In this free finance guide, we'll review the basics of how and why companies raise cash, or capital. These concepts are covered in more detail in our finance training in New York.
When you think of the word finance, what likely comes to mind is car financing, or financing a home purchase, etc. Car or home financing is simply how one plans to pay for those purchases.
Finance is how companies pay to make investments (like capital improvements, acquisitions, etc.) and maintain daily operations. The cheapest source of capital, or money, is cash on hand, or cash generated from the ongoing operations of the business. However, many companies need additional cash, and this is where debt and equity financing comes into play.
Debt financing includes loans from a bank or bond offering (see below for more detail on bonds). When taking on debt financing, a company borrows money and promises to repay the principal (original borrowed amount) and interest. The interest rate can be fixed or variable (based on certain interest rate benchmarks like LIBOR), and the principal must be repaid on the maturity date (some debt financing allows for early repayment without penalty - it varies). Debt financing is a cheaper source of capital than equity because of its senior position - debtholders must be paid before equity holders.
With debt financing the cheaper alternative, why would companies look at equity financing? And what exactly is equity financing? When a company raises by issuing equity, it is selling shares to investors for cash it can use to finance its operations and investments. The existing shareholders now own less of the company, but the company has the cash it needs to execute its plan.
Companies can raise equity through private or public issuances. Let's start with the widely-known Initial Public Offering or IPO. In an IPO, a company sells its shares for the first time to the public, meaning anyone can buy the shares. The shares trade on exchanges and can be bought and sold easily (increased "liquidity"). After an IPO, companies can sell additional shares to the public in what is called a Secondary Offering. Companies can raise equity on the private markets, often through venture capitalists or angel investors.
Another form of financing is preferred stock, which is a hybrid of debt and equity. Preferred stock has a fixed interest rate like debt, but the maturity date is often long or perpetual, giving it an equity-like risk profile. Preferred stockholders are not entitled to the same dividend or voting rights as stockholders.