Ways of Financing Business: Debt, Equity and BeyondShashwat Mahaseth
Businesses need money to survive and make more money. In this article, we will discuss in detail what are the several instruments used by the companies to raise the required capital. You might have heard that debt and equity are the two primary sources of raising capital by a company. However, you may need to know that there are many types of debt and equity deployed by the company depending on the need and the thinking of the management. Also, apart from traditional debt and equity, there are channels like crowdfunding, angel investment, governmental subsidies, etc. that can help finance a business.
Raising funds through equity means transferring a part of the ownership of the company to the 3rd party at an agreed upon price. In this case, the people who own stake in a company get a proportionate share of the profits of the company. Unlike debt, the company is not obligated to pay returns/dividends to the equity investor. This means a little more elbow space for the company i.e. a company can choose not to pay any dividend if the company’s management deems it necessary for the company’s survival and growth. This helps two types of companies, one with erratic cash flow and the other being high growth companies.
Fun Fact: Google is yet to pay a dividend to its shareholders!
The company issues the equities, and the finances can be raised from the public by listing the company in a stock exchange by the Initial Public Offering(IPO) route. Another less complicated way to raise money is to issue equities using private placements.
Not all types of equities are created equal, let us have a look at the types of equities that are issued.
Common stock, also known as “shares”, gives you part ownership of the company when you buy a stock of a particular company. This common stock gives the owner of the stock the right to share in the profits of the company. However, the quantum of profits that are disbursed in the form of dividends is subject to the decision of the management of the company. The company is not obligated to pay dividends. The common stocks owner also gets a right to vote on corporate policies and decisions related to the company’s board of directors.
Preferred stock is slightly different from common stock as it usually comes with an agreed upon fixed dividends. It is called “preferred” stock because this class of stocks has a higher claim on assets and earnings of a business than the common stocks. Preferred stocks are given higher priority to common stock, but lesser priority than bonds/debt for the payment of dividends or claims over the assets of the company in case of liquidation.
The preferred stock provides assured dividends like debt instruments and may also appreciate in price like common stocks. Best of both worlds! The only catch being that the preferred stock usually does not have any voting rights.
A Warrant is a type of security derivative that confers its holder the right to buy the stock of the issuing company at a pre-agreed price and quantity in the future. The holder of the warrant is not obligated to buy the shares; he/she can choose not to exercise the option as well. It sounds very similar to the stock options, and regarding the application, it is. However, Warrant is different from an Option as it is issued by the company directly and the Option is issued by the stock exchange.
Debt simply means a borrowing of money by a company at an agreed interest rate. The lenders have no stake in the company and irrespective of whether the business makes money or not, the company has to pay back the borrowed amount along with interest within the stipulated time. This is achieved by using instruments like bonds, ban loans, etc.
This is the simplest form of debt where the principal amount and the interest is paid in full only at the end of the borrowing period. It is called straight debt because there is no special feature of repayment other than paying the money.
As the name suggests, Convertible debt is a type of bond that the holder can convert into shares of the issuing company at a particular agreed upon time frame. As with debt, the bondholder can choose to get cash and interest instead of equity shares at the end of the tenure. Usually, the businesses with low credit rating go for convertible debt.
Exchangeable debt is quite similar to the convertible debt. The critical difference lies in the fact that at the end of the tenure the bondholder can convert the bond into the security of company other than the issuing company. This “other” company is usually a subsidiary company of the borrower.
Venture debt, a type of debt financing, is usually provided to early-stage startups and growth companies. They are typically offered by the specialized bank divisions and other specialized lending companies. The venture debt is generally raised by the company that does not have positive cash flow or significant assets to get traditional loans. To make up for the higher risk of default, venture debt providers usually get a portion of the equity of the company or a right to purchase stake at a low price.
In the age of internet and social media, crowdfunding is an increasingly popular method of raising capital. Crowdfunding finances a business by raising money from a broad base of users online by showcasing the project. Typically, crowdfunding raises small amounts of capital from a large number of individuals to finance a new venture. In 2015 about $35 billion was raised by crowdfunding. Kickstarter and Indiegogo are two of the most famous crowdfunding platforms.
When the company provides its goods or services to any party, it is owed money. This owed money is in the form of accounts receivable. Usually, this means that the company can collect the money from its customers at a future time. In ‘Factoring’, the company sells this accounts receivable to a 3rd party(called Factor) at a discount for instant cash. Typically, the discount rate varies from 2 to 6 percent. The factor pays 70 to 80 percent of the face value immediately, and the rest is paid when the accounts receivable/invoice is realized.
The government may give direct benefits in the form of cash and discounted machinery. In certain sectors, government subsidies financially support the companies to provide a boost to the industrial development. Also, the companies are benefitted with indirect benefits of tax breaks and exemptions. A good example of this can be seen in the Indian renewable energy space. Ministry of New and Renewable Energy (MNRE) provides a subsidy of 15% on rooftop solar Photo Voltaic (PV) plants. This has boosted the solar power generation by easing the financial burden on these companies.
To learn more about the nitty-gritty of business financing, you may view the recording of the webinar on ”Debt Vs. Equity: The Secret Ingredient to Successful Business Financing” by Dr. Anil Lamba which was held on 29 May 2018. Dr. Lamba is a bestselling author, financial literacy activist, and a corporate trainer of international repute. This short-term course in finance on “Good Finance Management” will help you learn in-depth about capital structure and many such exciting topics in corporate finance.