In general, there are two types of financing options: (1) debt and (2) equity. Essentially, every type of financing choice is based on one of these two options. In the case of debt, the financing is contingent on some obligation to pay interest in exchange for the use of the invested funds, which are also to be returned at the end of a stipulated period. In the case of equity, the financing is not contingent on any specified interest payment, but the holder of the underlying common stock expects either a periodic dividend payment, an appreciation in the share price on the open market, or a combination of the two. All forms of financing involve some degree of risk. A controller [or CFO or business owner] must be cognizant of all the forms of risk to ensure that management is made aware of the potential shortcomings of each one. Short descriptions, advantages and disadvatnages of these options are otlined in this post. Enjoy!
Financing Option #1: Leasing
In a leasing situation, the company pays a lessor for the use of equipment that is owned by the lessor.
- Advantage: Good for replacement of assets that wear out quickly; the sale-and-leaseback option makes available a large amount of cash.
- Disadvantage: Can be very expensive unless all components of the transaction are carefully evaluated and negotiated.
Financing Option #2: Loans
A company can obtain a loan either by borrowing funds from a lending institution or by issuing its own bonds to investors and paying interest to all of them on preset payment dates.
- Advantage: Least expensive form of financing.
- Disadvantage: May require assets as loan collateral, as well as loan covenants, some control over operations, and first call on the results of asset sales in the event of a liquidation.
Financing Option #3: Common Stock
When shareholders purchase shares from a company, the money they pay becomes equity in that organization.
- Advantage: Can raise substantial amounts of funds, and there is no need to pay back the capital.
- Disadvantage: Shareholder expectations for returns are very high, and it also gives them the ability to oust the board of directors and (indirectly) the management team if their performance expectations are not met. Also, dividend payments are not tax deductible.
Financing Option #4: Convertible Securities
A convertible security is a bond that can be converted into common stock. The common stock price at which the bond can be converted is based on the conversion ratio, which is the ratio of the number of shares that can be purchased with each bond.
- Advantage: Can avoid paying off bond debt, as well as reducing interest payments and improving the debt/equity ratio.
- Disadvantage: Reduces the earnings per share and weakens the control of current shareholders, but only if conversion to shares occurs.
Financing Option #5: Preferred Stock
When a company accepts payment for its preferred stock, its only obligation is to pay a prespecified interest rate on that investment in perpetuity, or until the shares of preferred stock are bought back by the company.
- Advantage: Can avoid paying back the principal.
- Disadvantage: The interest expense is not tax deductible.
Financing Option #6: Stock Rights
A stock right is an authorization to purchase additional shares of common stock at a set price, with a specified termination date to the offer. It is offered to existing shareholders in the same proportions as their stock holdings in the company.
- Advantage: Simple way to raise funds from existing shareholders.
- Disadvantage: Will not necessarily retain ownership interests in the same proportions prior to the stock rights offering.
Financing Option #7: Warrants
A warrant is a right to purchase common stock at a fixed price and usually has a distant termination date, if any.
- Advantage: Can reduce bond interest rates
- Disadvantage: Dilutes earnings per share and may weaken owner control of the company.
Given the wide array of available financing options, it is evident that a controller must be well aware of a company’s current loan covenants, ability to cover debt costs, and the degree to which the current owners want to maintain control of the organization, before making a decision regarding which financing option is the correct one to pursue.