15.1 How businesses raise financial capital  (Page 6/38)

At this point, a firm must often choose how to access financial capital. It may choose to borrow from a bank, issue bonds, or issue stock. The great disadvantage of borrowing money from a bank or issuing bonds is that the firm commits to scheduled interest payments, whether or not it has sufficient income. The great advantage of borrowing money is that the firm maintains control of its operations and is not subject to shareholders. Issuing stock involves selling off ownership of the company to the public and becoming responsible to a board of directors and the shareholders.

The benefit of issuing stock is that a small and growing firm increases its visibility in the financial markets and can access large amounts of financial capital for expansion, without worrying about paying this money back. If the firm is successful and profitable, the board of directors will need to decide upon a dividend payout or how to reinvest profits to further grow the company. Issuing and placing stock is expensive, requires the expertise of investment bankers and attorneys, and entails compliance with reporting requirements to shareholders and government agencies, such as the federal Securities and Exchange Commission.

Key concepts and summary

Companies can raise early-stage financial capital in several ways: from their owners’ or managers’ personal savings, or credit cards and from private investors like angel investors and venture capital firms.

A bond is a financial contract through which a borrower agrees to repay the amount that was borrowed. A bond specifies an amount that will be borrowed, the amounts that will be repaid over time based on the interest rate when the bond is issued, and the time until repayment. Corporate bonds are issued by firms; municipal bonds are issued by cities, state bonds by U.S. states, and Treasury bonds by the federal government through the U.S. Department of the Treasury.

Stock represents ownership of a firm. The stock of a company is divided into shares. A firm receives financial capital when it sells stock to the public. A company’s first sale of stock to the public is called the initial public offering (IPO). However, a firm does not receive any funds when one shareholder sells stock in the firm to another investor. The rate of return on stock is received in two forms: dividends and capital gains.

A private company is usually owned by the people who run it on a day-to-day basis, although it can be run by hired managers. A private company owned and run by an individual is called a sole proprietorship, while a firm owned run by a group is called a partnership. When a firm decides to sell stock that can be bought and sold by financial investors, then the firm is owned by its shareholders—who in turn elect a board of directors to hire top day-to-day management—and is called a public company. Corporate governance is the name economists give to the institutions that are supposed to watch over top executives, though it does not always work.

Problems

References

National Venture Capital Association. “Recent Stats&Studies.” http://www.nvca.org/index.php?option=com_content&view=article&id=344&Itemid=103Update.

Freddie Mac. 2015. “Freddie Mac Update: March 2015.” Accessed April 13, 2015. http://www.freddiemac.com/investors/pdffiles/investor-presentation.pdf.

Former, Jamie D. “Should Your Small Business Go Public? Consider the Benefits and Risks of Becoming a Publicly Traded Company.” U.S. Small Business Administration: Community Blog (blog) . Publication date March 23, 2010. http://www.sba.gov/community/blogs/community-blogs/business-law-advisor/should-your-small-business-go-public-consider-0.