Financing

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Last Updated:November 29, 2023

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What Is Financing?

When entrepreneurs want to start a firm or expand an existing one, they require money. But how do they do it? They raise funds!

This article will help you understand the definition of finance, many types of fundraising, and, most importantly, the advantages and disadvantages of debt and equity financing.

Financing is an activity in which a company uses different methods to raise funds from financial institutions or intermediaries.

The company makes predictions and decisions based on its production and operation status, capital ownership, and future business development needs.

Generally speaking, a company can start fundraising at any stage of the business's life based on the different reasons for fundraising.

A company's motivation to generate cash should adhere to particular criteria and be channeled through specific channels and approaches. For example, companies may raise capital for these three reasons: business expansion, debt repayment, or a combination.

The two types of raising funds are debt and equity.

Simply put, debt financing does not require the company to give up its stock or control; it simply involves repayment when due, and its interest can be deducted from costs and taxes; nevertheless, traditional lenders, such as banks, may want guarantees.

Although equity fundraising dilutes the promoter’s equity, there is typically no time limit on repayment.

What Is Debt Financing

It is when a company issues bonds or banknotes to individual or institutional investors to raise working cash or capital expenditures. Individual or institutional investors that give money to a business become a creditor and receive a promise from the business to repay the debt with interest.

Here are some characteristics of debt financing:

Fixed term: Debt-raising funds raise cash that must be returned on a schedule.
Reversibility: Businesses use it to get capital, and they must repay the principal and interest when the time comes.
Affordability: It is used by businesses to get capital, and debt interest must be paid, resulting in a fixed cost for the company.
Liquidity: The circulating market allows Liquidity Bonds to be freely traded.

Advantages Of Debt Financing

First, entrepreneurs don’t need to spend time seeking investors; they need to go to the bank (for example) to get a loan. And since it is a loan, you need to pay the money back with a fixed amount of interest and at a scheduled time.

Second, it is normally one of the most important reasons entrepreneurs sometimes choose debt financing: no dilution of company ownership.

In this raising funds method, institutions who provide money are creditors; they don’t get any share of the company. Therefore, there is no dilution. The company is still 100% controlled by the entrepreneur.

Disadvantages Of Debt Financing

However, debt financing has a severe disadvantage: the money must be paid back on time, no matter what.

Let’s take an example of a start-up in its R&D stage.

At this stage, the company needs a large budget of money to do research and development; if they can successfully create a product, it means they may have a chance to sell it in the future (but still need a lot of time to move from R&D to mass production).

However, it is also possible that they couldn’t build any product, and there would be nothing to sell!

In this case, the company needs to pay back the money at a fixed time, no matter if the company generates revenue or not. Therefore, if the company wants to use debt to finance, it must carefully decide if it can pay back the money.

Increasing The Debt-To-Equity Ratio Can Diminish A Company's Free Cash Flow While Also Improving Capital Use Efficiency

The amount of cash available to a corporation is referred to as free cash flow. If the company has a lot of free cash flow, it can pay down debt, buy back stock, and raise dividend payments.

When a company earns a substantial quantity of free cash flow, managers try to maximize their own worth by paying no or few dividends, leaving free cash flow for managers to use as they see fit. Over-investment affects capital efficiency, resulting in increased agency costs.

First, paying dividends to shareholders reduces the resources under the manager's control and so limits the manager's control, and even when the organization requires funds, it is subject to capital market monitoring, and managers are more likely to pay no or smaller dividends.
Second, when the organization has a significant amount of free cash flow, managers can exploit free cash flow for personal gain.
Third, business owners have an incentive to grow their businesses above their ideal size since their power grows as the resources they control grow, and the operator's remuneration, which is directly proportional to the growth in sales, grows as well, leading to excessive investment.

As a result, the enterprise's timely repayment of principal and interest to the creditor is a harsh constraint imposed by the law and the contract.

When a loan is due, business owners must return the principal and interest with a specific quantity of cash, or they will face lawsuits and bankruptcy.

Managers are motivated to successfully take on commitments to pay future cash flows by the fear of debt financing.

The cash outflow produced by debt repayment can be a good substitute for dividend distribution, lowering the agency cost of free cash flow and increasing capital utilization efficiency.

The Equity Structure Can Be Improved By Increasing The Proportion Of Debt

Increasing the quantity of debt financing in the investment will raise the proportion of the operator's equity and lower the divergence of goal interests between shareholders and operators if the operator's absolute investment amount in the firm remains unchanged.

First, increasing debt fundraising can improve the company's equity concentration and management's shareholding ratio while also increasing large shareholders in the event of decentralized equity and a limited proportion of management's shareholding.

Thus increasing the effectiveness of oversight and the alignment of managers' and shareholders' interests;

Second, creditors, particularly large ones, should be able to supervise and constrain large shareholders and management properly.

As a result, in a relatively dispersed equity structure, debt financing increases management incentives, restrains operators' behavior, prevents operators from over-investing, and improves corporate governance structure;

When the shareholding is too concentrated, the large shareholders utilize their control power to exert direct control over the operators by controlling the board of directors with an absolute majority.

Operators typically cater to significant shareholders to maintain their positions at this time, encroaching on the interests of creditors and other shareholders (especially small shareholders).

The higher the equity proportion of large shareholders, the more challenging external financing will be.

Because creditors and other small and medium-sized shareholders may either deny fundraising or demand higher investment returns if they anticipate this encroachment on the interests of major owners.

In terms of corporate governance, if external debt fundraising is unavailable, the oversight and restraint functions of such debt will be unable to function, impacting corporate governance efficiency.

What Is Equity Financing

It is a type of fundraising in which the company's shareholders are ready to give up a portion of their ownership in exchange for funds by introducing new shareholders through a capital raise, which simultaneously increases the total share capital.

The company does not have to repay the principal and interest because the funds were received through equity fundraising, but the new shareholders will get a share in the earnings and growth of the company.

Pre-IPO funding is private equity financing that has helped several companies successfully list on the stock exchange.

Pre-IPO fundraising, in its broadest meaning, encompasses not only the IPO preparations but also the direction and transformation of corporate management, production, marketing, finance, technology, and other areas of the company.

On the other hand, pre-IPO finance has only one goal: to assist companies in successfully raising capital.

The development of the crisis capital market has significantly shortened businesses' time to raise external equity capital. As a result, it is possible to receive external equity capital at the beginning of an enterprise's life cycle if there is significant growth potential.

This type of fundraising with value-added services follows the company through its start-up and expansion stages, after which the investment bank takes over the pre-IPO in a limited sense. After that, the company gradually establishes a good operating mechanism and accumulates business performance.

This is critical for increasing the overall quality of listed companies, lowering open market crises, and even boosting economic growth.

Advantages Of Equity Financing

1. Establishing a well-structured organizational structure is crucial for equity funding. It is usually made up of shareholders, a board of directors, and supervisors, who construct numerous constraints and a balance of rights mechanism among themselves, reducing the enterprise's business crisis.

2. People pay more attention to the openness and availability of information in the financial markets. In terms of information openness and capital price competitiveness, the securities market outperforms the debt market.

If a borrower owns a larger percentage of the company's equity, the chances of utilizing corporate money to engage in high-risk investments and cause moral crises are substantially decreased, and businesses are less likely to default on bank debt.

Disadvantages Of Equity Financing

1. When a company uses equity to raise funds from outside investors, the company's executives may engage in a variety of non-productive activities and adopt moral crisis behaviors like investment policies that benefit the company but not the shareholders, resulting in a conflict of interest.

2. A major moral crisis and adverse selection will develop when the agent hurts and encroaches on the interests of the principal by utilizing the principal's authorization to boost their own income.

Open Market Offering and Private Offering

There are two major forms of equity fundraising, private placement and public offering, which are split according to the funding channels.

The so-called open market offering is a type of equity fundraising in which a company raises cash by selling its shares to the public on the stock market, which includes the company's listing and additional issuance, all of which are specific forms of open market equity financing.

Compared to the private offering, the whole process of public offering will require a longer time and more restrictive regulations. However, making the company public is normally every entrepreneur’s dream!

A private offering is a type of fundraising where a firm identifies specialized investors on its own and encourages them to invest in the company through a capital increase.

It is difficult for most small and medium-sized businesses to satisfy the threshold for listing and issuing stocks because most stock markets have particular requirements for companies applying for stock issuance.

Private placement has become a popular method of obtaining equity fundraising for small and medium-sized businesses.

In the following section, you will learn what private placement and public offering are.

Financing Through Private Placements

Private finance for businesses entails not only the acquisition of funds but also the addition of new shareholders and partners. The ability of a new shareholder to become an ideal partner has a long-term impact on the company.

Individual investors, Despite the small amount they contribute, individual investors play a critical role in financial support for most start-ups in their early stages.

Some investors are directly involved in the company's day-to-day operations and management (hands-on approach). In contrast, others are just interested in the company's important business choices as shareholders (hand-off approach).

Such investors normally have close personal contact with the company's founder. After getting the corresponding returns, they will normally fade off as the business progresses.

Venture Capital is another major source of fundraising. They can help companies raise millions, if not tens of millions, in equity funding. VCs seek to maximize capital appreciation, with the ultimate goal of exiting the company via IPO, transfer, or M&A with a positive return.

Financing Through Public Offering

The most desirable fundraising method for most businesses is a public offering. On the one hand, by using the public offering financing method, the company's listing will bring in a significant quantity of money.

The capital market, On the other hand, the capital market will provide the enterprise with market-oriented pricing, allowing the market to identify the enterprise's value and bring massive wealth to the entrepreneurs.

Companies that raise capital through a public offering have substantial benefits over other funding methods:

A large sum of money is raised.
The original shareholders' equity and control rights are diluted less.
The company's reputation has improved.
It is advantageous to use the capital market to undertake follow-up fundraising.

However, because of the high threshold for open market offerings, only enterprises with a greater scale and higher profitability can contemplate this strategy after reaching a specific point.

Being a publicly listed entity can be considered a common dream for every company; entrepreneurs need to work hard to get their company listed to raise funds.