For today’s businesses that are looking to raise capital, there are many different options. It is important to make a smart, informed choice on this matter, as the manner in which a business chooses to raise capital can have a major, tangible impact on that business’s future and its capacity for growth. Both debt and equity are sensible options, and they both have their place for today’s businesses. The key is knowing when to use which and making the right strategic decision, taking into account the standing of the business itself.
When businesses are looking to raise capital, they might choose to issue bonds. This is a means of taking on more debt for the corporation. One of the upsides to issuing bonds – when compared to handing out equity – is that the interest that a company pays on its bonds is tax deductible. For some businesses, this provides a major strategic edge that can help them reduce or defer tax liability during a time when they very much need to do so. The dividends that are paid out to shareholders under an equity scheme do not offer those sorts of tax benefits. In addition, the issuance of bonds allows the ownership interest of current company owners to stay completely intact. In order to issue equity, the ownership interest for current owners will have to be diluted to make room for the new equity holders. For companies that believe they are on a strong growth trajectory, it makes sense to hold on to as much of the equity in the company as possible.
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The upsides to equity financing are important to keep in mind for businesses that need strategic partners. One of the upsides of this financing model is that a business can start out without the major hindrance of debt on its back. When one issues bonds, one will have to immediately begin making payments on that debt. With an equity model, there is no need to make these payments, and all of the cash can be poured into the starting of the business. Perhaps more importantly, when one uses the equity model, one may be able to round up investors who can contribute more than just their money. In many cases, those who invest in a business will be able to provide strong strategic advice on how to move the company forward. This is, of course, a double-edged sword. Those who provide advice may also envision for themselves a bigger role in the company than is possible or feasible. This can create management issues overall for the corporation. Another of the upsides is that it is probably easier in many climates to get people to invest rather than to get people to buy bonds. While bonds are a safer investment for would-be investors, equity offers the growth opportunity that many are looking for when they sink their money into a company.
When it comes time to raise this kind of capital, it is critical to have a strong investment banker who can provide the sort of strategic advice and legitimate guidance that will make the process much easier. Choosing an investment banker can be difficult, but one of the best pieces of advice is to choose an investment banker that has a strong understanding of how to deal with a business of one’s size. Investment bankers that are used to dealing with large businesses likely would not be the best choice for a small business, and those who do not have the experience working with a large business would not have the technical savvy to assist with a complex deal. Choosing a person with an understanding of business sizing is critically important to moving forward.
One of the critical things for any business to understand when they find themselves in this kind of situation is that it pays to diversify between common stock and the issuance of corporate bonds. Ultimately, there is a certain relationship between risk and reward with these two approaches, and historically speaking, companies have liked to hedge so that they do not take on too much risk or seek too little reward. A delicate balance between these things provides for a stronger long-term profile.
Historically speaking, issuing common stock has long been a riskier venture for investors, but it may provide a more stable option for issuing companies. Taking on bonds, on the other hand, is a much safer option for investors while also being a riskier venture for businesses (Marsh, 1982). There is, of course, some risk associated with the issuance of equity for corporate financing. One of the primary problems, it seems, is that companies can end up diluting their shares to such an extent that they take all of the potential out when it comes to future growth (Van Auken & Doran, 2011). Bonds are risky on the front end because they deprive the company of the cash flow that it desperately needs for purchasing inventory and investing in up-front marketing or employee acquisition. Likewise, there are many consequences for defaulting on debt, and those things spell trouble for companies. It is important to have some combination of these two forms of financing. With too much equity issued, there is very little chance for the company’s owners to make it big if the company is a hit. With too many bonds issued, the company will not have the legitimate cash on hand to put itself out into the marketplace. Some combination of these things is necessary depending upon the company, its size, and the industry.
- Marsh, P. (1982). The choice between equity and debt: An empirical study. The Journal of finance, 37(1), 121-144.
- Van Auken, H. E., & Doran, B. M. (2011). Small business capitalization patterns. Journal of Applied Business Research (JABR), 5(2), 15-22.
