Corporations raise capital by selling equity or by borrowing. Selling equity means issuing stock while borrowing involves short- and long-term bank loans and bonds. Each method has its advantages and disadvantages depending on a corporation’s goals, resources and market conditions.
Assuming that the upfront costs of issuing stock or bonds or originating bank loans are roughly the same, the carrying costs of long-term debt are much higher: the issuer must pay annual interest on the debt but it is under no obligation to pay dividends on a stock, which can be started, reduced or discontinued at any time. The borrower must pay interest until a bond matures, whether or not it needs the money. Many bonds come with a call provision (the earliest date that a corporation can pay off, or call, a bond prior to maturity) but until then it must continue to pay interest. Some bank loans may come with prepayment penalties.
Sharing Company Ownership
Selling stock means sharing company ownership with investors. If a company is controlled by upper management or founders, selling stock may mean ceding control to investors, who may elect a new board of directors and replace the management. Borrowing involves no ownership sharing as lenders are creditors to the corporation.
When a corporation issues more shares, its financial results must be divided by a larger number of shares, causing dilution. The same applies to investor ownership stakes: if an investor does not buy enough newly issued shares to keep his stake percentage constant, that stake shrinks as more shares are issued. Interest on debt may also affect financial results by reducing profitability but causes no ownership dilution.
Once a corporation raises capital through stock, it is free to use the proceeds in any way it pleases. Long-term debt, especially bank debt, may come with multiple restrictions, or covenants, stipulating how the money is to be spent or using certain corporate assets as collateral.
Temporary vs. Permanent Capital
Stocks are perpetual securities – corporations are under no obligation to redeem or buy them back from investors. Debt, on the other hand, always has a maturity date when the borrowed amount must be repaid in full. Some corporations use debt as a permanent source of financing by issuing new debt to pay off the maturing one, but if that option is not available the borrower must set aside enough money to repay the borrowed funds.
- “PassTrak Series 7: General Securities Representative License Exam”; Dearborn Financial Services; 2003