Alternative Sources of Finance: Meaning,
Features, Advantages, Disadvantages
Last updated on Jun 28, 2023
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Overview
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Alternative sources of finance are those channels of finances that have emerged outside of the traditional
finance systems like the regulated banks and capital markets. Alternative sources of finance come into the
picture when an individual or a company is not able to borrow money from the bank.
1. The ever-evolving Financial Sector has brought about continuous improvements in the Financial
Technology (FinTech). Hence, the traditional sources of finance such as the bank loans, private equity,
invoice discounting, overdrafts, etc. are no longer relied upon.
2. Today, there are other alternatives available through which individuals and/ or companies can arrange
their finances. These are clubbed together and called the Alternative Sources of Finance.
3. These sources include crowdfunding, leasing, financing, forfeiting, angel investors, and so on.
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Not only the topic of Alternative Sources of Finance is important from the practical knowledge perspective, it is
also crucial as far as the competitive exams are concerned. In the following finance study notes, we shall learn
more about the alternative sources of finance and understand the topic for both practical as well as RBI Grade
B mains exam-related aspects.
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Different Types of Alternative Sources of Finance
The different types of alternative sources of finance are listed as below:
1. Leasing
2. Franchising
3. Forfeiting
4. Peer-to-peer Platform
5. Crowdfunding
6. Angel Investors
7. Venture Capitalists
Leasing
1. A lease is defined as an agreement between the lessor (owner of the asset) and the lessee (user of the
asset), wherein, the lessor purchases an asset for the lessee and allows him to use it in exchange of
periodic payments called lease rentals or minimum lease payments (MLP).
2. The lessee is bound to pay the lease rental to the lessor for the use of the assets. After the end of the
period of the contract, the asset is transferred back to the lessor.
3. It refers to the renting of an asset for a certain period of time.
4. Parties involved include lease broker, lessor, lessee, and the lease assets.
Advantages Disadvantages
Lessee acquires the asset with a lower May impose certain restrictions on the use of the assets
investment
Simple documentation process Normal business may be impacted in the case of non-
renewal of lease
Does not dilute the capital structure Higher payout obligation in case equipment not found
Risk of obsolescence is born by the lesser Lessee cannot become the owner of the asset
Lease rentals are deductible for computing Regular maintenance of the asset
taxable profits
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Franchising
1. Franchising is the model in which the Company that does not have enough capital to expand, gives its
franchise rights to an individual or a company.
2. The company giving rights is called ‘franchisor’ while the company being given the franchise is called
‘franchisee’.
3. It is an arrangement where one party grants or licenses some rights and authorities to another party.
4. Franchising is a well-known marketing strategy to expand the business.
Advantages Disadvantages
Helps in expanding business Franchisor own goodwill may suffer in case of
failure by the franchisee
Builds a brand name and goodwill Lack of secrecy
Less efforts by franchisee for startup Lack of autonomy to the franchisee
Zero cost involved for training and assistance as it is Sharing of royalty and profits with the franchisor
provided by the franchisor
Types of Franchise:
1. Product franchise: An agreement where manufacturers allow retailers to distribute their products and
use names and trademarks.
2. Business format franchise: An agreement in which the franchisor provides the franchisee with an
established business, including name and trademarks for the franchisee to run independently.
3. Management franchise: The franchisee provides the management expertise, format and/ or
procedure for conducting the business.
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Forfeiting
1. It is a form of financing of receivables arising out of international business. Wherein, a bank or financial
institution undertakes the purchase of trade bills or promissory notes without recourse to the seller.
2. Purchases are made through discounting of the documents, hence covering the entire risk of payment
failure at the time of collection.
3. All risks become the full responsibility of the purchase
4. Forfeiture pays cash to the seller after the discounting of the said notes or bills.
Advantages Disadvantages
Immediate funds available for the exporters It is not available for deferred payments
Commercial bank can gain when the currency values Only selected currencies are considered for
appreciate forfeiting
Letter of credit provides great help No international credit agency to guarantee in case
of default
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Peer-to-peer (P2P) Lending
1. Peer-to-peer lending is a form of direct lending of money to businesses or individuals without any
official participation of any financial institution as an intermediary in the agreement
2. It is generally done through online platforms that relate lenders with potential borrowers
3. Peer-to-peer lending offers both secured and unsecured loans. However, most of the loans are
unsecured personal loans. Secured loans are an exception and are usually backed by luxury goods.
Advantages Disadvantages
High returns to the investors as there Credit risk because of low credit rating buyers
are no middlemen involved
More accessible sources of funding Government do no provide any insurance or protection on such
because of less complexity types of loan. It is not allowed in many countries
Services provided by P2P Platforms:
1. Finding new lenders and borrowers
2. Verification of borrower identity, bank account, income, and employment history
3. Legal compliance and reporting
4. Performing borrower credit checks and sorting out the unqualified ones
5. Servicing loans, providing customer service to borrowers, and attempting to collect payments from
borrowers who are in default
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Crowdfunding
1. It is the practice of funding a project by raising money from a large group of people.
2. It is a way of raising capital using the social networking sites like Facebook or Twitter or by using some
popular crowdfunding websites
3. Crowdfunding helps improve the presence of small businesses and startups across social media, it
increases their investment base, and funding prospects.
4. Various types of crowdfunding include debt-based, equity-based, cause-based, rewards-based,
software value token, litigation, etc.
Advantages Disadvantages
Quick way to raise finance Public may not show interest in all the projects
Feedback and expert guidance accompanies Significant resources needed for marketing about
funding projects
Great way to test public reaction It may not result in comprehensive financing
Easy to track progress Reputation of a business can be severely affected
Cheap source of finance Lack of project secrecy
Venture Capital
1. It refers to that capital and knowledge which are given for the formation and setting up of companies,
especially to those who possess any new methodologies or technology.
2. It is not merely a way of acquiring funds into a new firm but also a parallel support of the skills
required to set up the firm, devising its marketing strategy, organizing, and its management as well.
Stages of Crowdfunding
1. Seedling finance for the development of the business idea
2. Start-up finance for starting up the new business enterprise
3. Fledgling finance for the supply of funds as the company operates if it is not able to generate funds on
its own
4. Establishment finance to scale-up the business
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Advantages Disadvantages
Feeds wealth and expertise into the business Autonomy and control is shared with venture
capitalists
No obligation to repay the money Process is lengthy and complex
A large sum of equity finance is available Uncertain forms of financing
It provides valuable information, resources, and technical Benefits are available only in the long-run
assistance
Angel Investors
1. They are an individual or a group of individuals who invest their own money
2. They invest in the early stages of the company and in return opt for a share in the company
3. Angel investors typically invest less money that the venture capitalists
4. They are not involved much in the functions and management of the company. However, they may
advise and ask for reports and status.
Advantages Disadvantages
No need for collateral like personal Not suitable for investments below INR 5 lakhs or above INR 15
assets lakhs
No repayments or interest on It takes longer to find a suitable angel investor
borrowings
Better discipline due to outside Less structural support available
vigilance
You might also be interested in: Changing Landscape of the Banking Sector in India The above finance study
notes on Alternative Sources of Finances covering all the possible sources in the finance world. For more such
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