The corporate finance world is complex and challenging and the funding solutions employed are becoming increasingly innovative. The emergence of peer-to-peer lending and equity crowdfunding means that more and more retail investors are being exposed to corporate finance activities.
So, what does corporate finance actually mean? Corporate finance is the term used to describe the different types of capital employed by an organisation to fund its business operations.
There are essentially two forms of corporate finance: debt finance and equity finance.
Debt finance is money borrowed from a third party which must be repaid in full plus interest, within an agreed timescale.
Equity finance is money raised from investors which can be held by the company indefinitely, with no guarantee of an investment return or that it will even be repaid.
Then there is also hybrid financing: this is where debt takes on equity characteristics and equity takes on debt characteristics.
What is equity financing?
Equity financing is where a company raises capital by issuing shares to investors in exchange for money. These investors become members (shareholders) in the company and legally acquire a percentage ownership stake in the business in return for their share capital.
The shares issued to investors are held for either income and/or a capital gain. Income is received in the form a dividend distribution from available profits (if any). A capital gain arises when the shares are sold on to another investor at a price higher than the acquisition price.
The shares in issue can take many forms, but are broadly categorised into two classes: ordinary shares or preference shares. Different classes of shares can have different rights attached in respect of voting entitlement, dividend pay-outs and capital participation on winding-up.
For more information on share capital please read the Stocks and Shares guide.
What is debt financing?
Debt financing is the process by which a company raises capital by borrowing money from external lenders. These lenders can be banks, government agencies, mezzanine investors or specialists such as lease providers that facilitate the purchase of capital equipment.
There is an extensive range of debt financing options available to companies that need funding and these arrangements can take many different forms: bank term loans; overdraft facilities; finance leases; loan notes; mini-bonds; corporate bonds.
In essence, all debt arrangements have the same characteristics, the amount borrowed must be repaid in full and interest (or a coupon) will be charged. Some debts will be secured against the assets of the company and other will remain unsecured.
Hybrid financing
There will be occasions when a company needs to raise capital and straightforward debt or equity arrangements may not be acceptable to existing lenders or shareholders.
For example, lenders may object to more debt being loaded on the company and current shareholders may be concerned about the dilutive effects of additional shares being issued (where as a consequence they end up owning less of the company).
The solution is found in hybrid financing or debt AND equity financing. The best way to illustrate the concept of hybrid financing is to use two examples:
Debt as equity
Convertible loan notes (CLNs) are a form of debt arrangement. The company raises capital by issuing loan notes to third party investors (lenders) in return for paying interest (coupon).
A typical CLN document contains a clause that states should the company be unable to repay the loan notes within a specified time frame, then the holder has the right to convert the outstanding loan notes into equity on the repayment date at an agreed, specified conversion price.
So, a financing arrangement that was structured as debt, with a repayment date and coupon amount can be converted into equity, if certain conditions are not met.
Equity as debt
As mentioned above, equity capital can be categorised in many different ways but shares are broadly issued in two forms: ordinary or preference.
Preference shares issued to investors can include an entitlement to pay the holder a fixed dividend. This means that the dividend is paid out before any profit distribution is made to holders of ordinary shares.
However, preference shareholders may have restricted voting rights and be unable to influence strategic decisions in the way that ordinary shareholders can.
Although preference shares are considered an equity arrangement, fixed dividends are paid out in much the same way as interest is paid on loans.
Also, control and influence are restricted in much the same way as say a lender (or debt provider’s) decision-making influence would be.
History of banking
To learn more about corporate finance and how the modern banking system has evolved over time, please click here.
