Understanding External Financing Options to Raise Capital

Introduction

         There are a myriad of external financing vehicles for raising capital.  Therefore, a company should analyze the various vehicles to ensure that the appropriate financing vehicle, or a combination of vehicles to fund their project is chosen.  Some of these vehicles include debentures, equity finance, mortgages, short-term and long-term loans, and lines of credit/ supplier lines of credit.   

1.0 Debentures

       Debentures are debt vehicles that are not secured by assets or collateral.  The debenture is supported by only the reputation of the issuer and their creditworthiness.  Both governments and corporations issue this bond type to secure capital, like other types of bonds; debentures are logged in an indenture.  The government also issues debentures in the form of Treasury securities.  Debentures can be secured against particular assets, which provides a company with rights over the collateral asset; which would give the debenture holder authority over a company to discard or sell an asset without authorization. 

          Normally, debentures are issued in denominations of $1,000 or $10,000 with variable maturities.  Debentures usually have provisions that protect bondholders.  These provisions are:

• In order to keep issuer from overleveraging and diluting power of the bondholders, the debenture issue size is limited to the initial issue amount. 
• The issuer may be required by debenture to pay bondholders interest before any dividend payments can be made.
• A variety of covenants may be required to abide by to uphold certain financial ratios or operate in defined financial limits that decrease the chances of default.

There are advantages and disadvantages of debentures. 

Advantages:

• A company who has borrowed several debts in small amounts and duration can convert these debts in a single issue of debentures, which will be beneficial for a company, in that it is less expensive. 
• Costs affiliated with debentures are less expensive than the costs affiliated with equity shares.  Therefore, it is practical for a company to disperse debentures.
• Debentures do not have any voting rights, thus, by dispersing debentures, existing equity shareholders control is not influenced.
• Investors may not be ready to take risks during a depression period; therefore, the firm may issue debentures to raise long-term capital.

Disadvantages

• There is a legal obligation to the debenture holders for interest payments, and a business has to fulfill their commitment even during hard times; debenture holders will not understand no matter what business problems may arise.
• Debentures increase the company’s leverage, thus becoming high risk for bankruptcy, although this is not the only risk.  The whole project can be in jeopardy if the rate of return falls below the interest rate of the debenture.
• A business may not be able to operate business freely because of the restrictive covenants with the trustee bank or financial institution, which could ultimately affect business decision-making effectiveness.
• There are disadvantages to a fixed interest rate, even though a fixed rate has its advantages.  Low inflationary state can cause the value of money to grow, and the cash outflow to remain steady, thus producing a loss making discrepancy.

         When a company needs more money for a long period, it is not practical to issue shares every time.  Hence, the firm can raise a public loan.  The loan amount can be separated into units of small allotments and then sell them to the public.  Each unit is a debenture, and the debenture holder is the holder of these units.  The amount raised is the company’s loan.  A debenture is considered a unit of the amount of the loan.  Furthermore, a company issues debentures when it raises the loan amount from the public.  A company issues a certificate of loan, or debenture; it is a security type, and the creditor of the company is a debenture holder. 

2.0 Equity Finance

        Equity finance is money or assets that are supplied by an investor, in exchange for ownership in the business, such as shares in the company, or instruments that change into stock.  The investor can participate, without limit, in all the business’ profits.   Equity offerings are only for public companies.  Investors will provide cash to buy company shares.  The standard share is an ordinary share, which may have special rights, such as:

• The holder has the right to vote at company meetings, usually one vote per share.
• Receive dividends that the director proclaims payable.
• Upon sale or liquidation, the holder will acquire his share of the earnings of the assets.
• The payment of dividend or disbursement of capital to a shareholder is dictated by the amount of total ordinary shares they hold.

         A shareholder does have rights to sell his shares or to buy additional shares.  There are advantages and disadvantages of equity financing. 

Advantages:

§         As the business expands, investors may provide follow-up funding.

§         Just like the company, investors are genuinely interested in the success of the business, such as its profitability and growth, and increase in value; therefore outside investors may aid in growth ideas.

§         It allows you to use the capital for business operations because costs of servicing loans or debt finance will not have to be maintained.

§         If the business is being profitable, then investors realize their investment, for example, through stock market flotation or sale to new investors.

§         The proper venture capitalists and business angels can assist in decision making and strategy, as well as provide beneficial skills, experience, and contracts for the company.

Disadvantages:

§         Some of the management decision- making power will be lost, depending on the investor.

§         Management will have to invest their time in providing information updates for the investor to oversee.

§         Raising equity finance is taxing, time consuming, and high-priced, as well as steering the focus away from management’s core business operations.

§         When raising finance, there may be regulatory and legal issues to abide by.

§         In the beginning, a company may have a smaller stake (as a percentage and absolute monetary terms) in the business, although, if the investment brings the business more success, then the reduced share will be worth a lot more in absolute monetary terms.

§         Investors will produce a thorough background analysis of the business, looking at past forecasts and results, and will examine management as well.  However, some businesses find this to be beneficial, even if the fundraising is not successful.

         Unlike debt financing, or loans, equity financing does not have to be repaid.  Equity investing could come from friends and family (angel investors), or from venture capital or private equity firms, who has a high net-worth.  Equity investments are usually given to high growth companies, with potential of having a high rate of return.  Investors want to exit an investment within 3-7 years, therefore investors are looking for companies that have am apparent exit strategy, as well as potential significant financial returns, for example, profit margins of more than 50%, is the general rule of thumb.

3.0 Long-term and Short-term Loans

          There are two branches of business loans, short-term and long-term.  Short-term loans are any loans less than three years, and can be as short as ninety days, while long-term loans are any loans three years and over; these loans usually last up to tens years, and in some cases may be approved for up to thirty years.  Several factors is analyzed for the loan approval process, these include, a business’ balance sheet, credit history, financial statement, total years in business, and the established relationship between business and lending institution. 

           Unsecured loans, is approved without collateral, and is often approved to accredited customers for loans less than one year.  However, collateral is most often necessary for loans in the one to three year range.  A business’ assets, such as real estate, buildings, and equipment is sufficient for providing means of collateral, considering the assets worth is adequate.  Furthermore, the lending institution will properly assess the collateral’s value, as well as monitor the loan to make sure that the collateral maintains its worth over the duration of the loan.  These loan types are secured loans because if the loan is defaulted, then the collateral that assures repayment could be relinquished.  An approved line of credit, that could be used at the discretion of the business, throughout a year, could be negotiated as an alternative to an unsecured short-term loan.  Short-term loans are generally used to compensate for cash flow deficits or allow purchase of supplementary inventory. 

             Lenders will require a more thorough analysis of long-term loans that are more than three years, though the same is true for long-term loans as short-term loans, in that a good credit history, a prosperous balance sheet and financial statement, will speed up the approval process, and make it easier as well.  A long-term loan is a secured loan that requires collateral for approval of a loan.  For large acquisitions or purchasing equipment with a long life cycle, then long-term loans is propitious. 

             Short-term and long-term loans interest rates vary.  Mostly the rate will be 1-3% above the prime lending rate.  The timeframe of a loan determines how much interest will have to be paid; the shorter the loan period, then, the less interest will have to be paid.  Another factor that could determine interest rate is the collateral’s value.  There is less risk involved with short-term loans, than long-term loans.  It is imperative to look at the banks policies and procedures when choosing among lending institutions because no two banks are alike when it comes to policies and procedures.

              There are advantages as well as disadvantages in debt financing.  The advantages are the interest is tax deductible; lender does not have ownership of the business, thus, the business has full control; depending on the loan terms, repayment is often a fixed, monthly expense; the lender and borrower relationship ends once the entire loan amount is paid in full, and the borrower’s obligations to the lender is paying the loan.  The disadvantages includes, monthly payment requirement, with interest increasing steadily, which results in limited cash flow.  If the borrower cannot fulfill obligation to pay for the loan, or make on time payments, then credit can be tarnished, making the chances of raising additional capital limited; and this type of loan is often given to those who have an established, successful business.  There are two types of long-term debt financing payment types, a balloon payment, and variable rates.  A balloon payment is a new loan amount that is negotiated between the lender and borrower for the residual amount, at the end of the term.  Variable rates are interest rates that are adjustable according to market, and normally occur with long-term debt financing.

4.0 Line of Credit/ Supplier Lines of Credit

        A line of credit is much more flexible than a loan, and is usually supplied by banks and other suppliers, who give you a certain amount for your maximum line of credit, the money that you can borrow.  For example, if your line of credit is $40,000, then you can write checks for $1200, $1800, $9,000, etc., as long as you keep within that $40,000.  Then, you can reuse the money again, as soon as you start paying the amount of money borrowed from the line of credit.  Businesses that are unsure how much money they will need, or who need irregular amounts, then a line of credit is a good option.  There are advantages and disadvantages of lines of credit.

Advantages

• Interest payments is only required for the precise amount used.
• Interest and processing fees are tax deductible.
• Financial history will become aggrandize because credit transactions will build credit.
• It also helps in building relationships with banks and/or suppliers, for future financing.

Disadvantages

§         Collateral is needed to provide security for the credit.

§         A fixed annual fee is required by the lender to use credit, no matter of the actual use.

§          Debt can easily increase if not properly handled, which could cause a borrower not to fulfill their obligations, thus resulting in steep debt, devastated financial history, and a tarnished credit score.

       A supplier line of credit is credit that is given to a buyer by a supplier or seller.  This type of credit lets the buyer receive goods now, but pay for them later, but under the terms and conditions of an agreement with the seller.  Payments should be made on time to ensure company/supplier relationship and future deliveries of goods.