What is the Difference Between External vs Internal Sources of Finance?

As a startup founder, financing is essential to the continued growth and profitability of your business. It comes in various forms, including debt and equity. A lesser-considered but equally important form of finance is internal financing. This describes using the capital your company currently holds to fund whatever your project might be. 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 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.

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 to be compensated for their investment. Startup shareholder investors are usually prepared to delay any 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. 

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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, our experienced business lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page. 

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