Business owners are well aware of the obstacles and challenges that lie ahead when running a business. One of the biggest challenges is managing capital. You might know the term capital as money. While that isn’t necessarily true, capital raising does usually come in the form of raising money. Since every business needs capital to maintain operating, finding ways to raise capital becomes a necessity. Companies can do that in one of two ways. They can do it through debt or equity.
But to clarify the previous point, capital is represented in three ways – assets, cash, and securities. Companies handle all three differently. But that doesn’t take away from the fact that every business needs money to run.
So, let’s see how debt and equity raising work, what are the strengths of both, and where do both differ.
Capital Raising In the Form Of Debt Raising
As the name suggests, capital raising through debt means borrowing money and repaying it later. While this is a short and simple explanation, there is a more complex approach to debt raising. Whenever a company wants to raise capital through debt, the company has to find a lender.
A lender is usually a bank. The bank will give a loan and charge interest. Since the bank becomes the debtor, the company must repay the loan. Apart from loans, companies can also use bonds as a method of debt raising. Bonds work differently from loans. Instead of approaching a bank, a company issues corporate bonds to investors. The investors buy the bonds and are given a date when they can get their money back plus interest.
Strengths Of Debt Raising
Even if a company can take out a loan to generate capital, bonds are the primary way for companies to do so. But unlike loans, bonds are significantly riskier. This can be a good thing and a bad thing for investors. The good thing is that they come with higher yields. The bad thing is that they are much more likely to default.
Companies that raise capital through issuing bonds can use the money to fund business operations, expansions, and more. Loans are more straightforward. The company goes to a bank and agrees on a loan. The company is then supposed to pay back the loan plus interest.
One of the biggest strengths of this capital raising strategy is that it is a viable one. But that doesn’t mean debt raising doesn’t come with a downside.
Downside of Debt Raising
The biggest downside of debt raising is the interest. Interest can accumulate and cripple a company. Since a company is obliged to pay off this expense, it could mean losing profits. If a company mismanages this capital raising strategy, the accumulated interest payments can quickly overwhelm a company. Another downside of debt raising is that interest payments must be made regardless of how the company performs. Even during bad quarters, a company has to make timely payments.
Capital Raising In the Form Of Equity Raising
Equity raising works differently from debt raising. While in debt raising, the primary strategy to raise capital is by issuing bonds or taking out a loan from a bank or similar financial situation, equity raising works in the form of selling company stocks.
The reason why companies resort to debt raising is that there might not be enough financial room to take out additional loans. In that case, debt raising isn’t viable, and companies resort to selling shares. There are two types of shares companies can sell to investors. Those are common and preferred shares.
Common shares give investors the right to vote on company agendas. But that doesn’t mean these shares are hugely important in the grand scheme of things. Investors with common shares are at the very bottom of the voting tree. In the case the company liquidates, investors with common shares are paid the last. Preferrable treatment gets creditors and shareholders. So in a sense, common shares are not that important nor do they give investors that big of voting power. Investors with common shares can be overruled when voting on certain items and agendas.
On the other hand, preferred shares give investors no voting power or rights. Not only that, they give investors no ownership whatsoever. What they do give investors is a guaranteed dividend. This makes them much more appealing to investors who are only interested in getting paid. Companies that issue preferred shares must pay investors first over investors with common shares.
Strengths Of Equity Raising
Companies that raise capital through equity hold one advantage over those that raise capital through debt. In debt raising, the company must repay investors. With equity raising, the company isn’t obliged to do so. What companies are obliged to do so is make payments on dividends. Shareholders expect a return on their investmenting. The return of investment is calculated based on several factors such as market performance, stock valuation, and more.
Downsides Of Equity Raising
One of the biggest downsides of equity raising is that companies must remain profitable. Since equity raising is done through issuing shares, investors become small-time owners of the company. This largely depends on how many shares a company issues and how much ownership they want to forfeit. It also depends on the type of shares they issue.
Another disadvantage is that companies must maintain the stock price. If the stock price drops, then they would risk profits. Since the company must pay out expected dividends, it brings an additional layer of responsibility to the company. Investors that buy common shares are at a greater risk than those who buy preferred shares. Also, preferred shares take priority over common shares and that makes them less risky for investing.
All this takes a toll on the company if they don’t maintain profits. When that’s the case, equity raising is a costlier form of capital raising than debt raising.
Capital raising is at an all-time high. According to the Economist, companies raised more capital in 2020 than in any other fiscal year. The reasons for companies raising capital are numerous. But it’s safe to say that the pandemic has had a say in it.
Both public and private companies can raise capital. Both private and public companies can raise capital through equity or debt.