Top 2 Ways Corporations Raise Capital

Running a business requires a great deal of capital. Capital can take different forms, from human and labor capital to economic capital. But when most people hear the term “financial capital,” the first thing that comes to mind is usually money.

While it can mean different things, it isn’t necessarily untrue. Financial capital is represented by assets, securities, and yes, cash. Having access to cash can mean the difference between companies expanding or staying behind and being left in the lurch. But how can companies raise the capital they need to keep them going and to fund their future projects? And what options do they have available?

There are two types of capital that a company can use to fund operations: debt and equity. Prudent corporate finance practice involves determining the mix of debt and equity that is most cost-effective. This article examines both kinds of capital.

Key Takeaways

  • Businesses can use either debt or equity capital to raise money, where the cost of debt is usually lower than the cost of equity, given debt has recourse.
  • Debt capital comes in the form of loans or issues of corporate bonds. Equity capital comes in the form of cash in exchange for company ownership, usually through stocks.
  • Debt holders usually charge businesses interest, while equity holders rely on stock appreciation or dividends for a return.
  • Preferred equity has a senior claim on a company’s assets compared to common equity, making the cost of capital lower for preferred equity.

Debt Capital

Debt capital is also referred to as debt financing. Funding by means of debt capital happens when a company borrows money and agrees to pay it back to the lender at a later date. The most common types of debt capital companies use are loans and bonds, which larger companies use to fuel their expansion plans or to fund new projects. Smaller businesses may even use credit cards to raise their own capital.

A company looking to raise capital through debt may need to approach a bank for a loan, where the bank becomes the lender and the company becomes the debtor. In exchange for the loan, the bank charges interest, which the company will note, along with the loan, on its balance sheet.

The other option is to issue corporate bonds. These bonds are sold to investors—also known as bondholders or lenders—and mature after a certain date. Before reaching maturity, the company is responsible for issuing interest payments on the bond to investors. Because they generally come with a high amount of risk—the chances of default are higher than bonds issued by the government—they pay a much higher yield. The money raised from bond issuance can be used by the company for its expansion plans.

While this is a great way to raise much-needed money, debt capital does come with a downside: It comes with the additional burden of interest. This expense, incurred just for the privilege of accessing funds, is referred to as the cost of debt capital. Interest payments must be made to lenders regardless of business performance. In a low season or bad economy, a highly-leveraged company may have debt payments that exceed its revenue.

Example of Debt Capital

Let’s look at the loan scenario as an example. Assume a company takes out a $100,000 business loan from a bank that carries a 6% annual interest rate. If the loan is repaid one year later, the total amount repaid is $100,000 x 1.06, or $106,000. Of course, most loans are not repaid so quickly, so the actual amount of compounded interest on such a large loan can add up quickly.

Equity Capital

Equity capital, on the other hand, is generated not by borrowing, but by selling shares of company stock. If taking on more debt is not financially viable, a company can raise capital by selling additional shares. These can be either common shares or preferred shares.

Common stock gives shareholders voting rights but doesn’t really give them much else in terms of importance. They are at the bottom of the ladder, meaning their ownership isn’t prioritized as other shareholders are. If the company goes under or liquidates, other creditors and shareholders are paid first. Preferred shares are unique in that payment of a specified dividend is guaranteed before any such payments are made on common shares. In exchange, preferred shareholders have limited ownership rights and have no voting rights.

The primary benefit of raising equity capital is that, unlike debt capital, the company is not required to repay shareholder investment. Instead, the cost of equity capital refers to the amount of return on investment shareholders expect based on the performance of the larger market. These returns come from the payment of dividends and stock valuation.

The disadvantage to equity capital is that each shareholder owns a small piece of the company, so ownership becomes diluted. Business owners are also beholden to their shareholders and must ensure the company remains profitable to maintain an elevated stock valuation while continuing to pay any expected dividends.

Because preferred shareholders have a higher claim on company assets, the risk to preferred shareholders is lower than to common shareholders, who occupy the bottom of the payment food chain. Therefore, the cost of capital for the sale of preferred shares is lower than for the sale of common shares. In comparison, both types of equity capital are typically more costly than debt capital, since lenders are always guaranteed payment by law.

Example of Equity Capital

As mentioned above, some companies choose not to borrow more money to raise their capital. Perhaps they’re already leveraged and just can’t take on any more debt. They may turn to the market to raise some cash.

A startup company may raise capital through angel investors and venture capitalists. Private companies, on the other hand, may decide to go public by issuing an initial public offering (IPO). This is done by issuing stock on the primary market—usually to institutional investors—after which shares are traded on the secondary market by investors. For example, Facebook went public in May 2012, raising $16 billion in capital through its IPO, which put the company’s value at $104 billion.

The Bottom Line

Companies can raise capital through either debt financing or equity financing. Debt financing requires borrowing money from a bank or other lender or issuing corporate bonds. The full amount of the loan has to be paid back, plus interest, which is the cost of borrowing.

Equity financing involves giving up a percentage of ownership in a company to investors, who purchase shares of the company. This can either be done on a stock market for public companies, or for private companies, via private investors that receive a percentage of ownership.

Both types of financing have their pros and cons, and the right choice, or the right mix, will depend on the type of company, its current business profile, its financing needs, and its financial condition.

By Claire Boyte-White in Investopedia

Please contact Albert A. van Daalen for advice and support in Investment Services.

What Is the Lehman Formula?

The Lehman formula is a compensation formula developed by Lehman Brothers to determine the commission on investment banking or other business brokering services. Lehman Brothers developed the Lehman Formula, also known as the Lehman Scale Formula, in the 1960s while raising capital for corporate clients.

Key Takeaways

  • Lehman Brothers developed the Lehman formula to determine the commission an investment bank should receive for arranging client transactions.
  • Large investment banks work with corporations to raise capital, often through an initial public offering (IPO), a merger or acquisition, or through a spinoff.
  • For their services, an investment bank can charge flat fees for each transaction, earn commissions based on the dollar amount of the transaction, or a combination of both.
  • The Lehman formula structures the investment banking fee on a percentage of the transaction amount based on a set of tiered fees.

Understanding the Lehman Formula

As a provider of global investment banking services, Lehman Brothers needed a way to clearly convey to its potential clients the fees they would charge for their services. The advantage of the Lehman formula is that it’s easy to understand and easy for the client to quickly get a ballpark estimate on how much their transaction might cost them in fees. It’s not uncommon for large investment banking firms to assist clients with transactions worth hundreds of millions or billions of dollars. The Lehman formula structures the investment banking fee on a percentage of the transaction amount with a set of tiered fees.

How Investment Banks Earn Their Fees

Investment banks work with companies, governments, and agencies to raise money by issuing securities. An investment bank might help a company that has never issued stock to successfully complete its initial public offering (IPO). Other typical services that investment bankers provide include offering merger and acquisition (M&A) advice, developing reorganization strategies, or helping a company through a spinoff.

Investment banks make money in various ways. The can charge flat fees for each transaction, earn commissions based on the dollar amount of the transaction, or a combination of both. In the case of an IPO, an investment bank might provide underwriting services. The bank might buy stock in the IPO and then sell the shares to investors. The difference between what the bank purchased the IPO shares for and what they earn selling them to investors is the bank’s profit.

Examples of the Lehman Formula

The original structure of the Lehman Formula is a 5-4-3-2-1 ladder, as follows:

  • 5% of the first $1 million involved in the transaction
  • 4% of the second $1 million
  • 3% of the third $1 million
  • 2% of the fourth $1 million
  • 1% of everything thereafter (above $4 million)

Today, because of inflation, investment bankers often seek some multiple of the original Lehman Formula, such as the double Lehman Formula:

  • 10% of the first $1 million involved in the transaction
  • 8% of the second $1 million
  • 6% of the third $1 million
  • 4% of the fourth $1 million
  • 2% of everything thereafter (above $4 million)

A Brief History of Lehman Brothers

Lehman Brothers was previously considered one of the major players in the global banking and financial services industries. However, on Sept. 15, 2008, the firm declared bankruptcy, largely due to its exposure to subprime mortgages. Lehman Brothers also had a reputation for short selling in the market.

A subprime mortgage is a type of mortgage that is normally issued by a lending institution to borrowers with relatively poor credit ratings. These borrowers will generally not receive conventional mortgages given their larger-than-average risk of default. Due to this risk, lenders will often charge higher interest rates on subprime mortgages.

Lenders began issuing NINJA loans—a step beyond subprime mortgages—to people with no income, no job, and no assets. Many issuers also required no down payment for these mortgages. When the housing market began to decline, many borrowers found their home values lower than the mortgage they owed. Interest rates associated with these loans (called “teaser rates”) were variable, meaning they started low and ballooned over time, making it very hard for borrowers to pay down the principal of the mortgage. These loan structures resulted in a domino effect of defaults.

The bankruptcy of Lehman Brothers was one of the largest bankruptcy filings in U.S. history. Although the stock market was in modest decline prior to these events, the Lehman bankruptcy, coupled with the prior collapse of Bear Stearns, significantly depressed the major U.S. indexes in late Sept. and early Oct. 2008. After the fall of Lehman Brothers, the public became more knowledgeable about the forthcoming credit crisis and the recession of the late 2000s.

By Julia Kagan in Investopedia

What Is A Retainer Fee?

A retainer fee is an amount of money paid upfront to secure the services of a consultant, freelancer, lawyer, or other professional. A retainer fee is most commonly paid to individual third parties that have been engaged by the payer to perform a specific action on their behalf. These fees, almost always paid upfront, only ensure the commitment of the receiver. In addition, retainer fees usually do not represent the total final cost of the services provided.

Key Takeaways:

  • A retainer fee is a payment made to a professional, often a lawyer, by a client for future services.
  • Retainer fees do not guarantee an outcome or final product.
  • Portions of retainer fees can be refunded if services end up costing less than originally planned.

Understanding Retainer Fees

A retainer fee is an advance payment that’s made by a client to a professional, and it is considered a down payment on the future services rendered by that professional. Regardless of occupation, the retainer fee funds the initial expenses of the working relationship. For this reason, these types of fees usually remain in a separate account from the hourly wages of the consultant, freelancer, or lawyer. This ensures that money is not used for personal purposes before the services are fully performed.

The most common form of retainer fee applies to lawyers who, in most cases, require potential clients to provide an upfront retainer fee.

Example of a Retainer Fee

For example, a lawyer may charge a $500 retainer fee. If the lawyer charges a total of $100 an hour, the retainer covers all services up to the five-hour limit. The lawyer then bills the client for the cost of any additional hours they invest on behalf of the client.

In this example, if a trial case takes 10 hours of the lawyer’s time, the lawyer charges the client an additional $500, which comes to $1,000 when including the retainer. If the client’s case is resolved prior to reaching the five-hour limit, the lawyer refunds the remaining portion of the retainer to the client. If the case is resolved in three hours, for example, then the lawyer would refund $200 to the client.

Earned Retainer Fees vs. Unearned Retainer Fees

An unearned retainer fee refers to the initial payment of money that is held in a retainer account prior to any services being provided. Retainer fees are earned once services have been fully rendered.

In the example above, the retainer is considered unearned until the court case is closed and finalized. These unearned fees do not belong to the person performing the tasks, in this case, the lawyer until work actually begins. Any unearned retainer fees that are not used can be returned to the client.

Earned retainer fees, on the other hand, refer to the portion of the retainer that the lawyer is entitled to after work begins. Earned retainer fees may be granted to the lawyer bit by bit, depending on the number of hours worked. Distribution of retainer fees can also be based on tasks or milestones. For example, a lawyer may receive 25% of the retainer fee after completing the pre-trial process.

By Olivia Lagarde in Investopedia

How Brokerage Fees Work

There are two different types of brokerage firms: full service and discount. The differences between the two and the fees they charge are significant. So how much does a broker cost? Here’s a brief guide to how brokerage fees work with both types of firms.

What Are Brokerage Fees?

In general, brokerage fees are fees the broker charges you to hold and manage your investments. These fees might include annual fees, fees for researching investment data, and inactivity fees if you aren’t trading regularly. It’s important you are aware of the different types of brokerage fees, as well as the types of brokers available to manage your investments.

Full-Service Broker

In contrast, full-service brokers are paid commissions based on transactions. The average fee per transaction at a full-service broker is $150. This is much lower than in the past, but still much higher than discount brokers where on average a transaction costs approximately $10.

At a full-service broker, you are paying a premium for research, education, and advice. But it’s important to remember that full-service brokers are also salespeople.

There are also full-service brokers who charge an annual fee between 1% and 1.5% of total assets managed for a client and will eschew per-trade charges. If you don’t feel comfortable researching and making your own trades, this is a good option to consider. These brokers will also have an incentive to perform well because if your portfolio’s assets under management increase, this means that they make more for managing them.

Discount Broker

Discount brokers generally do not offer investment advice. Trading fees for online discount brokers range anywhere from $4.95 to $20, but most are between $7 and $10. This rate is subject to change since discount brokers are consistently lowering their fees in order to attract more customers and gain market share. Some even offer free trades. If you do, your homework discount brokers can save you a lot of money when it comes to transaction costs.

Doing Your Own Research

Most investors don’t bother reading Securities and Exchange Commission (SEC) filings, but SEC filings are available to the public, and the information within them is like taking an open book test. The answers are provided for you. Unlike press releases, a public company must state the facts in its SEC filings. This makes it relatively easy to research stocks.

Also, pay close attention to industry trends. If fast-casual food chains that offer natural and organic food are in, go with the trend, not against it. Do your research to determine the best of the breed. And you don’t even need to dive that deep. As a general rule, if the broader market is hot, revenue growth will be the key factor driving stock price appreciation. Investors and traders love revenue growth in bull market environments. If the broader market is cold, net income growth and a strong balance sheet will be the keys to success. Investors and traders like to run to safety for dividends and share buybacks in these environments.

The Bottom Line

If you’re impulsive and/or not willing to do your homework, then you should consider a full-service broker. Otherwise, a discount broker, which allows you to execute trades but does not offer investment advice, is a better option.

By Dan Moskowitz in Investopedia

Types Of Investments: Ownership, Lending, And Cash

The word investment has become muddled with overuse. A stock or a bond is an investment. People are now encouraged to make investments in their educations, their cars, and even their flat-screen TVs. All of these things may make sound financial sense, but they are not, strictly speaking, investments.

No matter what the commercials say, there are only three basic categories of investment. They are products that are purchased with the expectation that they will produce income or profit, or both.

1. Ownership Investments

Ownership is what comes to mind for most people when the word investment is batted around. These are the most volatile and profitable class of investment. The following are examples.

Stocks

Owning stock means owning a portion of a company. It may be a miniscule stake, but it’s ownership.

More broadly speaking, all traded securities, from futures to currency swaps, are ownership investments. Investors purchase them in order to share in the profits, or because they will increase in value, or both.

Some of these investments, such as stocks, come with the right to a portion of the company’s value. Others, such as futures contracts, come with the right to carry out a certain action that will benefit their owners.

Key Takeaways

  • Stocks, real estate, and precious metals are all ownership investments. The buyer hopes that they will increase in value over time.
  • Lending money is an investment. Bonds and even savings accounts are loans that earn interest over time for the investor.
  • Cash equivalents like money market accounts are easy to liquidate when needed and repay investors with a modest amount of interest.

Your expectation of profit is realized (or not) by how the market values the asset you own the rights to. If you own shares in Apple (AAPL) and the company posts a record profit, other investors are going to want Apple shares too. Their demand for shares drives up the price, increasing your profit if you choose to sell the shares.

Business

The money put into starting and running a business is an investment.

Entrepreneurship is one of the toughest investments to make because it requires more than just money. Consequently, it is an ownership investment with extremely large potential returns.

By creating a product or service and selling it to people who want it, entrepreneurs can make huge personal fortunes. Bill Gates, founder of Microsoft and one of the world’s richest men, is a prime example.

Real Estate

Houses and apartments that are purchased to rent out or to resell are investments.

The house you live in is a different matter because it is filling a basic need. It fills a need for shelter. It may appreciate in value over time, but it shouldn’t be purchased with the expectation of profit. The mortgage meltdown of 2008 and the underwater mortgages it produced are a good illustration of the danger of considering a primary residence as an investment.

Many people made the error of purchasing homes that they could not afford on the assumption that those houses could soon be sold for much more.

Precious Objects and Collectibles

Gold and precious gemstones, Impressionist paintings and signed LeBron James jerseys, all can all be considered ownership investments, provided that these objects were bought with the intention of reselling them for a profit.

Like any investments, they may rise or fall in value over time. Tastes in art and collectibles change. Gold and gems have market values that fluctuate.

From the cold-eyed view of the investor, they also have costs. They must be insured and kept in pristine condition in order to retain their value.

2. Lending Investments

Lending money is a category of investing. The risks generally are lower than for many investments and, consequently, the rewards are relatively modest.

A bond issued by a company or a government will pay a set amount of interest over a set period of time. The only real risk is that the company or government will go bankrupt, in which case the bondholder may get little or none of the investment back.

Saving Accounts

A regular savings account is an investment. The investor is essentially lending money to the bank. The bank will pay interest to the account holder and will earn its profit by loaning out the rest of the money to businesses at a higher rate of interest.

The return on savings accounts is currently quite low, but the risk is essentially zero. In the U.S., savings accounts are fully insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC).

Bonds

Bond is a catch-all category for a wide variety of investments from U.S. Treasuries and international debt issues to corporate junk bonds and credit default swaps (CDS).

The risks and returns vary widely between the different types of bonds. Overall, these types of lending investments pose a lower risk and provide a lower return than ownership investments.

3. Cash Equivalents

These are investments are “as good as cash,” which means that they can be converted back to cash easily and quickly.

Money Market Funds

Money market funds are similar to savings accounts and can be purchased at any bank. The difference is that the investor commits to leaving the money alone for a period of time in return for a slightly higher rate of interest. The time period is as little as three months and no longer than a year.

Money market funds are more liquid than other investments, meaning you can write checks out of money market accounts just as you would with a checking account. Although, once you start writing checks on it you’ve erased much of its value as an investment.

These Are Not Investments

Education

Education is often called an investment and certainly, it can have lifelong rewards that include a higher income. It could be argued that we sell our education as if it was a small business service in exchange for a steady income.

By this logic, we’re investing when we buy a stress ball or a cup of coffee. These are goods that offer benefits but they are not investments.

Consumer Purchaces

Beds, cars, mobile phones, TVs, and anything else that depreciates in value with use and time, are not investments. You may spend more to acquire something of higher intrinsic value but once you’ve used it it’s still used goods.

By Andrew Beattie in Investopedia

Please contact Albert A. van Daalen for advice and support in Investment Services.