Funding a Company and Capital Structure

Investors need to understand not only how a company funds its operations but also the makeup of its capital structure, since both are critical to successful companies and investment returns. Borrowing from banks is just one way a company can fund its operations and investments, and several different classes of capital are available to firms throughout their corporate life cycle.

When it comes to financing, companies raise money in two basic ways: they borrow it and/or they sell ownership interest in their business. The former is known as debt, and the latter as equity. Each offers rights and rewards to investors, but vary by instrument, company, characteristics, and legal terms. Companies carefully manage their capital structure to optimize the cost of capital, fund business strategy, and build investor confidence. The type and amount of funding available to them depends on different factors, including size, market, business model, track record, and financial health. Early stage companies are limited in the kinds of funding they typically attract, while large companies can often tap into a much larger pool of institutional, bank, and retail investors to raise financing.

Companies just getting started may decide to raise funds through angel investors or venture capitalists, who buy stakes in ground-floor companies hoping to find the next Google or Apple. Other companies may use funding from founders, friends and family, while others could go the loan route and seek funding from banks or government organizations like the Small Business Administration. Once a company grows, private equity, strategic investors, and institutional investors may join through a series of investment rounds, usually equity, that focus on funding the company through various stages of growth. For example, Series A equity is usually meant to capitalize a company for six months to two years and typically less then $10 million. Banks may also increase the size and amount of lending to the company during this phase to address the company’s need for working capital, supply chain finance, and infrastructure build-out.

As a company continues to grow and reaches sufficient scale of operations, it may decide to issue equity in the form of common stock to the public. Going public occurs through an initial public offering (IPO), usually structured and sold by an investment bank with connections to a broad pool of institutional and/or retail investors. Companies may go public for several reasons, including to raise more capital, to expand liquidity, to create a currency (in the form of stock) to exchange for another company’s public equity during a merger or acquisition, or to compensate for the loss of capital when early investors exchange their piece of the company back to the firm for cash.

Companies normally sell fewer shares than they are authorized for under their incorporation documents. The stock they do sell is called ‘issued stock”. When a company buys back its own shares, often so that the reduction in supply in publicly available shares will boost individual share prices, those shares become “treasury stock”. ‘Outstanding stock” is the difference between issued and treasury stock.

Institutional investors, retail investors, and investment bankers who manage the IPO become shareholders, or owners, in the company. As part owners, shareholders have a vote in certain decisions by company management. They also benefit from the dividends companies may periodically pay on each share of stock. The fate of their investments is tied closely to the companies performance. In addition to dividends that are paid out when a company performs well, a company’s stock price will often rise too. When corporations are not doing well, shareholders are the first to feel pain as companies are more likely to reduce or withhold dividends, likely reducing the stock’s value.

Shareholders are also the last to get paid in liquiidation, behind secured creditors, unsecured creditors, and subordinated creditors. Even administrative expenses get paid before equity holders. If any funds are left, owners of preferred shares, which usually come with a fixed dividend but no voting rights, get paid before common shareholders. Higher up the company’s capital structure to instruments with a greater claim on a company’s assets in the case of a liquidation are bonds. When a company sells bonds (debt), the investors who buy them are lending the company money for a preset period at an agreed interest rate. For example, in issuing a bond, a company could agree to pay an investor 5% annual interest until the bond reaches maturity after a set number of years.

Bondholders, unlike stockholders, have no ownership interest, and their returns are limited to the interest the corporation pays to borrow the money, with some opportunity for capital appreciate based on interest rate movements. Like any lender, the bondholders assume credit risk, that is the risk that the amount of funds extended is not repaid in full. Bondholders are often unsecured creditors, which means their instruments are not backed by specific assets of the company. But, bonds have a greater claim to the company’s assets than equity, and they are usually considered safer. With a set interest rate, bonds pay investors a predictable stream of income, provided the company can meet its obligations. On the flip side, bonds offer less potential than equity for capital appreciation, usually do not protect against inflation, as most bonds have fixed rather then floating rate interest rates, and their credit risk cannot be mitigated by covenants and claims on collateral typically used in bank lending.

Secured loans by banks and other lenders occupy the space at the top of a company’s capital structure. They usually have first priority on a company’s assets in the case of liquidation or bankruptcy, though loan structures can specify tiers of priority in subordination agreements. Business loans are sometimes unsecured but are commonly secured by all or a portion of the company’s assets. When a company’s liquidity needs are large enough, perhaps for an amount larger than a single bank lender would be willing to take on, it might consider the syndicated loan market, where a group of banks spread exposure, credit risk, and funding commitments by dividing up a company’s loan between several lenders. The largest, most creditworthy borrowers, as defined by credit rating agencies, might obtain unsecured, undrawn credit lines to support operations. Or they might borrow to fund an acquisition. Less creditworthy borrowers usually will be required to pledge assets to secure their loan.

Common stock, bonds, and syndicated loans all trade either on public markets or in over-the-counter markets, so today’s owners of and lenders to a company may not be tomorrow’s.