In its early stages, a business may borrow from or sell equity to friends and family members, rely on small loans (including using overdrafts and credit cards), apply for government grants, or receive investment from business angels. As a business grows, it may use its cash reserves to fund day-to-day operations and increasingly rely on debt (where the funders are lenders) or investment rounds (where the funders are private investors such as venture capital firms) to raise the capital it needs to scale (i.e. grow). Far larger, mature businesses (i.e. businesses with a higher profile, a solid track record and considerable turnover) that are looking to raise significant amounts of money may then look to the capital markets to raise capital, by way of issuing bonds or selling shares to the public.

It’s common for businesses to combine multiple forms of financing, for instance by selling shares for cash, whilst also taking on multiple layers of debt from different sources. Businesses may also borrow money even if they have cash available. For instance, a business may choose to use cash to fund day-to-day operations and to keep some cash in reserve just to ensure that it won’t run into cash flow issues if it experiences a sudden drop in revenue. However, that business may also then borrow money or sell shares to raise the capital needed to invest in expansion or an acquisition.

With all this in mind, below are some of the most common methods businesses use to finance deals.

Cash

Financing operations using existing cash resources (for instance, retained profit).

✓ Control: the owners retain full ownership and control of the business and its assets. 

✓ Cost savings: no interest payments or dividends will need to be paid.

✓Easy to arrange: businesses can access their own capital immediately and without incurring hefty administration fees.

✗ May lack sufficient funds: some firms may not have enough cash to finance investment and maintain sufficient cash flow.

Loans

Businesses can borrow from banks and then pay back the loans in instalments, plus interest. The interest rate can be fixed (making it easier for a business to predict its costs) or floating, in which case the rate may be linked to the fluctuation of a benchmark interest rate (for instance LIBOR), which could in turn end up costing less than fixed rate repayments if interest rates happen to fall. A bank may be persuaded to issue a loan on the strength of a well-prepared business plan, a strong previous relationship with the borrower, a financial guarantee from another party, or a company’s ability to provide collateral.

✓ Control: the owners generally retain full ownership and control of the business so long as repayments are met. Note however that lenders may be able to exert some control over a borrower’s business through taking security over assets on terms that restrict the ability of the borrower to sell those assets.

✓ Cost savings: money can be borrowed as and when it is required, meaning that the borrower may only have to make interest payments that reflect the actual capital in use (i.e. the money drawn out of the bank account). In addition, interest payments made are tax-deductible, meaning they will lower a business' profit figure, and therefore its corporate tax liability. 

✓ Effectiveness: banks are generally more suited to complicated lending structures as they have extensive experience of evaluating risk. They may thus be more inclined to approve financing and once a loan is approved, a business is generally guaranteed to receive the full amount immediately. Banks may however decide to hedge risk through releasing funds in instalments. This could prevent borrowers from using capital recklessly or for purposes not previously agreed. Under such circumstances, borrowers may only qualify for new instalments once certain targets have been met.

✓ Can be easy to arrange: small loans are quicker and cheaper to arrange than bond or share issues. However, as mentioned, large, syndicated loans may be incredibly costly and complicated to arrange.

✗ Security: a borrower may need to grant security to a lender, which typically entitles the lender to take control of some (or all) of the borrower’s assets if the borrower fails to repay the loan as agreed. Under such circumstances, a lender could seize and sell any secured assets in order to retrieve their money. The terms of a security agreement can also restrict a borrower’s ability to use the relevant assets (which can impact their ability to operate), whilst companies that lack valuable assets may struggle to secure loans due to their inability to offer sufficient collateral. 

✗ Cost: interest payments may be substantial, depending on a borrower’s credit rating and the state of the economy.

✗ Repayable on demand: certain loans (notably overdrafts) are repayable on demand, which could cause cash-flow issues if repayment is demanded earlier than expected.

Bonds

Capital markets: these are financial markets that link organisations seeking capital and investors looking to supply capital. Securities including shares and bonds are traded in the capital markets between governments and companies seeking capital, banks, private investors and other investors such as hedge funds and pension funds.

Bond issue: this is where a company (the “issuer”) issues (i.e. sells) debt instruments called bonds to investors through the debt capital markets, in exchange for cash. Bonds entitle investors to regular interest payments (these are known as “coupon” payments) over a given period, at the end of which the bonds “mature” and each investor becomes entitled to receive back their initial investment (known as the “principal” amount) in full. In this sense, bonds are a little like IOUs. Note that bonds are tradable, meaning investors can sell their bonds to other investors in order to recoup some of all of their initial investment before those bonds mature.

✓ Control: bond issuers do not have to offer bond purchasers an ownership stake in their business or security over their assets (meaning issuers remain free to use their assets as they see fit) and bondholders rarely try to restrict a bond issuer’s business operations.

✗ Demand-led: if a company has a low credit rating or a low profile, it may struggle to sell enough bonds to raise all the capital it requires (and banks may be unwilling to underwrite the issue). To stimulate demand, companies sometimes offer bonds with higher returns (known as “high yield” or “junk” bonds).

✗ Costly to arrange: bond issues are time consuming and costly to arrange, so are unsuitable for small capital raises. 

Underwriters: bond issues can involve underwriters (e.g. investment banks) which agree - for a fee - to purchase all the bonds in advance and then sell them on to investors, or to purchase unsold bonds post-issuance. This enables the bond issuer to ensure in advance that it will receive all the capital it needs (as the underwriter takes the risk).

Prospectus: this is a legally required document that must precede bond or share issues. It advertises the issue to potential investors and contains information about the issuer’s business, its financial circumstances, and the potential risks, in addition to the terms and conditions of the issue.

Selling equity

A share issue involves a company selling (i.e. "issuing" or "allotting") its shares. Investors provide money in exchange for shares that represent an ownership stake in a company, with the aim of reaping returns in the form of capital growth (if those shares are later sold at a profit) and dividends (if the company elects to pay dividends). 

Initial public offering (IPO): this is where a company lists its shares on a stock exchange for the first time (hence the phrase initial public offering) in order to sell those shares through the equity capital markets. Listing through a stock exchange also facilitates the subsequent trading of those shares.

Dividends: payments made by a company to its shareholders out of its profits/retained earnings, typically annually. 

In general, the advantages and disadvantages of selling shares can include: 

✓ Cash flow: no interest payments are required, which can be beneficial from a cash flow perspective.

✓ No security: companies need not provide security in exchange for the funds, which means they won’t be restricted in how they use their key assets (subject to any restrictions agreed with equity investors).

✓ Complementary skills: some investors (e.g. business angels and private equity firms) may contribute skills, experience, expertise and contacts that benefit the company. 

✓ Profile: listing on a stock exchange can enhance a company’s profile, which may increase its access to the market for additional capital and enable it to negotiate more preferential terms with suppliers and creditors.

✗ Control: equity represents an ownership stake in a business that usually affords the owners some level of control (e.g. in the form of voting rights). When a company allots more shares, this dilutes the ownership stake of existing shareholders (unless those shareholders buy additional shares), meaning their level of control may decrease. 

✗ Cost: the greater the number of shareholders (and the greater the size of their shareholding), the more the company’s profits will need to be shared. This might mean splitting the dividend “pot” between more people (although dividend payments are discretionary, subject to limited exceptions), or splitting the proceeds of a future sale of the business. In other words, equity investors share in both the risks and the rewards. If a company lists its shares on a stock exchange, it may also become vulnerable to a hostile takeover as it can do little to prevent existing shareholders from selling their shares to a prospective acquirer.

✗ Demand-led: as with bonds, if insufficient demand exists, a company may fail to raise all the capital it requires. 

✗ Administration: share sales can be time consuming, complicated and costly to administer. Moreover, if a company lists on a stock exchange, it will become subject to continuing (and at times onerous) disclosure requirements.

Choosing between different methods of financing

There are other factors that a company must consider when choosing between different methods of financing, including: its level of existing debt; the assets it has available to grant security over; any restrictions on its flexibility to borrow; its particular objectives; and current market conditions. 

These factors can affect the “cost of borrowing”, i.e. the size of the interest payments it will have to make to compensate a lender for the risk of giving the loan. Lenders may be unwilling to lend to riskier borrowers, or may only be willing to lend if those borrowers are willing to make high interest payments (lenders may feel that the risk is worth the potential for a high financial return).

Assets

As discussed in the “Security” lesson of the Key commercial law principles chapter, the extent to which a borrower has valuable assets over which security can be taken can determine whether (and if so, on which terms) a lender will be willing to lend.

Capital structure

The amount of debt a company has already taken on may affect the viability of different methods of financing. If a company has a high ratio of debt in comparison to equity, this means it is “highly geared” and indicates it may lack sufficient assets to support debt repayments if additional debt is taken on. Lenders may therefore perceive highly geared companies as more risky borrowers and consequently charge them higher interest rates (or even refuse to lend them capital).

The market

When assessing the options for raising finance, general market conditions and investor sentiment can also be major factors to consider. In particular:

• Demand: if the value of a company is low, or it lacks a high profile or strong reputation, it may be unable to sell a sufficient number of shares or bonds at a price high enough to raise the required level of capital. 
• Market Conditions: during an economic downturn, businesses in general perform less well (in part due to a decrease in consumer spending). This can reduce the willingness of investors to lend money at viable interest rates or invest in shares due to the increased risk of businesses becoming insolvent or underperforming.
• Interest Rates: interest rates are typically higher for borrowers with lower credit ratings. This is because lenders may demand a higher premium to compensate them for the increased risk of such borrowers defaulting. Therefore, debt financing may be less viable for companies with low credit ratings due to the potentially high cost of borrowing.
• Banks: issuing bonds may not be viable if investment banks are unwilling to underwrite the issue (which may be the case for firms with low credit ratings). In addition, banks may refuse to lend to firms lacking assets that can be used as collateral.