Equity
Selling common and preferred shares is essentially a permanent form of financing. It is also a form of financing that requires no repayment. In addition to raising funds, equity may also be issued for the purpose of expanding ownership of the stock, reducing concentration of voting power, and making the stock more liquid for stock market purposes.
There are three particularly important categories under the general heading of stockholders’ equity that deserve attention here:
1. Venture capital
2. Preferred stock
3. Common stock
Venture Capital
Investors who supply venture capital are usually financing not much more than an idea, perhaps supported by a business plan. To obtain this type of financing, the founders of a company must be people who have some sort of track record or credentials indicating that they can effectively span the gap between idea and marketable product. Venture capital financing is most frequently available to high-tech ideas.
Venture capital financiers are a very valuable source of earlystage investment funds. The companies they finance are not candidates for any sort of bank borrowing unless the principals or their backers are high-net-worth individuals who are willing to personally guarantee the loans.
People seeking venture capital financing will have a number of fundamental issues to deal with. Venture capital investors will want a large piece of the equity so that if the company is successful, its success will pay for their probable other failures. They will be intimately involved in how their money will be spent. On the other hand, the company founders may very well not have any alternative, and also may not have the managerial and marketing skills to create a viable business. Therefore, unless the company founders have an ‘‘angel’’ investor, venture capital is a very valuable option.
An ‘‘angel’’ investor is usually a high-net-worth individual who finances many start-ups that may not appear attractive to more traditional investment firms. Such an investor often mentors the start-up’s management team and provides necessary management and marketing skills.
Preferred Stock
Preferred stock is a hybrid class of equity that is usually associated with mature businesses with considerable, predictable cash flow. The company may have very high investments in fixed assets and may have limited ability to raise money through debt issues. Preferred shareholders receive an indicated, not guaranteed dividend. In periods when cash is tight, holders of preferred stock receive their full dividend before common shareholders can receive any dividend. Preferred stockholders generally are not entitled to vote, unlike common shareholders, but they may have an option to convert their stock into common stock. While interest payments on debt are tax-deductible for the issuer, preferred dividends are not. Thus, for the company this is a fairly expensive form of financing.
Common Stock
A company that is going public for the first time will do an initial public offering, or IPO. By going public, the company can both raise a considerable amount of cash and create a market for the stock. This means that the stock held by the existing owners (the company’s founders and venture capitalists) will become a liquid asset, enabling them to eventually sell some of it. Going public is very expensive. SEC filings and legal expenses can cost many hundreds of thousands of dollars. In addition, the equity of existing owners will be diluted, possibly to the point where they will lose effective control.
Many public companies issue additional shares to investors over the years to raise funds, improve the liquidity of the stock, and make shares available to employees.
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