How do Businesses Raise Capital?

Are you a business owner seeking more ways you can raise capital for your business? Or are you just a reader fascinated by how the business world works? In this article, we have highlighted the major ways most businesses raise capital.

Why Capital?

To ask for the importance of capital is almost as asking why do fishes need water? Or why do humans need oxygen? There are many other things that humans require to survive in life, but the major requirement is oxygen. The same applies to businesses, the focal point to any business is capital. For any startup or fully operational business to thrive, it requires adequate capital. Capital may take any form, either human and labor capital, or financial capital. However, the most known type of capital is financial capital. Financial capital basically covers both the cash and access to cash (securities) a company owns. So, how exactly do companies raise enough capital to keep then operational per time? Or How can companies raise enough capital to keep them operational and to fund future projects?

Ways Businesses Raise Capital

There are two major ways companies can raise capital: (1) debt capital, and (2) equity capital. Every other method can be derived from these two. These other methods include early-stage investors, borrowing through bonds or banks, reinvesting profits, and selling stock. Debt capital is a situation when a company borrows money through bank loans or bonds and promises to pay back with interest at an agreed date. While equity capital is when a company generates money by selling shares of company stock through IPOs or accepting investment offers from “angel investors.”

Early-stage investors: Usually, when businesses start out, the pioneer(s) of the business think of possible ways to fund the business. The overall aim of every business is to make profits. A lot goes into a business beyond funding it. Businesses at the early-stage or startups may have a great idea or product prototype or services that they believe would rock the market, but no solid customer base yet. A business with little or no customer base cannot earn profits enough to fund the business or even handle future projects.

For many startups or businesses that do not have the capacity to launch out in a big way, the top source of a startup is the owner(s) of the business. Here, the pioneer(s) of the business would have to take a loan or take out money from personal savings to get the business to a reasonable stage that might interest a few personal investors. These personal investors may include family and friends. Asides personal investors of family and friends, some cities have “angel investors” who offer to invest their money into a small new business at an early stage in exchange for owning a fraction of the company. These angel investors are usually wealthy and successful individuals who are also private investors.

Another category of investors that can provide capital for businesses at the early-stage is venture capital firms. The aim of venture capital firms is to pick out relatively small companies that have good potentials to grow over time. To provide small businesses with the capital they require, these venture capital firms gather money from different investors such as institutional or individual investors. Venture capital firms also provide their client companies with financial and business management advice that can help the business grow and build a solid customer base. In venture capital, investors do not directly invest in the companies, rather they invest through the venture capital funds and receive returns based on the performance of the funds.

Like all investments, early-stage investing comes with its own risks. The major risk is that not all small businesses will eventually meet up to the investors’ expectations of “hitting big.” As a matter of fact, many small businesses fail within the first year of operating, and shutdown eventually. On the other hand, some others meet up to expectations and perform well in the market. This is a risk that all early-stage investors are aware of and must be willing to take if they decide to put their money into early-stage small companies.

Reinvesting profits: As earlier stated, it is the aim of every business to make substantial profits. However, a business that desires to grow beyond its current level would have to reinvest some of its profits back into the business. The reinvestment can be in the form of purchasing new equipment, raising new structures, or sponsoring research and development, all of which would be beneficial to the business. For example, a manufacturing company may decide to use part of its profits to set up a processing plant that would benefit the business over the next 30 years. However, reinvesting profits will only be possible if a company’s revenues are greater than its expenses. This is applicable to mainly established companies that seek more ways to increase financial capital. For new businesses, it may be quite strenuous considering the fact that their expenses may be greater than their revenues at the onset.

Borrowing through banks and bonds: Borrowing is not particular to any size of company, as both small and big companies often take loans from financial institutions. A company may be considered eligible to take a bank or bond loan when they meet the lender’s demand for revenue level. In other words, a company will be eligible to take a business loan if they have a good record of generating substantial revenues as proof that they are capable of repaying the loan with interest.

There are two official ways companies can borrow money: either through banks or bonds. Small businesses, however, may have the option of taking loans from close relatives and friends. When it comes to loans, banks give out all kinds, ranging from personal loans to business loans. The same rules apply to business loans like other types of bank loans. The borrowing-company fills in an application requesting a business loan from a bank. The loan is approved on the grounds that the business would repay the principal and interest at a given period of time. Collateral would also be required by the bank, should in case the company fails to meet up to its part of the agreement. If a business fails to meet up to its part of the agreement, the bank can either sue the business or sell the given collateral to retrieve the loan.

Borrowing through bonds is another channel to getting financial capital. Unlike bank loans, a bond is more of a financial contract. In this contract, the borrower must agree to repay the amount that was borrowed with the agreed interest at an agreed date. Failure to do so will attract legal implications. There are different types of bonds such as corporate bonds that are issued by corporations, and government bonds which are issued on different levels of government. Government bonds include Treasury bonds and municipal bonds.

Some companies prefer bonds over bank loans. The fact still remains that both methods of borrowing have their individual perks and downsides. For example, bank loans may be more ideal for relatively small companies since the loans can be customized. Banks are able to properly assess the borrowers by looking at their deposits and withdrawals and grant them loans according to their capacity. On the other hand, some large companies prefer bonds over bank loans for individual reasons. This is not to say that there is a fixed rule that says smaller firms must borrow from banks while larger firms can take up bonds. There are also instances where a group of banks can come together to offer large loans and some small firms can also issue out bonds.

In the case of corporate bonds, raising financial capital works in two ways for both the borrower and the lender. While relatively small firms take up bonds to fund their businesses, large firms that issue these bonds do so as a means of raising financial capital as well. These large firms may need to raise financial capital to pay for investments, acquire other firms, or pay off old bonds.

Selling stock: This is a common way of raising financial capital amongst most corporations, especially public traded companies. Private companies that seek to expand their investor-base and their access to funds or capital often opt to go public. By going public, these companies get listed on stock exchanges. That way, public investors can buy the stock of such companies. A stock is a type of security that represents part ownership in a corporation. It can also be said to be the total shares into which ownership of a company is divided. Collectively, shares are known as stock, and one share of a stock represents part ownership of a company in proportion to the total number of shares.

Investors who buy the shares of stock of a company are known as shareholders. A shareholder’s ownership is determined by the number of shares the holder owns in proportion to the number of outstanding shares. Simply put, the number of shares you own in a corporation would be proportionate to the percentage of your ownership in that company. For example, if a company has 2,000 shares of stock outstanding and you purchase only 100 shares, you would be entitled to only 5% ownership and claim of the company’s assets and earnings. Assuming an investor owns 100% of a company’s stock, by all implication, the person owns the entire company.

It is possible for a single company to have hundreds or thousands of investors. As a result of this, it is possible to think that a company would most likely be at a loss if it has to split all its profits across many investors. So, how exactly do corporations make money off selling stocks? Once these companies have been able to successfully get listed publicly they would offer investors the opportunity to buy shares of the company through an initial public offering (IPO).  An IPO serves two functions: (1)to raise funds to pay back early-stage investors, (2) provide financial capital for a company to expand its business operations.

Investors can benefit from buying company stocks either by receiving dividend payments (if the company pays) or by selling their stock at a profit when the company’s value increases. For example, you buy a share of stock in Tesla for $60 at a given time. After a while passes by, the value of the company increases and by extension the stock price of the company (let’s say $95). If you decide to sell your stock at the current high price of $95, you would have had a profit of $35 on what you bought for $60.

It is a win-win situation for both companies and investors. The company raises financial capital through an IPO while the investors get returns on dividends paid by the companies or by selling their stock at a profit.

Considering that a company may have thousands of investors and it would be illogical to take in thousands of decisions on a daily basis. Instead, through their shares, holders are able to vote in the election of new board members they believe are capable of running the affairs of the company with the best interest of the shareholders at heart. Though the shareholders do not directly have a say in the management of a company, they still have a level of impact on the policy of the company through the elected board of directors. The candidates are usually nominated by company insiders. If the shareholder perceives that the board is not performing well they can select or elect a new board to handle the affairs of the company.