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22.1 General Sources of Corporate Funds

Learning Objectives

  1. Discuss the main sources for raising corporate funds.
  2. Examine the reinvestment of earnings to finance growth.
  3. Review debt and equity as methods of raising funds.
  4. Consider private equity and venture capital, and compare their utility to other forms of financing.

Sources

To finance growth, any ongoing business must have a source of funds. Apart from bank and trade debt, the principal sources are plowback, debt securities, equity securities, and private equity.

Plowback

A significant source of new funds that corporations spend on capital projects is earnings. Rather than paying out earnings to shareholders, the corporation plows those earnings back into the business. PlowbackReinvesting corporate earnings in the corporation as a method of raising funds. is simply reinvesting earnings in the corporation. It is an attractive source of capital because it is subject to managerial control. No approval by governmental agencies is necessary for its expenditure, as it is when a company seeks to sell securities, or stocks and bonds. Furthermore, stocks and bonds have costs associated with them, such as the interest payments on bonds (discussed in Section 22.1.3 "Debt Securities"), while retaining profits avoids these costs.

Debt Securities

A second source of funds is borrowing through debt securities. A corporation may take out a debt security such as a loan, commonly evidenced by a note and providing security to the lender. This is covered in Chapter 11 "Secured Transactions and Suretyship" and Chapter 12 "Mortgages and Nonconsensual Liens". A common type of corporate debt security is a bondA debt security to raise corporate funds where the corporation pays periodic interest (the coupon rate) and the face value at maturity., which is a promise to repay the face value of the bond at maturity and make periodic interest payments called the coupon rate. For example, a bond may have a face value of $1,000 (the amount to be repaid at maturity) and a coupon rate of 7 percent paid annually; the corporation pays $70 interest on such a bond each year. Bondholders have priority over stockholders because a bond is a debt, and in the event of bankruptcy, creditors have priority over equity holders.

Equity Securities

The third source of new capital funds is equity securities—namely, stockAn ownership interest in a corporation (synonymous with shares).. EquityOwnership interest, such as stock, in property or a business. is an ownership interest in property or a business. Stock is the smallest source of new capital but is of critical importance to the corporation in launching the business and its initial operations. Stock gives the investor a bundle of legal rights—ownership, a share in earnings, transferability and, to some extent, the power to exercise control through voting. The usual way to acquire stock is by paying cash or its equivalent as consideration. Both stock and consideration are discussed in more detail in Section 22.3.2 "Par Value and No-Par Stock" and Section 22.4 "Initial Public Offerings and Consideration for Stock".

Other Forms of Finance

While stock, debt securities, and reinvested profits are the most common types of finance for major corporations (particularly publicly traded corporations), smaller corporations or start-ups cannot or do not want to avail themselves of these financing options. Instead, they seek to raise funds through private equityFinance conducted through private investors, either individuals or firms., which involves private investors providing funds to a company in exchange for an interest in the company. A private equity firm is a group of investors who pool their money together for investment purposes, usually to invest in other companies. Looking to private equity firms is an option for start-ups—companies newly formed or in the process of being formed—that cannot raise funds through the bond market or that wish to avoid debt or a public stock sale. Start-ups need money to begin operations, expand, or conduct further research and development. A private equity firm might provide venture capitalFinancial capital provided to early-stage, high-potential, high-risk start-up companies by investors who often expect a return on the investment by an eventual sale of the company or by taking the firm public. financing for these start-ups. Generally, private equity firms that provide a lot of venture capital must be extremely savvy about the start-up plans of new businesses and must ask the start-up entrepreneurs numerous challenging and pertinent questions. Such private equity firms expect a higher rate of return on their investment than would be available from established companies. Today, venture capital is often used to finance entrepreneurial start-ups in biotechnology and clean technology.

Sometimes, a private equity firm will buy all the publicly traded shares of a company—a process commonly termed “going private.” Private equity may also be involved in providing financing to established firms.

Another source of private equity is angel investors, affluent individuals who operate like venture capitalists, providing capital for a business to get started in exchange for repayment with interest or an ownership interest. The main difference between an angel investor and a venture capitalist is the source of funds: an angel investor invests his or her own money, while venture capitalists use pooled funds.

Private equity firms may also use a leveraged buyout (LBO)The acquisition of another company using a significant amount of borrowed money to pay for the acquisition. Often, the assets of the company being acquired may be used as collateral for the loans. to finance the acquisition of another firm. Discussed further in Chapter 25 "Corporate Expansion, State and Federal Regulation of Foreign Corporations, and Corporate Dissolution" on Corporate Expansion, in the realm of private equity, an LBO is a financing option using debt to acquire another firm. In an LBO, private equity investors use the assets of the target corporation as collateral for a loan to purchase that target corporation. Such investors may pursue an LBO as a debt acquisition option since they do not need to use much—or even any—of their own money in order to finance the acquisition.

A major drawback to private equity, whether through a firm or through venture capital, is the risk versus return trade-off. Private equity investors may demand a significant interest in the firm, or a high return, to compensate them for the riskiness of their investment. They may demand a say in how the firm is operated or a seat on the board of directors.

Key Takeaway

There are four main sources of corporate finance. The first is plowback, or reinvesting profits in the corporation. The second is borrowing, commonly through a bond issue. A corporation sells a bond, agreeing to periodic interest payments and repayment of the face value of the bond at maturity. The third source is equity, usually stock, whereby a corporation sells an ownership interest in the corporation. The fourth source is private equity and venture capital.

Exercises

  1. What are the main sources of corporate finance?
  2. What are some of the legal rights associated with stock ownership?
  3. Describe private equity. What are some similarities and differences between private equity and venture capital?