One way to put your head around how financial instruments work is to understand why they were created in the first place. For this, you need to think like an entrepreneur, not an investor.
We tend to forget this but, Apple or Tesla stocks were not created to generate money for investors – but as a way for these companies to raise funds for specific needs and share their risks. Understanding this will open you up to new perspectives.
And that’s what we will cover in this article.
What if you became an entrepreneur?
First things first, let’s grant you something you may have dreamed of before: Being the CEO of a successful company. Imagine you are comfortably seated in your executive armchair, contemplating the empire you built, reflecting on the journey of the company you founded. The time is long past when you were fighting to launch your startup.
Now, let’s take another leap and go back to your beginnings: Designing your product, mobilizing resources, building your infrastructure, hiring employees and incentivizing them, allocating capital to marketing, etc. Money is crucial to starting and expanding a business, and as a CEO you often have to fight to find this funding.
Equity or debt? That’s the question
Why you might want to choose debt
There are primarily two ways to finance a company: by issuing equities or by contracting debt. The latter needs no introduction, even to someone who has never invested (many of us have debt: mortgages, loans, etc). Finding a lender with who you can borrow money with the promise to return it later, usually with interest – that’s the basic principle of debt.
In Switzerland, you’ll find different types of lenders, but for small companies, this role is primarily assumed by banks and financial intermediaries. For small companies, it is rather difficult to obtain loans. Or at least at a decent cost. And that is quite understandable: Lenders usually require guarantees. They like to understand your cashflows, the state of your finance, what you can bring as collateral, etc. to assess your ability to repay the debt. And as a startup with no customers what you have to offer is often only a business plan…
In essence, owning a stock means that the investors own a portion of the company. And if the shares have voting rights attached to them, they can influence the decisions and future of the company. Needless to say, they are also sharing the risks.
But then, why not try equity?
That’s why issuing equities is very often the preferred way for startups and small companies to finance their activities.
What are equities? In essence, an investor will put some capital in your business and will claim in return a portion of the income and assets. For example, if the investor owns one share of your company in which you have issued 10 shares, he is basically entitled to a tenth of the company income and a tenth of the assets.
In essence, owning a stock means that the investors own a portion of the company. And if the shares have voting rights attached to them, they can influence the decisions and future of the company. Needless to say, they are also sharing the risks.
In the early stages of a startup, the capital is often privately held by a limited set of initial investors: Founders, friends, partners, employees, business angels, and private equity funds… this allows for better control – but as the company and the ambitions grow (let’s say for example that you want to conquer a new market with your product), more capital is needed. And it is usually time to go public.
Equity or debt: There is no one-size-fits-all answer
How do you go public? By listing your company on a stock exchange, through what we call an IPO (Initial Public Offering). With an IPO, you can reach a broader base of investors, who will be able to exchange the shares of your company in a marketplace.
This has a lot of advantages: you can raise more significant amounts of capital for the development of your company, you can also make some profit on your initial participation, and finally, you get a direct measurement of the performance of your company (through the price of your shares). On the flip side, going public means less control, more work, more costs, and more pressure to deliver results!
That’s why, when you become a mature company, issuing stocks is not always the best way to finance your activities. In fact, debt can play at your advantage. First, if your business is in good health, you can borrow money at a lower cost while retaining control (debt usually has no voting right). And using debt also presents fiscal advantages. But beware not to issue too much debt or the consequences could be severe.
As a successful CEO, you know now that you absolutely need to ask yourself if you should use equities or debt to finance your company.
One solution may be more suitable than the other depending on the stage your company is in and your specific needs. In fact, balancing your sources of funding between equity and debt is a delicate yet important exercise.
Some key findings:
- Stocks are a way for companies to raise money.
- Companies can raise money privately or on public markets. Not all companies go public, take IKEA for example.
- Going public is also a way for founders and owners to sell their participation more easily. But it also has a cost and consequences.
- Companies can use the market value of their stock to evaluate their own performance.
- A company can also use stocks to reward employees. It is often a cheaper way for small companies to get funding.
- Companies that are publicly traded can use their stock to pay for acquisitions.
- Raising equity generally has a few disadvantages: Your performance is publicly evaluated; when the stock drops, it becomes more difficult to raise money and keep employees; and stock usually comes with voting rights. So, anyone who owns stocks with voting rights can influence the management of the company.
- Another way to raise money is through issuing debt. This is often linked to specific business needs.
- The advantage of debt is that you don’t give away control over your company.
- Having a bit of debt is interesting for a company as it means lower taxes. Too much debt puts you at risk, however.
- For people to lend you money, you need to have a reputation and solid finances, that’s why it is difficult for a start-up to use debt (although banks lend money to a lot of small companies in Switzerland, as we saw during the Covid crisis). Lenders usually ask for visibility on the cash flows.
Knowing this, you can safely slip back into the shoes of the investor and ask yourself when you are considering buying a share of a company or a bond: What is the company expecting from me?
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