
LegalVision’s Startup Manual is essential reading material for any startup founder looking to launch and grow a successful startup.
What are the Disadvantages of Internal Financing?
A common misconception is that your internal sources of financing, particularly your retained earnings, are free sources of capital. That is not true. All businesses have obligations to return wealth to their investors.
If your startup has borrowed money in debt or convertible notes that remain unconverted, you need to service the interest payments on the debt. This requires your startup to generate sufficient cash to meet these interest obligations.
Moreover, your shareholders expect compensation for their investment. Startup shareholder investors usually prefer to delay dividend payments in favour of the startup reinvesting available earnings into the company to grow its asset value. Nonetheless, there is a value your startup should place on its ability to generate sufficient earnings to reinvest back into the business.
You can work out the minimum returns your startup must generate in cash flow to meet its interest payments and achieve sufficient capital growth (or distribute dividends, as the case may be). This figure is called your startup’s weighted average cost of capital.
If your startup intends to draw on its retained earnings, it should be confident that the proceeds of these finances will exceed the weighted average cost of capital.
Internal Financing and the Pecking Order Theory
Modern financial management theory argues that businesses should prioritise the following sources of capital in what is called the pecking order theory:
- use retained earnings where at all possible;
- if you do not have sufficient capital, you should use debt financing; and
- as a last resort, you should raise equity capital.
However, the pecking order theory is less relevant for startups. This is because raising equity finance is the primary source of capital for businesses in their early stages of growth. An entire segment of the investment market is prepared to assume the relatively high risk of investing in startups in exchange for the potential upside of investing in a successful company.
Thus, while internal financing can be a great source of capital for your startup, financial management theories that prioritise internal financing may not capture the growth objectives of your startup.
Key Takeaways
Internal financing offers startups the advantage of using their own capital without diluting the existing shares or incurring onerous borrowing obligations. However, you must have adequate retained earnings to draw from to finance a project internally. Nor is internal financing a free source of capital. The return on the invested internal source of funds must exceed the required return on capital employed, just as it would using external financing. Finally, while more mature businesses tend to favour internal financing as a capital source of first resort, startups have different objectives. For these reasons, you may need to embrace external financing in the form of equity and hybrid financing.
If you need help with your startup, LegalVision provides ongoing legal support for businesses through our fixed-fee legal membership. Our experienced startup lawyers help businesses manage contracts, employment law, disputes, intellectual property, and more, with unlimited access to specialist lawyers for a fixed monthly fee. To learn more about LegalVision’s legal membership, call 0808 196 8584 or visit our membership page.
Frequently Asked Questions
What is the difference between internal and external financing for startups?
Internal financing refers to using the company’s existing capital, while external financing involves seeking funds from outside sources such as venture capital investors or lenders.
What is the main advantage of internal financing for startups?
Internal financing allows startups to use their capital without diluting ownership or incurring borrower obligations, giving them greater control over their funding.
What is the pecking order theory and does it apply to startups?
The pecking order theory suggests businesses should use retained earnings first, then debt, then equity as a last resort. However, this is less relevant for startups, which often rely on equity financing as their primary capital source due to limited retained earnings in early growth stages.
What is weighted average cost of capital?
Weighted average cost of capital is the minimum return your startup must generate to meet its interest obligations and achieve sufficient capital growth for shareholders. Before drawing on retained earnings, you should be confident the returns from that investment will exceed this figure.
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