Using that cash, the company then purchases other things such as equipment, supplies, and so on. This chapter explores the different ways that corporations raise money, who the magical money-fairies are, and how to present your story to them in a way that pleases them.
Raising Capital
Everything that makes up a corporation and everything a corporation owns, including the building, equipment, office supplies, brand value, research, land, trademarks, and everything else, are considered assets. Believe it or not, when you start a corporation, that company’s assets aren’t just included in a Welcome Letter; you have to go out and acquire them. Generally speaking, you start off with cash, which you then use to purchase other assets. For most new companies, this cash consists of a combination of the following:
The owner’s own money: This money is considered equity because the owner can still claim full possession over it.
Small loans, such as business and personal loans from banks, business and personal lines of credit, and government loans: The money obtained through loans is considered a liability because the corporation has to pay it back at some point. In other words, these loans are a form of debt.
The combination of these two funding sources brings me to the explanation of the most fundamental equation in corporate finance:
Assets = Liabilities + Equity
The total value of assets held by a company is equal to the total liabilities and total equity held by the company. Because the total amount of debt a company incurs goes into purchasing equipment and supplies, increasing debt through loans increases a company’s liabilities and total assets. As owners contribute their own funding to the company’s usage, the total amount of company equity increases along with the assets. Note: Capital, assets, money, and cash are basically all the same thing at this point; after a company raises the original capital, or cash, it exchanges that cash for more useful forms of capital, such as erasable markers.
Unlike liabilities, equity represents ownership in the company. So, if a company owns $100,000 in assets and $50,000 was funded by loans, then the owner still holds claim over $50,000 in assets, even if the company goes out of business, requiring the owner to give the other $50,000 in assets back to the bank. For corporations, the equity funding varies a bit, however, because the owners of a corporation are the stockholders. The equity funding of corporations comes from the initial sale of stock, which exchanges shares of ownership for cash to be used in the company.
The rest of this chapter discusses the two main ways businesses raise capital.
Diving into Debt
Regardless of what the money’s for, when a corporation wants a loan, it starts by putting together a proposal. For startup companies, this proposal comes in the form of a business plan, but anytime a corporation receives a loan significant enough to influence the capital structure of the company (not lines of credit), it has to present a proposal for the use of the funds. This proposal includes financial information about the corporation, including detailed predictions for future financial well-being, called projections, that prove the company can pay back the loan on time and without risk of default. For more information about business plans, which you can use in many forms of proposals, you may want to read Business Plans For Dummies (Wiley Publishing, Inc.) by Paul Tiffany, PhD, Steven D. Peterson, PhD, and Colin Barrow.
The following sections explain what a corporation must do after its proposal is ready to go, including where to go to ask for money and how to evaluate the worth of a loan and its terms.
Asking the right people for money
After the proposal is in place, corporations have a few options for where to go to ask for the money they need:
Commercial banks: Banks are very common sources for corporate debt financing. These loans work very similar to any other loan, wherein your ability and planned use of the funds will both be evaluated in detail before the bank agrees to offer the loan. The findings of their investigation will determine, in part, the interest rate they will charge, the amount they will loan, and the duration of the loan.
Government loans: These loans are frequently available, but they’re often reserved for special types of corporations (usually in a field that the government is trying to promote), corporations with a special role in the nation (such as defense contractors).
Issuance of bonds: Bonds, which basically act as IOUs, are possibly the most popular form of debt financing. A company goes through an underwriter to have bonds issued, and then private investors purchase those bonds. The company keeps the money raised as capital with a promise that it’ll pay back the bondholders’ money with interest. Bonds come in many different flavors; turn to Chapter 11 for more details.
After a potential moneylender receives the corporation’s loan application, an interview process typically occurs, along with an underwriting process during which the potential lender assesses the borrower for risk, financial ability to repay the loan, credit history, and other variables. If the lender approves the loan application, the money is deposited in the corporation’s bank account, making it available for use by the corporation in a manner consistent with the original proposal.
Making sure the loan pays off in the long run
The responsibility for making sure a particular loan is beneficial to a company lies with that company. Every loan, except for those rare federally subsidized loans in which the government pays for the interest, incurs interest, meaning you and your company pay more money back to the lender than the lender originally gave you.
Here’s a quick look at how interest works:
This equation says that the balance (B) is equal to the principal amount (P) times the rate (r) exponentially multiplied by time (t). So, if your company borrowed $100 at an interest rate of 10 percent for one year without making any payments, then the amount of money your company owes at the end of that one year looks like this:
The answer, then, is $110 (because $10 is 10 percent of $100 and interest is accrued annually for only one year).
