External sources of finance come from outside the business. Support from family and friends belongs to external sources of finance. When businesses need to use the money for a short period of time (less than one year), this creates the need for short-term finance.
1. Family and Friends
Owners of small businesses can raise informally a significant amount of finance from close friends and family members.
This source of finance is very popular and quite common in many cultures featuring collectivism such as China and India. Money from family and friends is mainly used by unincorporated businesses – sole traders and partnerships.
Benefits of borrowing from family and friends
- Inexpensive. Borrowing money from family and friends is cheap. Family members and friends may, or may not, demand to be paid annual interest. However, when borrowing from a bank, interest must always be paid.
- No collateral required. When borrowing from a bank, collateral will most likely be required before authorizing a loan. Family members and friends will often lend money to you in good faith because they truly want to help you out to succeed, not because they want to make profit out of you.
Drawbacks of borrowing from family and friends
- Limited amount. This source of finance is usually very limited, especially, if you do not have rich family members.
- Family feuds. Borrowing from family and friends may often provoke disagreements and disputes. In the worst-case scenario, it may even worsen the relationship within the family forever.
Alternatively, sole traders and partnerships may take on partners to inject further capital into the business organization.
