Wall Street — June, 2007
Suppose for a moment that you are a company: You Company. You Company is poised for growth and has a plan for wonderful expansion. Research has been done. A pilot project was conducted. Alternatives have been considered. You Company's plan, though not perfect, is sound. The only problem is that You Company must raise some capital to launch the plan.
In the world of corporate finance, there are two general ways of raising money: debt financing and equity financing. Simply put, debt financing is borrowing money. Companies can take out loans or sell bonds. Either way, the lender expects that the principal and interest will be repaid at some future date. Once paid, the debt is settled. Equity financing, on the other hand, involves selling a stake in the company. This can be accomplished by selling shares of stock or taking on partners. Either way, the investor expects to share in the future prosperity of the company.
While there are advantages and disadvantages to both debt and equity financing, there exists some prevailing wisdom in the world of business, and it is this: finance as much as you can through debt before pursuing equity financing. At the surface, many people balk at this. Why should You Company borrow a bunch of money that absolutely must be repaid? Wouldn't it be easier to sell stocks and simply share the profits if the new plan succeeds? And don't the shareholders share some of the risk with stocks?
Consider this: You Company is looking to raise capital to finance an idea that it considers sound. You Company is not engaging in willy-nilly business practices. Therefore, You Company has a reasonable expectation that the new business expansion will be profitable. If You Company borrows money to finance the growth, and works diligently to make the growth successful, the loan can be repaid with the profits. Once the loan is repaid, all future profits belong to You Company, and only You Company. On the other hand, if You Company sells stock to finance the growth, the new shareholders will expect a share of all future profits related to all of You Company's success—not just the new success. Further, You Company's shareholders now have a vote in the way You Company conducts all its business—not just the new business. If ever the shareholders are malcontented, they can initiate a hostile takeover, vote in new board members, and take control of You Company. This is the problem with equity financing. You Company no longer controls You Company. They do.
We've all got shareholders in our lives. Our loved ones, friends, coworkers, and peers all hold stock in our lives. And it's important that they do. We all need to raise capital quickly now and then. Our shareholders can be there when we need them the most. But I urge you strongly to always hold a majority share of your own stock. Never let others play their hand with your business. You will never be able to make decisions that please all your shareholders anyway. And it's better to owe a debt of gratitude than to let anyone else control your board.
And if you still feel the need to share your profits, there's philanthropy, and it's a beautiful thing.
Now if you'll excuse me, I have to work on my strategy for an exciting merger.
~ topher