Top 2 Ways Companies Raise Capital


Finance operations with capital

Running a business requires a lot of capital. Capital city can take different forms, from human capital and labor to economic capital. But when most people hear the term “financial capital,” the first thing that comes to mind is usually money.

This is not necessarily wrong. Financial capital is represented by assets, securities, and yes, in cash. Having access to cash can make the difference between businesses that thrive or stay put and get left behind. But how can companies raise the capital necessary for their sustainability and to finance their future projects? And what options do they have available?

There are two types of capital that a business can use to finance its operations: debt and equity. Careful business Finance The practice is to determine the most profitable combination of debt and equity. This article examines both types of capital.

Key points to remember

  • Businesses can use either debt or equity to raise funds, as the cost of debt is usually lower than the cost of equity, since debt has recourse.
  • Debt capital comes in the form of loans or corporate bond issues. Equity comes in the form of cash in exchange for ownership of the business, usually through shares.
  • Debt holders typically charge companies interest, while equity holders rely on stock appreciation or dividends for a return.
  • Preferred stocks have a priority claim on a company’s assets over common stock, which reduces the cost of capital for preferred stock.

Debt capital

Debt capital is also called debt financing. Debt financing occurs when a business borrows money and agrees to repay it to the lender at a later date. The most common types of debt capital used by companies are loans and obligations, which large companies use to fuel their expansion plans or to finance new projects. Small businesses can even use credit cards to raise their own capital.

A business looking to raise capital through debt may need to go to a bank for a loan, where the bank becomes the lender and the business becomes the debtor. In return for the loan, the bank charges interest, which the company will note, along with the loan, on its balance sheet.

The other option is to issue corporate bonds. These bonds are sold to investors, also known as bondholders or lenders, and mature after a certain date. Before reaching maturity, the company is responsible for issuing interest payments on the bond to investors.

Rating agencies, such as Standard and Poor’s (S&P), are responsible for assessing the quality of corporate debt, signaling investors how risky bonds are.

Advantages and disadvantages of loan capital

Since corporate bonds typically have a high amount of risk—The risks of default are higher than government-issued bonds — they pay a much higher return. The money raised by the issuance of bonds can be used by the company for its expansion plans.

While this is a great way to raise much-needed funds, debt capital has a downside – it comes with the added burden of interest. This expense, incurred only for the privilege of accessing funds, is called the cost of borrowing capital. Interest payments must be made to lenders regardless of the performance of the business. In low season or in bad economy, a leveraged the business may have debt payments that exceed its income.

Example of debt capital

Let’s look at the loan scenario as an example. Suppose a business takes out a $ 100,000 business loan from a bank with an annual interest rate of 6%. If the loan is repaid one year later, the total amount repaid is $ 100,000 x 1.06, or $ 106,000. Of course, most loans are not repaid that quickly, so the actual amount of compound interest on such a large loan can add up quickly.

Equity

Equity, on the other hand, is not generated by borrowing, but by the sale of shares in the company. Stock. If taking on more debt is not financially viable, a company can raise capital by selling additional shares. These can be either ordinary actions or preferred shares.

Ordinary shares give shareholders right to vote but doesn’t really give them much else in terms of importance. They are at the bottom of the ladder, which means their ownership is not prioritized like other shareholders are. In the event of bankruptcy or liquidation of the company, the other creditors and shareholders are paid first. Preferred shares are unique in that the payment of an eligible dividend is guaranteed before such payments are made on the common shares. In exchange, the preferred shareholders have limited ownership rights and have no voting rights.

Holders of debt are generally referred to as lenders, while holders of shares are referred to as investors.

Advantages and disadvantages of increasing equity

The main advantage of raising equity capital is that, unlike debt capital, the company is not required to repay the investment to shareholders. Instead, cost of equity refers to the amount of return on investment expected by shareholders based on the performance of the broader market. Those Return come from the payment of dividends and valuation of shares.

The downside to equity is that each shareholder owns a small portion of the business, so ownership becomes diluted. Business owners are also beholden to their shareholders and must ensure that the business remains profitable to maintain a high stock valuation while continuing to pay expected dividends.

Since preferred shareholders have a higher claim on company assets, the risk for preferred shareholders is lower than for common shareholders, who occupy the bottom of the food payment chain. Therefore, the cost of capital for selling preferred stock is lower than that for selling common stock. In comparison, the two types of equity are generally more expensive than loan capital, since lenders are always guaranteed payment by law.

Example of equity

As mentioned above, some companies choose not to borrow more money to raise their capital. Maybe they are already in debt and just can’t get into debt anymore. They can look to the market to raise funds.

A start-up can raise capital through angel investors and venture capitalists. Private companies, on the other hand, can decide to go public by issuing a initial public offering (IPO). This is done by issuing shares in the primary market, usually to institutional investors, after which the shares are traded in the secondary market by the investors. For example, Facebook went public in May 2012, raising $ 16 billion in capital through its IPO, bringing the company’s value to $ 104 billion.

The bottom line

Businesses can raise capital through debt financing or equity financing. Debt financing involves borrowing money from a bank or other lender or issuing corporate bonds. The full amount of the loan must be repaid, plus interest, which is the cost of the loan.

Equity financing involves transferring a percentage of the ownership of a company to investors who buy shares in the company. This can be done either on the stock exchange for public companies, or for private companies, via private investors who receive a percentage of ownership.

Both types of financing have their advantages and disadvantages, and the right choice, or the right combination, will depend on the type of business, its current business profile, its financing needs and its financial situation.


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