Top 2 Ways Corporations Raise Capital

Funding Operations With Capital

Running a business requires a great deal of capital. Capital can take different forms, from human and labor capital to intellectual property. However, when most people hear the term capital, the first thing that comes to mind is usually money.

That’s not necessarily untrue. Capital is anything that confers value or benefit and, in most cases, comes down to cash. Having access to cash can mean the difference between companies expanding or losing customers and going out of business. But how can companies raise the capital they need to keep going and fund future projects? And what options do they have available?

There are two types of capital that a company can use to fund operations: debt and equity. In this article, we examine both.

Key Takeaways

• Businesses can use either debt or equity capital to raise money.
• Debt capital is money that is borrowed, such as through a loan or corporate bond.
• Equity capital is money free of debt and comes from retained earnings and selling company ownership for cash.
• Debt holders usually charge businesses interest, while equity holders rely on stock appreciation or dividends for a return.
• The cost of debt is usually lower than the cost of equity.

Debt Capital

Debt capital, also referred to as debt financing, is borrowed funds. With this type of funding, a company borrows money and agrees to pay it back to the lender at a later date. 

The most common types of debt capital companies use are loans and bonds, which larger companies use to fuel their expansion plans or to fund new projects. Smaller businesses may even use credit cards to fund their capital requirements.

A company looking to raise capital through debt may need to approach a bank for a loan, where the bank becomes the lender and the company becomes the debtor. In exchange for the loan, the bank charges interest, which the company will expense through its income statement.

Another common option is to issue corporate bonds. These bonds are sold to investors and mature after a certain date. Before reaching maturity, the company is responsible for issuing interest payments on the bond to investors.

Pros and Cons of Debt Capital

Debt capital can be a great way to raise much-needed money. It doesn’t dilute ownership and the cost of debt is usually lower than the cost of raising equity. Investors generally take on more risk buying a company’s stock rather than its bond and, as a result, demand higher returns for equity.

Another advantage of debt capital is that the borrowing company can use interest expenses to lower taxes, reducing the effective interest rate they pay.

Debt capital also has downsides, notably the additional burden of interest. This expense, incurred just for the privilege of accessing funds, is referred to as the cost of debt capital. Interest payments must be made to lenders regardless of business performance. In a low season or bad economy, a highly leveraged company may have debt payments that exceed its cash flow.

Example of Debt Capital

Assume a company takes out a $100,000 business loan from a bank that carries a 6% annual interest rate. 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 so quickly, so the actual amount of compounded interest on such a large loan can add up quickly.

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

Equity Capital

Equity capital is money that isn’t borrowed. It is generated through retained earnings and the sale of shares of company stock. If taking on debt isn’t an option, a company can raise capital by selling additional shares. These can be either common shares or preferred shares.

Common stock gives shareholders voting rights but doesn’t really give them much else in terms of importance. They are at the bottom of the ladder, meaning their ownership isn’t prioritized as other shareholders are. If the company goes under or liquidates, other creditors and shareholders are paid first.

Preferred shares are unique in that payment of a specified dividend is guaranteed before any such payments are made on common shares. In exchange, preferred shareholders have limited ownership rights and have no voting rights.

Pros and Cons of Raising Equity

The primary benefit of raising equity capital is that, unlike debt capital, it doesn’t need to be repaid. That doesn’t mean it doesn’t come at a cost, though.

The cost of equity capital is the return on investment shareholders expect based on the performance of the larger market. These returns come from the payment of dividends and stock valuation.

Business owners are beholden to their shareholders and must ensure the company remains profitable to maintain an elevated stock valuation while continuing to pay any expected dividends. That can be expensive.

Another major disadvantage of equity capital is that issuing more shares results in ownership becoming diluted. Company founders generally don’t like to cede control and other shareholders don’t like to see their percentage of ownership decrease and be forced to stump up cash to prevent this from happening.

Important

The cost of capital for the sale of preferred shares is lower than for the sale of common shares

Because preferred shareholders have a higher claim on company assets, the risk to preferred shareholders is lower than to common shareholders, who occupy the bottom of the payment food chain. Therefore, the cost of capital for the sale of preferred shares is lower than for the sale of common shares.

In comparison, both types of equity capital are typically more costly than debt capital, since lenders are always guaranteed payment by law.

Example of Equity Capital

Some companies choose not to borrow money to raise capital. Perhaps they’re already leveraged and can’t take on any more debt, or have a bad or zero credit history. In such cases, they may turn to the market to raise some cash.

A startup company may raise capital through angel investors and venture capitalists. Private companies, on the other hand, may decide to go public by issuing an initial public offering (IPO). This is done by issuing stock on the primary market—usually to institutional investors—after which shares are traded on the secondary market by investors.

Once a company has gone public, it can create additional shares and sell them to investors to raise more capital.

Note

Debt holders are generally known as lenders while equity holders are known as investors.

What Are the Two Main Sources of Capital for a Company?

Companies have two main sources of capital they can tap into to cover their costs, fund expansion, or serve other business needs. They can borrow money and take on debt or go down the equity route, which involves using earnings generated by the business or selling ownership stakes in exchange for cash.

What Is the Best Way a Company Can Raise Money?

That depends on the company’s needs, objectives, and credit profile, the economic environment, and various other factors. Generally, debt is the preferred way to raise capital as it doesn’t dilute ownership and tends to cost less than equity. However, borrowing money isn’t an option open to all companies and can be less favorable when interest rates are high.

What Is Bootstrapping a Business?

Bootstrapping a business means starting a business with little capital. The company’s founder or founders don’t rely on outside investment, instead attempting to build the company using operating revenues and their own personal finances.

The Bottom Line

Companies can raise capital through either debt or equity financing. Debt financing requires borrowing money from a bank or other lender or issuing corporate bonds. The full amount of the loan has to be paid back, plus interest, which is the cost of borrowing.

Equity financing involves giving up a percentage of ownership in a company to investors, who purchase shares of the company. This can either be done on a stock market for public companies, or, for private companies, via private investors that receive a percentage of ownership.

Both types of financing have their pros and cons. The right choice, or the right mix, will depend on the type of company, its current business profile, its financing needs, and its financial condition.