TYPES OF BUSINESS FUNDING OPTIONS
There are two types of funding options: (1) debt and (2) equity. In the case of debt, the funding 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. The most pure version of debt is the long-term loan, which is usually collateralized against some group of company assets, carries a stated interest rate that may move with an underlying interest rate or pricing indicator, and must be paid back either in installments or in total on a specified date. Variations on this concept are the lease, in which the creditor may own the underlying asset, and preferred stock, in which there is no obligation to pay back the funds on a specific date, but there is an interest payment obligation.
In the case of equity, the funding 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. Equity has no underlying collateral, so the holder is at much greater risk of losing the invested funds, which is why the expected return is much higher for equity than for debt. Preferred stock is also a variation on equity, because it is not collateralized and there is no obligation to pay it back on a specific date. Another variation on the equity concept is stock rights, which can be issued to current shareholders, giving them the right to purchase more shares of stock. Also, warrants can be attached to various debt instruments to make them more attractive; warrants give the holder the right to buy common stock at a specific price. These are all forms of funding that fall under the general concept of equity.
It is also possible to convert debt into equity. This is called a convertible security and is sometimes used when selling bonds, so that buyers can later switch their bonds over to debt if a specific stock price point is reached at which the conversion is an attractive one. This is not a third form of funding option, however—just a hybrid form that shifts from debt to equity at the buyer's option. Preferred stock can also be considered something of a hybrid, because it contains characteristics of both debt (with a fixed interest payment) and equity (with no specified payback date for the underlying investment).
COSTS OF BUSINESS FUNDING OPTIONS
There are significant differences between the costs of the two main kinds of funding. In the case of debt, an interest payment must be paid to the lender on specified dates. If payments do not reach the lender on those dates, then penalty payments will also be charged. The interest rate charged will vary greatly, depending on the willingness of the borrowing organization to put up its assets as collateral. If it is not willing to do so or has no significant assets to use as collateral, then the risk of the lending institution is correspondingly greater, because it will have no specified assets at its disposal for liquidation purposes if the borrower is unable to pay for the borrowed funds. For this type of debt, the interest rate can be quite a few percentage points higher than the prime rate charged by local lending institutions. Also, if the borrower has a spotty earnings or debt payment record, lenders will charge the highest possible interest rates for use of their funds.
This may sound as though debt is an expensive option, but it can be extraordinarily inexpensive for those companies with a large base of available assets for use as collateral. Also, if the borrowing company is a very large one with an excellent financial credit rating, it can borrow well below the prime rate, perhaps only a fraction of a percent above the London Interbank Offer Rate (LIBOR), which is the minimum borrowing rate available. For these institutions, it makes a great deal of sense to use debt as a major financing source as much as possible.
In the case of equity, there is the surface appearance of free money, because the company receiving the equity is under no specific obligation to pay it back or to issue dividends. However, this is not the case for two reasons. First, the investments of shareholders are not secured by any form of collateral—if the company falls into financial difficulty and is liquidated, shareholders are likely to lose all their funds. Because of this increased level of risk, they want an inordinately high level of return, which they can receive either through dividend payments, stock appreciation, or a combination of the two. Second, interest payments on debt are tax deductible, whereas dividend payments are not, thereby making payments to shareholders more expensive than payments to creditors. Thus, the more expensive option is equity.
When deciding between the use of debt or equity, the management team may have a tendency to lean toward the acquisition of more debt, because it is less expensive than equity. However, there are serious risk issues associated with having an excessively leveraged company.