My wife hates debt. She makes most of her purchases, even the big ticket items with cash, and she strives to keep her credit card balances to zero. I on the other hand, do not mind debt and lose no sleep if I do not zero out my credit card balance at the end of the month.
Truth is, very few people have no debt. In fact, most of us cannot resist the temptation to borrow when credit is available even if it is expensive. Some borrow to consume and others to invest. Borrowing to buy a car, pay funeral or wedding expenses can lock you in to paying interest for the long-term. However, borrowing to pay school fees, build a house or start a business is an investment that can yield long term returns far in excess of the cost of debt. Don’t get me wrong, both categories of expenses are necessary. Also, people have different risk tolerances. So, whereas some would have no issues driving away in their dream car having made only the minimum down payment, others will rather build their house with their own cash, no matter how long it takes. So on a very basic level, the question of equity versus debt financing, for me, is one of immediate consumption versus interest expense and is influenced, among others, by an individual’s risk tolerance.
Making business financing decisions is not different from personal financing. It’s common for companies growing faster than their current income to seek outside capital to keep up the momentum. An under-capitalized business will find it difficult to make the required investment to grow incrementally. Raising external funds to start and/or grow a business is generally a good thing, but question is, should it be equity versus debt? What are the key differences between the two financing options? Also, if people can end up living beyond their means with credit, can businesses do likewise, and what is the consequence? Let’s explore these issues further by taking a close look at equities in this article and then debt in my next article (next issue of magazine).
In 1958 Modigliani–Miller (M &M), noble prize laureates, did ground-breaking work on capital structure- how firms finance their investments. In one of their propositions, they stated that capital structure is irrelevant under perfect market conditions of; no tax, no transaction costs, no bankruptcy costs and no information asymmetry. This irrelevancy means that the choice of financing; debt or equity, does not affect the value of the firm. Unfortunately, markets globally are real and firms pay taxes, incur transaction and bankruptcy costs. In other words, if capital structure is irrelevant in a perfect market, then imperfections in the real world must be the cause of its relevance. Consequently, it matters how a business finances itself. M&M adjusted their model later to reflect this reality in subsequent propositions.
Equity financing involves bringing in investors or partners who provide capital in exchange for a share of the business. This is external equity. Using retained earnings (net income) is referred to as internal equity.
The owner of a business concept or company has a subjective value attached to it called equity. This value accrues from resources invested into the business, including ideas, time and money. The measure of the equity of any asset, whether intellectual (intangible) or physical (tangible), is the value someone is willing to pay for it, less all its associated liabilities. Accordingly, if liability exceeds assets, negative equity exists.
Once the owner determines the value of the asset, s/he can then sell parts of the equity to investors in order to raise capital. There are a variety of methods to raise equity capital including Seed, Angel, and Venture Capital. Seed capital often involves family, friends and other small investors. An Angel Investor or angel (also known as a business angel) is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or equity. Some angel investors organize themselves into angel groups or angel networks to share research and pool their investment capital, as well as to provide advice to their investee companies. Venture capital (VC) is financial capital provided to early-stage, high-potential, high risk, growth start-up companies. The typical venture capital investment occurs after the seed and angel funding round and will often generate a return through an eventual realization event, such as an outright sale or through an Initial Public Offering (IPO) when the firm’s shares trade on the stock exchange for the first time.
In Ghana, we have the Venture Capital Trust Fund (VCTF), a government sponsored initiative, which was established in 2004 through an Act of Parliament (VCTF Act 680). VTCF has since partnered with the private sector through a Private Public Partnership (PPP) model to create 5 venture capital funds called Venture Capital Finance Companies (VCFC). Quite recently, the VCTF has also partnered with successful entrepreneurs to form an Angel network called Ghana Angel Investor Network (GAIN) to support early-stage ventures. These developments are also spurring the formation of venture capital and private equity units by some private investment institutions. On a whole, this is a positive development for our economy since it provides a viable financing source for the close to 90% of businesses registered on the Registrar General’s database as Small to Medium Enterprises (SMEs). The sheer numbers of SME businesses calls for significant resources to adequately capitalize the VCTF. In my experience, a well-structured tax-incentive program for individual to invest in such high-risk Funds can provide the required funding to stimulate business development and innovation in our economy. It goes without saying that jobs will be created and the tax base will increase, providing a win-win scenario for businesses and government.
After investing, the equity investor might play an active role in the decision making of the company. Because they have “bought into” the company, they are now partners, and their percentage ownership often determines how active they become. Their level of involvement needs to be discussed up front otherwise it may result in complications and potential inability to raise additional capital later. It is therefore important to deal with professional investors. Another important risk to the company when new shareholders come on board is that, current shareholder can lose control of the company. The new shareholders can take over the management of the firm if they acquire enough shares. By defining, a controlling interest is an ownership interest in a corporation that has control of a large enough percentage of voting shares such that no one stock holder or coalition of stock holders can successfully oppose a motion by that interest. A majority interest is always a controlling interest. A given position; control and minority, affects the valuation of the associated shares. There is valuation premium for control because the controlling shareholder is able to determine how the assets of the firm are employed. On the other hand, there is a discount for lack of marketability for non-publicly traded shares and lack of liquidity for illiquid shares. Some firms issue special shares with different voting privileges, including preferred shares to prevent the loss of control.
In return for their investment, shareholders expect dividend payments and capital gains. However, unlike debt holders who receive mandated interest payments from the firm, in the case of shareholders, it is the firm that decides if it should pay dividends, how much it should pay and when to pay it. Additionally, shareholders are the first to lose their investments when a firm goes bankrupt. These facts make shares more risky for the investor than debt. Consequently, shareholders require a higher return on their investment than debt holders.
Finally, raising equity financing for an existing business, often means issuing additional shares of common stock to investors. With more shares of common stock issued, the previous stockholders’ percentage of ownership decreases, a phenomenon referred to as dilution of ownership. As mentioned earlier, my next article will focus on debt financing.