Debt & Equity Funding
What is Debt Financing?
Debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid. The other way to raise capital in the debt markets is to issue shares of stock in a public offering; this is called equity financing.
Breaking Down Debt Financing
When a company needs money through financing, it can take three routes to obtain financing: equity, debt, or some hybrid of the two. Equity represents an ownership stake in the company. It gives the shareholder a claim on future earnings, but it does not need to be paid back. If the company goes bankrupt, equity holders are the last in line to receive money. The other route a company can take to raise capital for its business is by issuing debt – a process known as debt financing.
Debt financing occurs when a firm sells fixed income products, such as bonds, bills, or notes, to investors to obtain the capital needed to grow and expand its operations. When a company issues a bond, the investors that purchase the bond are lenders who are either retail or institutional investors that provide the company with debt financing. The amount of the investment loan, referred to as the principal, must be paid back at some agreed date in the future. If the company goes bankrupt, lenders have a higher claim on any liquidated assets than shareholders.
Cost of Debt Financing
A firm’s capital structure is made up of equity and debt. The cost of equity is the dividend payments to shareholders, and the cost of debt is the interest payment to bondholders. When a company issues debt, not only does it promise to repay the principal amount, it also promises to compensate its bondholders by making interest payments, known as coupon payments, to them annually. The interest rate paid on these debt instruments represent the cost of borrowing to the issuer.
The sum of the cost of equity financing and debt financing is a company’s cost of capital. The cost of capital represents the minimum return that a company must earn on ts capital to satisfy its shareholders, creditors, and other providers of capital. A company’s investment decisions relating to new projects and operations should always generate returns greater than the cost of capital. If returns on its capital expenditures are below its cost of capital, then the firm is not generating positive earnings for its investors. In this case, the company may need to re-evaluate and re-balance its capital structure.
Interest Rates on Debt Financing
Some investors in debt are only interested in principal protection, while others want a return in the form of interest. The rate of interest is determined by market rates and the creditworthiness of the borrower. Higher rates of interest imply a greater chance of default and, therefore, a higher level of risk. Higher interest rates help to compensate the borrower for the increased risk. In addition to paying interest, debt financing often requires the borrower to adhere to certain rules regarding financial performance. These rules are referred to as covenants.
Debt financing can be difficult to obtain, but for many companies, it provides funding at lower rates than equity financing, especially in periods of historically low interest rates. Another perk to debt financing is that the interest on debt is tax deductible. Still, adding too much debt can increase the cost of capital, which reduces the present value of the company.
What is Equity Financing?
Equity financing is the process of raising capital through the sale of shares. Companies raise money because they might have a short-term need to pay bills or they might have a long-term goal and require funds to invest in their growth. By selling shares, they sell ownership in their company in return for cash, like stock financing.
Equity financing comes from many sources; for example, an entrepreneur’s friends and family, investors, or an initial public offering (IPO). Industry giants such as Google and Facebook raised billions in capital through IPOs.
While the term equity financing refers to the financing of public companies listed on an exchange, the term also applies to private company financing.
How Equity Financing Works
Equity financing involves the sale of common equity but also the sale of other equity or quasi-equity instruments such as preferred stock, convertible preferred stock, and equity units that include common shares and warrants.
Equity financing is used when companies, often start-ups, have a short-term need for cash.
It is typical for companies to use equity financing several times during the process of reaching maturity.
National and local governments keep a close watch on equity financing to ensure that everything done follows regulations.
A startup that grows into a successful company will have several rounds of equity financing as it evolves. Since a startup typically attracts different types of investors at various stages of its evolution, it may use different equity instruments for its financing needs.
Equity financing is distinct from debt financing; in debt financing, a company assumes a loan and pays back the loan over time with interest, while in equity financing, a company sells an ownership share in return for funds.
For example, angel investors and venture capitalists—who are generally the first investors in a startup—are inclined to favor convertible preferred shares rather than common equity in exchange for funding new companies because the former have greater upside potential and some downside protection. Once the company has grown large enough to consider going public, it may consider selling common equity to institutional and retail investors.
Later, if the company needs additional capital, it may choose secondary equity financing such as a rights offering or an offering of equity units that includes warrants as a sweetener.
The equity-financing process is governed by rules imposed by a local or national securities authority in most jurisdictions. Such regulation is primarily designed to protect the investing public from unscrupulous operators who may raise funds from unsuspecting investors and disappear with the financing proceeds.
Equity financing is thus often accompanied by an offering memorandum or prospectus, which contains extensive information that should help the investor make an informed decision on the merits of the financing. The memorandum or prospectus will state the company’s activities, information on its officers and directors, how the financing proceeds will be used, the risk factors, and financial statements.
Investor appetite for equity financing depends significantly on the state of the financial markets in general and equity markets in particular. While a steady pace of equity financing is a sign of investor confidence, a torrent of financing may indicate excessive optimism and a looming market top. For example, IPOs by dotcoms and technology companies reached record levels in the late 1990s, before the “tech wreck” that engulfed the Nasdaq from 2000 to 2002. The pace of equity financing typically drops off sharply after a sustained market correction due to investor risk-aversion during such periods.