The first issue that must be addressed in raising capital for a corporation is its capital structure. You must decide whether to raise debt, equity or some combination of the two by analyzing the tradeoffs between them in light of flexibility risk, income, control, and timing.
FINANCIAL MANAGEMENT: The greater the business risk and the greater the need for financial flexibility, the greater the reliance the corporation must place on equity financing. On the other hand, if the goal is to maximize income (return) to current owners and maintain their control of the corporation, the corporation can rely more on debt as its source of financing.
During startup and early stages, corporations usually rely almost exclusively on equity financing because of the great risk associated with the business and the need to maintain flexibility for the future. Equity provides more flexibility than debt, which usually requires cash interest and principal payments. As corporations develop more stable revenues, they normally increase the use of debt in their capital structure. This policy gives the current owners the best chance of maintaining control of the business and the benefit from the potential income as the business grows.
As a corporation seeks financing, a key issue is whether it will issue a security as part of the financing transaction. If a corporation uses a security it will be subject to federal and state securities law; if it does not, it will not.
Generally a financing transaction involves issuing a security whenever one entity supplies money or an item of value to another for the purpose of generating profits or other monetary return and if the supplier of the funds has only a passive involvement in the business. However; this broad definition would result in issuing securities for all financing transactions,which would then be subject to federal and state securities laws.
In practice, therefore, many common financing transactions, such as bank loans or the provision of trade credit, are not included in the definition of security transactions, and their basic legal documents, such as loan notes and account receivables, are not subject to securities laws.
KEY POINT: Under federal and state securities laws, the basic types of securities used in financing a corporation fall into two categories: equity securities and debt securities. The three basic types of equity securities are
- common stock,
- preferred stock (which may be ordinary preferred or convertible into another security such as common stock), and
Debt securities may be straight or convertible debt, secured or unsecured by the corporation’s assets.
These security types are used, sometimes in combination, to finance the private company as it progresses from startup to initial public offering. Therefore, it is important to understand their features and characteristics. To decide which securities are appropriate often includes evaluating significant tradeoffs that affect the company’s growth and cost of capital. In addition, different security types can also create significantly different contractual obligations, some of which may not be readily apparent.
SOURCES OF CAPITAL
Once you have selected the type of capital structure to finance your corporation’s development, you can choose among several sources for that capital, including private investors and angels, venture-capital firms, other corporations, leasing companies, government, commercial banks and finance companies, and public equity markets. Which sources you use depends partly on the type of capital structure you are seeking to develop. Each source comes with its own legal issues that revolve around its effect on flexibility risk, income, control, and timing. A finance company that specializes in short-term accounts-receivable lending has a different set of issues and approaches than a venture capitalist who focuses on long-term equity investment. An aspect that is often central to selecting a source of capital is whether the planned financing will require the use of a security that must be registered under federal or state securities laws.