charged. After all, by keeping the loan, the corporation agrees to pay back interest as well as the principal. So, if your company spends the money it borrowed in the preceding example on a new machine, it has to generate more than 10 percent profitability from that single machine in order to make the loan worth the 10 percent interest rate. This is a simplified example that doesn’t take several real-world variables into consideration, but before you consider more realistic examples you need to learn about some additional topics.
If a company absolutely must raise capital but can’t generate enough value to pay back the interest rate, it’ll end up losing money on the loan. As a result, it might want to pursue an alternative option for raising capital, such as selling equity.
Looking at loan terms
You have a few different options available when choosing a loan for your company. To make the best choice for your company, you need to be aware of the pros and cons of each loan type. If you’re not sure which one is best for you, ask a professional analyst — not the person trying to sell you the loan. Here are some terms you need to be aware of:
Fixed versus variable rate: When you take out a fixed-rate loan, the percentage interest you pay will always be the same. For example, if you take out a loan with 5 percent APR (annual percentage rate, which is your annual interest rate), then you will always be charged 5 percent interest per year. With a variable rate loan, the interest rate you pay will change; the amount of change depends on the type of loan. Variable rate loans come in many types, and their rates change based on another interest rate, a stock market index, your income, or some other indicator. Some increase gradually over time, while others start low and jump after a period of time (these are called teaser-rates). While the wide variety of variable rate loan options is great news for the financially inclined, these types of loans can be very dangerous for beginners. The amount of information and the calculations involved in predicting the movement in variable interest rates can be a deceptively daunting task, even for experienced analysts.
Secured versus unsecured: Secured loans are tied to some asset, which becomes collateral. Basically, you tell the bank that if you fail to pay back your loan, the bank can keep and/or sell that particular asset to get its money back. With unsecured loans, no assets are directly considered to be collateral to which the lender has automatic rights upon the borrower’s default of the loan. However, they can still hurt the credit history of the company, and a lender can still sue to get their money back.
Open-ended versus closed-ended: Closed-ended loans are your standard loans. After your company gets one, it makes periodic payments for a predetermined time period, and then the loan is paid back, and you and the lender are both done. Think of a closed-ended loan like a mortgage, except that it’s not used to buy a house. Open-ended loans are more similar to credit cards. Your company can draw upon an open-ended loan until it reaches a maximum limit, and it just continuously makes payments for as long as it has a balance.
Simple versus compounding interest: Simple interest accrues based only on the principal loan. In other words, if a loan for $100 charges 1 percent interest, the lender will make $1 every period. On the other hand, compounding interest pays interest on interest. So, if the borrower doesn’t make any payments on a loan of $100 with 1 percent interest in the first year, then the loan will charge 1 percent interest on $101 rather than the original $100 the second year. This type of interest is far more common with bank accounts than loans. (Turn to Chapter 9 for more on these two types of interest.)
Schmoozing Investors
Raising money by selling shares of equity is a little more complicated both in theory and in practice than borrowing money using loans. What you are actually doing when you sell equity is selling bits of ownership in a company. Ownership of the company is split up into shares called stock. People only buy stocks when they are excited by the things they hear about them, so your story has to be particularly good when compared to the relatively number-driven world of loans. Although it is illegal to say anything fictional, it is common to share a company’s vision of their future with potential investors, providing a bigger emotional impact.
When you own stock in a company, you own a part of that company equal to the proportion of the number of shares of stock you own compared to the total number of stock shares. For example, if a company has 1,000 shares of stock outstanding (meaning that this is the total number of shares of stock that make up the entire company) and you own one share, then you own 0.1 percent of that company, including any profits or losses it experiences (because profits belong to the owners of the company). So, when you sell equity to raise cash, what you’re really selling are the rights to a certain amount of control over how the company is managed in addition to your rights to the future profits of that company.
Selling stock to the public
When a company is getting ready to go public, meaning it’s opening up the purchase of equity to the public, it must first put all its records and reports in the proper format. The U.S. Securities and Exchange Commission (SEC) requires that all U.S. public companies follow specific criteria for keeping track of financial information and reporting it to the public. The company must also meet a number of accountability requirements and other more minor requirements. In other words, before becoming a corporation, a business must act like a corporation. Often this includes hiring a consultant or an investment banker to help make sure everything is in order. Then, finally, the company can go through the process of becoming established as a corporation and selling stock.
During the underwriting stage, an underwriter evaluates the value of the company and estimates how much the company needs to raise, how much it should raise, and how much it’s likely to raise. That same person verifies that the company meets all the requirements for being a corporation and selling stock. After that, the company can have its first IPO.
