What is Debt and Equity Capital Raising?
Debt capital raising is a process where firms borrow money from banks and take on debt by agreeing to pay back specific amounts over time, with interest added on top. Debt is generally issued in a lump sum or in stages. In most cases, Fintalent’s debt & equity capital raising consultants agree that debt will not be issued at the same time it is needed, but rather debt will be issued as the company is started or as the founders are ready to start operations.
Equity capital raising, on the other hand, involves an entrepreneur seeking money from investors in exchange for a part ownership of their company. Institutions like banks and investment funds offer equity capital through general solicitation (such as at an initial public offering). The goal with equity capital raising is to raise enough money to start operations while still maintaining some of your ownership rights (like voting rights and dividends), while also being able to repay the borrowed money.
A key difference between these two types of capital raising is that debt is funded with money that was previously borrowed from another source, whereas equity is funded with money that comes from investors.
The financial markets have been on a downward trend for the better part of the last decade. That doesn’t necessarily mean that they are going anywhere, but it is worth noting that public companies in general have been going through some tough times. With this has come a shift in how capital is raised by public companies. More specifically, traditional debt and equity markets as observed by Fintalent’s debt & equity capital raising consultants, are being replaced by alternative forms of capital raising, such as crowdfunding and private placements with professional investors or direct investment from founders themselves (called equity capital raising). Let us take a quick look at how the traditional way of raising capital works and what is changing.
Debt Financing
Debt financing is simply borrowing money with the expectation that the amount borrowed can be paid back using cash flows from operations or with future borrowings. Though it might seem like this would be a one-sided arrangement (borrower giving away interest and fixed payments to lender), there are some incentives built in for both parties. The borrower gets to deduct interest payments on its tax return while lenders get to claim interest as an income tax deduction as well. This means that the borrower is paying interest for no purpose other than to offset taxes. This can be thought of as a donation from the borrower to the lender (in the form of loss of interest deductions) in return for a promise from the lender to make up this loss. The only additional cost that comes along with debt financing is company management fees, which are usually paid out of profit earned after debt is paid back or refinanced.
In some cases, companies may choose not to issue debt at all and instead issue shares (equity financing) or sell their equity directly (primary stock offering). In this case, there would be no need for a third party like a bank to lend them capital in order to create an investment thesis.
Equity Financing
During an equity financing, companies sell shares of stock to investors in exchange for cash. This is done directly through a company’s own website or with the help of a broker-dealer or investment bank. The shares that are sold are either from new offerings (IPO) or from secondary offerings (existing shareholders selling some of their stake).
The main benefit to an equity financing is that it allows for companies to raise as much capital as they require, almost instantly. This means that if a company needs money, they can start accepting orders on their new stock offering and be selling their shares in no time at all. Furthermore, investors get to benefit from owning the equity of a company they believe in.
In return for this benefit there are costs that usually come in the form of services provided by the broker-dealer or investment bank involved. These services include everything from advertising and marketing to legal help. While these services do cost money up front, they can save companies a significant amount of money down the line in administrative fees and other costs that would have been required to raise capital without help from an investment bank or broker-dealer. The downside is that companies are limited in what they can sell to investors.
Private Placement
In a private placement, investors are sold an ownership stake in a company. In that sense, it is very similar to equity financing, except for the fact that these stocks are not listed on any public market and so cannot be traded. This means that these types of investments can only be liquidated by selling them back to the company itself at the original purchase price.
The primary benefit of this type of financing is that it allows companies to raise capital from large-scale or institutional investors willing to purchase large blocks or even entire portfolios of securities at one time. Another benefit is that companies are able to benefit from the expertise of professional investment bankers, who can help navigate the public markets and help to further enhance or maximize the potential return on investment. For companies that are ready to scale their operations, a private placement might be better suited than traditional debt or equity financing.
Crowdfunding & Equity Capital Raising
While there has been a lot of talk about crowdfunding in recent years, it hasn’t yet reached the level of mainstream popularity that equity capital raising has. To put it simply, crowdfunding works because it enables people who like a product or service offered by a company to pledge their own money towards its development. It is essentially a way for people to invest in projects without the need of inside knowledge into the inner workings. It is essentially betting on an idea rather than on a company. Once the product or service has been made available (to anyone interested) and those who invested have received their promised returns, all investors get paid back in full.
This concept has morphed into equity capital raising where accredited investors can purchase stock from an early-stage company at discounted rates to help them scale their operations. Investors are able to purchase stock from companies that have yet to go public or begin trading on a public market. This allows investors to benefit from the potential upside of a company that is still operating in private.
This type of financing usually involves a small number of large investors who have the capital required to make significant investments in companies, unlike crowdfunding, where there are many investors and each investor puts in relatively small amounts. This means that individual investors can only get involved when the minimum investment limit is set at the equivalent of $25,000 or more. Since these types of investments are typically made by those with large amounts of capital (and therefore significantly larger pools of investing options), they tend to be very selective about which companies to invest in and how much they will put into each one. This can take time to get set up.
Crowdfunding & Private Placement
Crowdfunding and private placements are very similar in that they both can be used for startups to raise capital for growth. While crowdfunding has the benefits of being an easy way for small investors to get involved in the early stages of a company’s growth, it doesn’t have the financial heft from large blocks of investments (as seen in private placements). The big benefit to having a crowdfunding campaign is its ability to help drive brand awareness and customer acquisition, which is usually not part of a VC or PE firm’s mandate.
Conclusion
There is still a lot of potential in equity financing, private placements and direct equity offerings. And while crowdfunding and peer-to-peer lending have already changed the way that traditional lending is done, they have yet to reach the level of popularity among large institutional investors. It will be interesting to see what the future holds for equity financing in particular and how companies approach raising capital.
