Extra Reading – Lecture 02

Sources of Long Term Funding - MBA 513

Options to Collect Long Term Finance Requirements

Limited Liability Companies and Their Share Capital ?

When a limited liability company is formed, the share holders (owners) are only responsible for
the value of share capital they invested in. If the company is liquidated then they will only loose
the share capital they invested and not liable for any value beyond. The Memorandum of
Association (one of the documents by which the company is formed) will clearly state: the
amount of share capital the company will have; and the division of the share capital into shares
of a fixed amount.

In a company limited by shares, the company's Memorandum of Association has a capital clause
which states the amount of the share capital by which the company proposes to be registered and
its division into shares of a fixed amount. The amount of share capital with which a company is
initially registered (or the amount to which it may subsequently be increased) is the
AUTHORISED or NOMINAL capital of the company. It sets the maximum number of shares
that the company can issue together with the value of each share at any given time.

For example, a company with a capital clause stating it can have a maximum of Rs 10,000,000
share capital of Rs 10 each, of 1,000,000 shares. The authorised share capital is then Rs 10M.
Authorised share capital can only be increased with the approval of the existing shareholders by
ordinary resolution.

There is NO maximum to any company's authorised share capital and NO minimum share capital
for private limited companies. However, a public limited company at Colombo Stock Exchange
must have an authorised share capital of at least Rs 500 Million ( for the main board) and Rs 100
Million for the Dirisavi Board).

ISSUED OR ALLOTTED CAPITAL

Issued capital is that part of the company's total authorised or nominal capital which has been
issued and taken up by the members of the company, having been issued either for cash or for a
consideration other than cash, and is expressed by reference to the aggregate nominal value of
the shares issued. The amount of issued capital cannot exceed the amount of the authorised
capital.

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PAID-UP CAPITAL
This is the proportion of the nominal value of the issued capital actually paid by the shareholder.
It may be the full nominal value, in which case the share is said to be fully paid up and it fulfils
the shareholder's responsibility to outsiders. Alternatively the share may be only partly paid up,
in which case the company has an outstanding claim against the shareholder.

Where a company has issued shares as not fully paid up it can at a later time make a call on those
shares. This means that the shareholders are required to provide more capital, up to the amount
remaining unpaid on the nominal value of their shares. Called capital should equal paid-up
capital: uncalled capital is the amount remaining unpaid on issued capital.

Equity (Ordinary and Preference Shares)

Shares

An equity interest in a company can be said to represent a share of the company’s assets and a
share of any profits earned on those assets after other claims have been met. The equity
shareholders are the owners of the business they purchase shares by paying money to the
company. The money is used by the company to buy assets, the assets are used to earn profits,
and the assets and profits belong to the ordinary shareholders. Equity entail no agreement on the
company’s part to return to the shareholders (unless redeemable preference shares) the amount of
their investment.

Ordinary shares are sometimes referred to as the risk capital of a business; it is the ordinary
shareholders who take most of the risk in business

Characteristics of shares:
The main characteristics of shares are following:
1. It is a unit of capital of the company.
2. Each share is of a definite face value.
3. A share certificate is issued to a shareholder indicating the number of shares and the amount.
4. Each share has a distinct number.
5. The face value of a share indicates the interest of a person in the company
6. Shares are transferable units.

Investors are of different habits and temperaments. Some want to take lesser risk and are
interested in a regular income. There are others who may take greater risk in anticipation of huge
profits in future. In order to tap the savings of different types of people, a company may issue
different types of shares. These are:
1. Preference shares, and
2. Ordinary Shares.

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Ordinary Shares:

Ordinary shares are shares which do not enjoy any preferential right in the matter of payment of
dividend or repayment of capital. The equity shareholder gets dividend only after the payment of
dividends to the preference shares. There is no fixed rate of dividend for equity shareholders.
The rate of dividend depends upon the surplus profits. In case of winding up of a company, the
equity share capital is refunded only after refunding all other creditors and due payments. Equity
shareholders have the right to take part in the management of the company buy voting in key
decisions. However, equity shares also carry more risk.

Advantages of Ordinary Shares:

To the shareholders:
1.In case there are good profits, the company pays dividend to the ordinary shareholders at a
higher rate.

2.The value of Ordinary shares has a very close relationship with profits.( i.e Higher the profits
higher the capital gains)

3.Ordinary shares can be easily sold in the stock market ( more liquid than preference shares).

4.Ordinary shareholders have greater say in the management of a company as they have the
voting rights on key decisions.

To the Company:
1. A company can raise fixed capital by issuing ordinary shares without mortgaging their assets.

2. The capital raised by issuing ordinary shares is not required to be paid back during the life
time of the company. It will be paid back only if the company is wound up.

3. There is no liability on the company regarding payment of dividend on ordinary shares. The
company may declare dividend only if there is enough profits.

4. If a company raises more capital by issuing ordinary shares, it leads to greater confidence
among the investors and creditors.

Disadvantages of Ordinary Shares

To the shareholders
1. Uncertainly about payment of dividend. Ordinary share-holders get dividend only when the
company is earning sufficient profits and the Board of Directors declare dividend. If there are
preference shareholders, ordinary shareholders get dividend only after payment of all due
accumulated dividends to the preference shareholders.

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2. Speculative. Often there is speculation on the prices of ordinary shares. This is particularly so
in times of boom when dividend paid by the companies is high.

3. Danger of over–capitalization. In case the management miscalculates the long term financial
requirements, it may raise more funds than required by issuing shares. This may amount to over-
capitalization which in turn leads to low value of shares in the stock market.

4. Ownership in name only. Holding of ordinary shares in a company makes the holder one of
the owners of the company. Such shareholders enjoy voting rights. They manage and control the
company. But then it is all in theory. In practice, a handful of persons control the votes and
manage the company. Moreover, the decision to declare dividend rests with the Board of
Directors.

5. Higher Risk. Ordinary shareholders bear a very high degree of risk. In case of losses they do
not get dividend. In case of winding up of a company, they are the very last to get refund of the
money invested. Equity shares actually swim and sink with the company.

Preference Shares :

Preference shares entitle their holder to a fixed rate of dividend from the company each
year. This dividend ranks for payment before other equity returns and so the ordinary
shareholders receive no dividend until the preference shareholders have been paid their fixed
percentage.

Preference shares carry part ownership of the company and allow due participation in the profits
of the business. In fact, their dividend is an appropriation of profits and so if a bad year means no
profits, it also means no dividend for the preference shareholders.
 
Preference Shares are the shares which carry preferential rights over the ordinary shares. These
rights are
(a) Receiving dividends at a fixed rate,
(b) Getting back the capital in case the company is wound-up.

Investment in these shares is less risky than investing in ordinary shares.

This point constitutes the essential distinction between preference shares and debentures.
Debenture holders are not part owners of the company; their interest claims have to be met
whether the company has made a profit or not. Interest payments are not an appropriation of
profits. It is for this reason that the tax treatment of each of the two forms of fixed percentage
capital is different. Debenture interest, as a charge, is a tax-deductible expense and, like any
other form of tax-allowable expenditure, it reduces the company’s tax bill. Preference dividends,
as an appropriation of profits, are not tax-deductible. Tax is payable on the profits figure before
the preference dividends are deducted. Consequently, a company earning profits and committed
to paying out, say, 8 per cent on capital raised, would prefer to be paying it on debentures (for

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which the interest charge is net of tax) than on preference shares for which the company would
have to stand the gross cost.

Debentures

Whenever a company wants to borrow a large amount of fund for a long but fixed period, it can
borrow from the general public by issuing loan certificates called Debentures. The total amount
to be borrowed is divided into units of fixed amount say of Rs.100 each. These units are called
Debentures.

These are offered to the public to subscribe in the same manner as is done in the case of shares.
A debenture is issued under the common seal of the company. It is a written acknowledgement
of money borrowed. It specifies the terms and conditions, such as rate of interest, time
repayment, security offered, etc.

Debenture holders are not part owners of the company; their interest claims have to be met
whether the company has made a profit or not. Interest payments are not an appropriation of
profits. It is for this reason that the tax treatment of each of the two forms of fixed percentage
capital is different. Debenture interest, as a charge, is a tax-deductible expense and, like any
other form of tax-allowable expenditure, it reduces the company’s tax bill. Preference dividends,
as an appropriation of profits, are not tax-deductible. Tax is payable on the profits figure before
the preference dividends are deducted. Consequently, a company earning profits and committed
to paying out, say, 8 per cent on capital raised, would prefer to be paying it on debentures (for
which the interest charge is net of tax) than on preference shares for which the company would
have to stand the gross cost.

Characteristics of Debenture
i) Debenture holders are the creditors of the company. They are entitled to periodic payment of
interest at a fixed rate.

ii) Debentures are repayable (redeemed) after a fixed period of time, say five years or seven
years as per agreed terms.

iii) Debenture holders do not carry voting rights.

iv) Generally, debentures are secured. In case the company fails to pay interest on debentures or
repay the principal amount, the debenture holders can recover it from the sale of the specific
asset secured against the debentures.

Types of Debentures :
a) Redeemable Debentures Vs Irredeemable Debentures
b) Convertible Debentures Vs Non-convertible Debentures.

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c) Secured Vs Un-Secured

Redeemable Debentures :
These are debentures repayable on a pre-determined date or at any time prior to their maturity,
provided the company so desires and gives a notice to that effect.

Irredeemable Debentures :
These are also called perpetual debentures. A company is not bound to repay the amount during
its life time. If the issuing company fails to pay the interest, it has to redeem such debentures.

Convertible Debentures :
The holders of these debentures are given the option to convert their debentures into equity
shares at a time and in a ratio as decided by the company.

Non-convertible Debentures:
These debentures cannot be converted into shares.

Unsecured Debentures :
These are debentures are not secured against any asset. If the company is wound up then the
debenture holders will be listed among the other creditors.

Secured Debentures:
These debentures are secured against specific assets.

Secured or unsecured Debentures

Debentures and debenture stock can be secured or unsecured. It is usual, however, to use
the expression ‘debenture’ when referring to the more secure form of issue and the term ‘loan
stock’ for less secure issues. When the loan is secured this is by means of a trust deed. The deed
usually charges, in favour of the trustees, the whole or part of the property of the company. The
advantages of a trust deed are that a prior charge cannot be obtained on the property without the
consent of the debenture holders, the events on which the principal is to be repaid are specified
and power is given for the trustees to appoint a receiver and in certain events to carry on the
business and enforce contracts. The debentures can be secured by a charge upon the whole or a
specific part of a company’s assets, or they can be secured by a floating charge upon the assets of
the company.

In this latter case the company is not precluded from selling its assets. The latter case is known
as a general lien, whereas the debenture issued on the security of a specific asset is a mortgage
debenture or mortgage bond. With a floating charge, when the company makes a default in
observing the terms of the debentures, a receiver may be appointed and the charge becomes
fixed, with the power to deal in the assets passing into the hands of the receiver. Such restrictions
are referred to as ‘covenants’.

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Advantages of debentures :

1) Raising funds without allowing control over the company, as debenture holders have no
right either to vote or take part in the management of the company.

2) Reliable source of long term finance. Since debentures are ordinarily issued for a fixed
period, the company can make the best use of the money. It helps long term planning.

3) Tax Benefits. Interest paid on debentures is treated as an expense and is charged to the profits
of the company. The company thus saves income tax.

4) Investors’ Safety. Debentures are mostly secured. On winding up of the company, they are
repayable before any payment is made to the shareholders. Interest on debentures is payable
irrespective of profit or loss.

Disadvantages of Debentures

1. As the interest on debentures have to be paid every year whether there are profits or not, it
becomes burdensome in case the company incurs losses.

2. Usually the debentures are secured. The company creates a charge on its assets in favour of
debenture holders. So a company which does not own enough fixed assets cannot borrow money
by issuing debentures. Moreover, the assets of the company once mortgaged cannot be used for
further borrowing.

3. Debenture-finance enables a company to trade on equity. But too much of such finance leaves
little for shareholders, as most of the profits may be required to pay interest on debentures. This
brings frustration in the minds of shareholders and the value of shares may fall in the securities
markets.

4. Burdensome in times of depression. During depression the profits of the company decline. It
may be difficult to pay interest on debentures. As interest goes on accumulating, it may lead to
the closure of the company.

Retained Earnings

Like an individual, companies also set aside a part of their profits to meet future requirements of
capital. Companies keep these savings in various accounts such as General Reserve, Debenture
Redemption Reserve and Dividend Equalisation Reserve etc. These reserves can be used to
meet long term financial requirements.

The portion of the profits which is not distributed among the shareholders but is retained and is
used in business is called retained earnings or ploughing back of profits.

Benefits of using retained earnings as long term financing

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1. Cheap Source of Capital for mature companies. The cost of capital of retained earning is ROI.
For mature companies the ROI is generally low hence cheap cost of capital

2. Financial stability. A company which has large reserves can manage their business even in
Difficult times.

Convertibles

Convertibles are hybrids between equity and debt finance. They offer investors a fixed return but
also give the investor the right to convert into the underlying ordinary shares of the company at
fixed terms. There are various types of convertible: convertible debentures, convertible loan
stock, and convertible preference shares. All carry the right to convert into the underlying
ordinary shares, and represent less risk to the investor than ordinary shares because they have
greater priority for repayment should the company be liquidated. The most secure is the
convertible debenture which is secured upon the tangible assets of the company.

One advantage that is often quoted for convertible debt is that it is cheaper than ordinary debt
finance since the conversion option allows the security to be issued with a lower coupon rate
than would otherwise be the case. Although it is true that the coupon on convertibles is lower,
this does not mean that the overall cost is lower, since one must also consider the expected cost
of the conversion option. The lower coupon rate of a convertible may, however, be advantageous
from a liquidity point of view. This form of finance may suit a project where the cash inflows are
expected to be low in the early years.

Prior to conversion, the security will represent debt finance and will therefore increase the level
of gearing of a company. Convertibles are seen as a way of issuing deferred equity. This may be
particularly advantageous if existing shareholders want to minimise any loss of control since the
number of shares issued via a convertible (assuming conversion takes place) will be smaller than
if straight equity were issued. A useful aspect of convertibles is that, assuming the company’s
share price rises sufficiently to force conversion, the debt is self-liquidating. Since it is replaced
by equity, conversion will reduce the level of gearing and thereby enable the company to issue
further debt finance.

While convertibles remain as debt, the interest is tax-deductible. This gives rise to the tax
advantage that also accompanies other forms of debt finance. However, since the coupon rate on
this security is lower than that associated with normal debt, the tax advantage is consequently
reduced also. As the convertible stock carries the right of conversion into the underlying ordinary
shares, its price will be directly linked to that of the equity for as long as the conversion option
exists. As the ordinary shares increase in price, so will the convertible and vice versa.

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 Borrowing from Banks and financial institutes

loans are offered by the high street banks and their popularity has increased for a number of
reasons, not least their accessibility, which is of importance to smaller businesses.

A term loan is for a fixed amount with a fixed repayment schedule. Usually, the interest rate
applied is slightly less than for a bank overdraft. The lender will require security to cover the
amount borrowed and an arrangement fee is payable dependent on the amount borrowed.

Loans also have the following qualities:

They are negotiated easily and quickly. This is particularly important when a cash-flow
problem has not been identified until recently and a quick but significant fix is needed.

Banks may offer flexible repayments. High street banks will often devise new lending
methods to suit their customers; for example, no capital repayments for, say, two years,
thus avoiding unnecessary overborrowing to fund capital repayment.

Variable interest rates. This may be important given the uncertainty that exists with interest rates

Commercial banks offer term loans to companies to satisfy their long term cash requirements.
The loans will be secured against specific assets and interest charge and repayment terms are
governed by the loan contract signed.

Advantages of borrowings from Commercial Banks

1. It is a flexible source of finance as loans can be repaid out of earned profits.

2. Cheaper source of finance compared to other tools as the banks take less risk.

3. Less time and cost is involved as compared to issue of shares, debentures etc.

4. Banks do not interfere in the internal affairs of the borrowing concern; hence the management
retains the control of the company.

5. Loans can be paid-back in customized installments.

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Disadvantages of borrowings from Commercial Banks

1. Banks require securities to pledge against loans. Startup companies may not have assets
cannot raise further loans on these assets.

2. Interest and capital will have to be paid even if the company makes losses hence high risk to
the company.

3. Too many formalities are to be fulfilled for getting term loans from banks. These formalities
make the borrowings from banks time consuming and inconvenient.

Debt or Equity ?
Life Cycle Model agued by Keith Ward

Early-stage businesses are risky, as there are too many unknowns. This being the case, it would
be foolish to attempt to finance them with debt, which would both increase their overall risk, and
lead to outflows of cash from companies that are already cash negative. Thus, businesses at the
launch stage should be financed with equity that is prepared to accept a high risk, such as venture
capital.

At the growth stage, the business is still risky: managing rapid growth is hard work, and many
companies fail to make the transition successfully. Accordingly, debt is generally not a good idea
for growth companies either their finance should mostly be equity, often taken from the capital
markets.

However, once the business has stabilized and reached maturity, its business risk reduces. At this
point it can and should reduce its overall cost of capital by taking on cheap debt to replace the
expensive equity. And once the business goes into managed decline, its risk (the volatility of
expected results) is low we know what is going to happen – and so the financial risk can increase
and the company should borrow.

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 Business Risk Vs Finance Risk

Business Risk

Businesses take risks, they have to: without risk there is little chance of a reward. One of the
characteristics that distinguishes successful businesses from those that fail is the way in which
they understand and manage the risks they face, both business and financial. Accordingly, an
understanding of financial strategy involves, first, a clear appreciation of business risk. Once
the business risk is analyzed, the financial strategy can be designed to complement it. If the
financial strategy is appropriately designed and properly implemented it can enhance shareholder
value but, even more dramatically, when an inappropriate financial strategy is applied the entire
business can be placed in jeopardy.

Accordingly, we start by considering business risk. Business risk describes the inherent risk
associated with both the underlying nature of the particular business and the specific competitive
strategy which is being implemented. Thus a very new, focused, single product, high-technology
company (such as a business developing a specific aspect of biogenetic engineering or a new
style of super-computer) would have a very high intrinsic business risk. At the opposite end of
the spectrum is the very well-established, highly-diversified (both geographically and
industrially) conglomerate-style group, which has a relatively low overall business risk. It
must be remembered that, of itself, neither a high nor a low business risk is better; as long as the
relative level of return matches the level of associated risk, either is acceptable.

The simplest way to consider business risk is that it relates to all of the risks that the company
faces, other than those which relate directly to financing decisions. It thus deals with the
volatility of the operating cash flows. Such volatility might arise from sources external to the
organization, for example: changes in legislation or in fashions or public opinion; the actions of
competitors; or the general economic climate. Internal risks also need to be considered, for
example: the risks associated with a particular manufacturing process; or the ways in which an
organization communicates with its key stakeholders; or its cost structure. Internal risks are often
easier to control than external risks, but all potential risks need to be considered.

A simple model can be used to analyze the business risk

In the above model the constituents of profitability are broken down to facilitate analysis. As
business risk relates to variability in operating results, it seems reasonable to examine the factors
making up these operating results, which takes us back to the basic accounting model: Sales less

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costs equals Profits. We can then begin to see what affects each of these items for our particular
company. For sales, it might be appropriate to examine what affects our selling price and the
volumes we sell; or an analysis of products and markets may be more useful; or both may be
used. For cost analysis, a preliminary approach may be to determine the ‘ operating leverage ’
the relative level of fixed to variable costs, on the basis that companies with high levels of fixed
costs may have difficulty achieving breakeven if sales fall. The level of committed costs may
also be important; a business with a high commitment to forward expenditure is more vulnerable
(i.e. riskier) than one with no such commitments.

Finance Risk
Financial risk relates to the level of debt a company is carrying (its gearing, or leverage). In
assessing the riskiness of debt and equity it is essential to specify the perspective from which the
analysis is being made. Any commercial lender such as a bank will try to reduce its financial risk
by a whole series of actions. These include ensuring that it has priority in terms of both
repayment of principal and payment of interest, possibly by taking security over specific assets,
and by insisting on covenants in its loan agreements, which can entitle it to demand early and
immediate repayment if the financial position of the borrower appears to deteriorate. Clearly
these steps transfer a large part of the financial risk to the company, as any breach of the loan
agreement conditions (such as failing to pay interest on the due date) can place the continued
existence of the company in jeopardy.

Balancing Bisness Risk with Finance Risk

Financial risk should complement the business risk profile, in order to develop logical alternative
financial strategies for different types of business. Combining together a high business risk
strategy with a high financial risk strategy (such as would be achieved by borrowing to fund a
start-up bio-tech company) gives a very, very high total risk profile: such a company may
succeed spectacularly but it is much more likely to fail completely and disappear.

Thus, as illustrated above , the combination of strategies in red section is not a logical, long term
basis for creating a successful business. However when the differing risk and return profiles of
various stakeholders are taken into account, this type of strategy can be seen to be potentially
very attractive to risk-taking entrepreneurs. If most of the required funding can be raised in the
form of debt, the entrepreneurs have to inject very little of their own money. If the business turns
out to be successful, they will get the vast majority of these upside gains: the return to the lenders
of the debt financing being fixed. However, if the high-risk business fails, as it probably will,

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they can only lose the small amount of equity which they have injected. From their perspective
this appears to be the ultimate combination of ‘ you take all the risk and we’ll take all the return!
’. Unfortunately for these entrepreneurs, lenders do not see this as an acceptable combination of
risk and return.

It is now well-established that very high business risk enterprises should be funded with equity
which the investors know is potentially at risk (i.e. venture capital). Where it has proved possible
to raise large amounts of inappropriate debt capital for such high business risk investments, the
fault lies with the lender far more than with the borrower, because the lender is committing what
can be regarded as the most heinous sin of corporate finance: accepting a debt-type return while
taking equity-type risk. In our opinion, funding should only be regarded as ‘ true ’ debt when
there is an alternative way out, that is, if the lender can still recover the balance outstanding even
if the business or project concerned fails to perform as originally expected. Normally this
alternative exit route would be provided by realizing the underlying value of certain assets
owned by the business or pledged as security for the loan by a guarantor. If no such realizable
assets exist, the true risk associated with the funding is that of an equity investor. Hence, if the
lenders settle for an interest-based return, they are not matching their real risk profile to the
return being achieved.

There is nothing wrong in taking on a high risk equity investment, as long as the expected return
is commensurately high; otherwise it is a totally unacceptable risk/return relationship. Referring
to above diagram , this means that high business risk companies should use low-risk financing,
that is, equity venture capital, and should keep their cost bases as variable and discretionary as
possible. This logic is now fairly well understood and accepted by the capital markets, even to
the extent that venture capital is primarily provided by a relatively small number of specialist
finance organizations. They understand the high business risks involved and aim to manage these
risks by demanding a very high level of return on their investment and using portfolio
management techniques, which allow for a proportion of their investments failing completely,
resulting in a total financial loss.

The greater problems at this very simple level of financial strategy tend to be encountered with
the lower business risk companies. In general, business risk tends to reduce as companies
mature; not least because the unsuccessful ones will fail and cease to exist. For example, the
earlier examples of high-technology start-up companies have a very high business risk, but the
surviving equivalent high-tech start-ups of 100 years or 50 years ago are now the well-
established major corporations of today, with much lower business risk profiles. Not only
does the business risk decline but, as the company matures, the cash flow tends to become
heavily positive, having been significantly negative during the development and launch stage.
Therefore, if the initial financing has been raised in the most relevant form of equity, the
financial structure of this more mature company can easily stay predominantly equity based, due
to a lack of need for substantial external funding once the cash flow becomes significantly
positive

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Changing Finance Strategies over the Life Cycle

Having looked at business risks and cash flows, we can develop the appropriate financial
strategy for each stage of the life cycle. Two, related, matters need to be considered:

● The business should make the best use of its available cash.

● Business risk and financial risk should be inversely correlated

Let us remind ourselves of the key characteristics of debt and equity, from the point of view of
the company being funded. Debt is high risk, and involves cash outflows in interest and
repayments. Equity is low risk, with no contractual cash outflow, although the board may choose
to declare a dividend. Thus, a company in the high-risk launch and growth stages, needing to
invest in assets and development, would be foolish to let cash leak out of the business to service
debt (even if a lender could be found with such a poor appreciation of risk that they would fund
it). In maturity, with a lower business risk and less need for cash for investment, it is altogether
appropriate to make use of debt as a low-cost source of funding. Coupled with this is the inverse
correlation of business and financial risk.

Since the business risk decreases as the product moves through its life cycle, it is logical that the
financial risk can be correspondingly increased without creating a completely unacceptable
combined risk for the shareholders and other stakeholders in the company. This leads to the
obvious question of what impact this changing risk profile has on the financial strategy of the
business.

The financial risk profile should be very low during the very high-risk stage of product
development and launch . In essence, an investment at this early stage is made on the strength of
a product concept, with possibly some prototypes and some market research, and a business
plan indicating the future prospects for the eventual product. It is desirable at this stage to use
low-risk equity sources of funding, raising capital from specialist investors who understand the
high business risk associated with the company. This funding is properly described as venture
capital. together with substantial future growth prospects a much larger body of potential
investors becomes available to the company. This is just as well, because the growth stage will
demand more funding. This can be combined with providing an exit for the venture capital
company, funding is through the flotation (listing) of the company onto a public stock market,
where a much broader range of equity investors can be attracted to buy shares in the company.

Such an initial public offering (IPO) is not normally possible for a start-up company as, by
definition, the business has no track record which can be used to indicate its existing success or
its realistic prospects for the future. (We prefer to draw a veil over the excesses of the stock
markets during the Internet bubble of the late 1990s, when companies appeared able to defy
gravity by floating with little more than a catchy name and an improbable business plan.)
This maturity stage carries less business risk so that a medium level of financial risk can now be
taken on by the company.

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The cash flow from the product has also turned significantly positive at this time and this
combination allows the company to borrow, rather than only using the equity sources of funding
which have been accessed so far in its development. It is also important to consider the business
from the perspective of the rational investor, who quite rightly regards this cash positive, mature
stage as the most attractive phase of the life cycle. So far equity funding has been injected into
the business to develop and launch the product and then to increase both the total market size and
the company ’ s share of that market.

If more equity funding is required during the maturity stage, this investment starts to look a lot
like a financial black hole; money keeps going in, but nothing ever comes out. Therefore the only
logical source of additional equity funding during this maturity stage is for some of the profits
being made by the company to be reinvested into the business. It must be remembered not only
that these profits should be substantial in order to justify the investments made earlier in the
cycle but also that additional financing can be raised through borrowing money.

This is now practical because the positive cash flow of the business provides the source of
servicing the debt, paying the interest, and repaying the principal. If debt financing is used at the
earlier stages of the life cycle, the absence of such positive cash flow means that the repayments
can only be made by rolling-over the original loans or by raising equity to repay the debt
funding. This highlights a key issue regarding the use of debt and equity funding; as mentioned
earlier, the risk associated with debt funding from the viewpoint of the lender is lower than the
equity investors ’ risk, due to the security taken and legally granted priority on full repayment.
(Remember that the risk ranking is reversed when viewed from the perspective of the company,
i.e. the user of the funding.) Risk and return are positively correlated, so that the return required
on debt funding should always be less than that required on equity financing for the same
company, that is, debt is cheaper for the company. This is completely logical from the company ’
s perspective because, as debt is higher risk funding for the company, the company should
demand a cost saving to justify incurring the extra risk.

Therefore, as long as increasing the financial risk through borrowing (increasing the ‘ leverage ’
of the company) does not lead to an unacceptable total combined risk, the cheaper debt funding
will increase the residual profits achieved by the company. Thus the profits generated by the
mature company, which uses some debt financing, will be enhanced and the return on equity will
look even better, as less equity is required to fund the business. This is even more important
when the product moves into the decline phase of the life cycle, and it becomes clear that the
product is dying. As debt is cheaper than equity, it is financially beneficial to the shareholders to
extract their equity investment from the dying business as early as possible by replacing
it with debt.

Clearly it should not be acceptable to a lender to take on an unacceptable, equity-type risk, but it
is often quite practical to borrow against the residual value of those assets which are, of
necessity, tied up in the business until it is finally liquidated. These funds can then be distributed
to shareholders, effectively representing a repayment of capital. In this way the present value of
the shareholders ’ investment is increased, without adversely affecting

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the position of the lender who is suitably secured on the residual value of the assets, and who
receives a risk-related rate of interest. Consequently the principal source of funding for the
declining business is debt finance with its associated high financial risk, partially offsetting the
low business risk associated with this final stage of development.

Debt Profile

In considering the balance between debt and equity in a company ’ s financial strategy, one other
issue should be mentioned: of the debt, how much should be borrowed short-term, and how
much long-term? The answer to this question depends, unsurprisingly, on the company ’ s
business, its assets, and the structure of its operations. Broadly, the company ’ s debt and short-
term assets with short-term funding sources. So, the acquisition of a building would best be
financed through long-term debt (if, indeed, debt is the best solution); additional inventories
should be funded using short-term facilities such as an overdraft or revolving credit line.
However, if a company has permanent working capital, this should be regarded as part of long-
term needs.

The advantage to a company of using long-term rather than short-term debt finance is that once
the loan has been agreed, the company can be confident that it cannot be taken away. Short-term
debt needs to be refinanced at regular intervals and, if the company’s financial situation has
deteriorated or the credit market tightened, this may become a problem. Exceptions do exist to
this broad rule about using long-term funding for long term needs. If short-term interest rates are
considerably lower than long-term ones, and the company believes that long-term rates will fall,
it may be worth using short-term finance to start, with the intention of refinancing at a later date,
in a more favorable environment. This strategy does, of course, carry obvious risks. The point
here is that the policy would be for long-term debt, the issue is one of timing.

Financing Using Equity vs. Debt

At various times in the life of a company there are going to be requirements for outside
assistance in order to grow the business. One requirement will be the need for additional capital.
Choosing which financing vehicle is best for your company is very important. It’s choosing the
right tool to fix the problem. Deciding whether to seek out equity capital or debt financing is the
first step. Usually companies trying to get equity capital are very early stage with little or no real
assets. While companies on their way to a steady growth curve use debt financing.

As the owner of a business idea, plan, or company - you hold ownership to a subjective value
called equity. The equity of any type of property whether intellectual or physical is the value
someone is willing to pay for it minus any liability attached to it. In business that could mean the
value of an entity today measured in time and money invested versus the value in the future
measured by comparable growth.

Once the owner and investor determine the "valuation" of the equity, the owner can then sell
parts of the equity in order to raise capital. There are a variety of methods you can raise equity
capital and you should learn the pluses and minuses for each. An equity capitalist is interested in

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picking a company that shows great potential. They are expecting that there will be
significant growth due to their involvement. That could mean that the company will grow tenfold
within five years.

Without a doubt, first and foremost on any equity capitalist’s due diligence list will be the
management team. Even before the idea itself, it is commonly stated, great idea’s with a bad
team will get nowhere, whereas, bad idea’s with a good team still have a chance to make it big.
You should also realize, that once invested, the equity capitalist will be having an active role in
the decision making of the company. Because they have "bought in" to your company they are
now your partners, how active they become needs to be sorted out up front.

Conversely, raising capital through debt financing does not entail "selling" your equity, but
instead works by "borrowing" against it. Debt financing is only available to business owners who
have something of value that the lender can instantly liquidate. The debt finance company is not
interested in becoming a partner in your endeavor, instead they are in business to make money
from their money, letting you use it for periods of time.

Like equity financing there are a variety of methods available to raise debt financing. Traditional
banking will always be the least costly source for your financing, but along with that bankers are
not in business to take on risk. When they ask for three years of company tax returns its because
they want to see a steady reliable set of profitable growth numbers. Borrowing from the bank
relies on two variables, the collateral that secures the loan, and your ability to repay the loan.
You might have enough collateral, but if your business is losing money, the bank can’t expect
you to handle the added expense of loan payments.

Many early stage companies turn to private commercial financing which is better suited to deal
with riskier issues. Factoring companies use the loans you make to customers (invoices for
finished work) as the collateral for their loans. Here the emphasis will be the creditworthiness of
your customers rather than the credit of your company. Equipment leasing companies will allow
you to purchase new equipment and pay for it over time, usually three to five years.

When seeking outside capital, whether equity of debt, remember that certain sources are familiar
and like to work with particular industries. Take the time to look around and be sure that the
source you are considering is well-aquatinted with your type of business.

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