Raising Money for Business Purposes
In this lesson, you’re expected to learn:
– the basics of raising capital for your company
– how to raise funds by acquiring debt
– how to pay off a loan
To start a business and make money, you need to have capital available. But where do you get this capital from?
Companies raise finance in two main ways:
– by incurring debt
– by selling equity
In both cases, the goal is for the company to acquire things of value, starting with cash and then using that cash to purchase other items such as equipment, supplies etc.
Let’s explore the different methods that companies use to raise money.
Everything that a company owns, including the building, equipment, office supplies, brand value, research, trademarks and so on, are considered assets.
When you start a company, all these assets are not just given to you – they need to be acquired.
Generally, you start off with cash, which you then use to purchase other assets.
For most new companies, cash consists of a combination of:
· Owner’s personal money: money that the owner has converted to equity by issuing himself shares in the company.
· Loans: includes loans from banks, financiers and government loans. The money obtained through loans is considered a liability because a company has to pay it back at some point. In other words, these loans are a form of debt.
The combination of these two funding sources (personal money and loans) reveals the most fundamental equation in corporate finance which we also saw in the Accounting module.
Assets = Liabilities + Equity
Because the total amount of debt a company incurs goes into purchasing equipment and supplies, increasing debt through loans increases a company’s liabilities and total assets.
As the firm’s owners contribute their own funding to the company’s usage, the total amount of company equity increases along with the assets.
– the start-up of a new company,
– the expansion of an existing company,
– the purchase of equipment or
– the acquisition of another company.
Sometimes this proposal has to include an explanation of how the funds are going to be used including detailed predictions for future wellbeing (projections) that prove that the company can pay back the loan on time and without risk of default.
The most common sources for corporate debt financing. The bank evaluates your ability to repay and planned use of the funds before agreeing to offer the loan. This evaluation determines the following:
· the interest rate the bank charges
· the amount it’s prepared to lend
· the duration of the loan
Banks can also include covenants, which are conditions that a borrower must comply with.
These loans are frequently available but they are often reserved for special types of companies, firms with a special role in the nation or large companies that have been managed poorly.
Bonds, which act as IOUs*, are a popular form of debt financing. A company goes through an underwriter to have bonds issued and then private investors purchase those bonds. The company keeps the money raised as capital with a promise to repay the bondholders’ money with interest.
Every loan (except government-subsidized loans) incurs interest meaning that you and your company pay more money back to the lender than the lender originally gives you.
Balance (B) is equal to the principal amount (P) times the rate (r) exponentially multiplied by time (t). This can be represented by the following equation:
B = P (1 + r)t
For example, if your company borrows €100 at an interest rate of 10% for one year without making any payments, the amount of money it owes at the end of the year = 100 (1 + 0.1)1 = €110
So, continuing with the example above, if your company spends the money it borrows on a new machine, it has to generate more than 10% profitability from that machine in order to make the loan worth the interest being charged.
When choosing a loan for your company, there a re a few different options available. To make the best choice, you need to be aware of the pros and cons of each loan type.
Fixed rate loan: the percentage of interest you pay is always the same. For example if you take out a loan with 5% APR (annual percentage rate), you’re always charged 5% interest per year.
Variable rate loan: the interest rate you pay changes – the amount of change depends on the type of loan. Variable rate loans come in many different types, changing their rates based on the interest rate, a stock market index, your income or another indicator.
Secured loans are tied to an asset, which becomes collateral. Essentially, you tell the bank that if you fail to pay back the loan, the bank can keep and/or sell that particular asset to get its money back.
With unsecured loans, no assets are directly considered to be collateral to which the lender has automatic rights upon the borrower’s default.
Open-ended loansare similar to credit cards. Your company can draw on an open-ended loan until it reaches a maximum limit.
Close-ended loans, on the other hand, are standard loans. After a company gets one, it makes periodic payments for a predetermined time period and then the loan is paid back. Thus, it is similar to a mortgage.
Simple interest accrues based only on the principal loan while compounding interest pays interest on interest.