Various Funding Sources - Dissertation Example

? Report on Various Funding Sources Table of Contents Executive Summary 3 II. Sourcing Funding for the Firm 4 III. Real-World Examples 13 IV. Glossary 14 V. Conclusion 15 VI. Referencing and Presentation 16 1. Executive Summary This report details the different funding options available to finance the ?100m in funding needed for the new project at this UK renewable energy firm, and makes recommendations for the appropriate funding source, given company concerns about yielding control of the company, as well as costs and other long-term viability of any additional funding sourcing moving forward. The company has no debt and is equally divided in terms of ownership among five private individuals. Differing debt and equity funding opportunities present their own challenges, advantages, disadvantages, and sets of relationships, with equity financing offering greater flexibility on the surface and reduced impact to cash flows, but likewise compromised by its tendency to dilute control and to be of higher cost in the long term compared to debt financing. Debt financing, especially senior debt financing, offers the advantages of low costs in terms of lower interest rates, and of giving the borrowing company complete, unadulterated control of the company's destiny. On the other hand, debt financing impacts cash flow and hinders the company from using cash flow and profits to finance other projects. This is due to the payments that are required on a regular basis to service the debt. There is an opportunity for the firm to float shares in an initial public offering on markets outside of the UK, but this has to be explored in greater depth, given how any equity infusion dilutes ownership and control. On balance, and culling the insights from real-life companies employing differing modes of financing, senior debt financing is the best option for the company (FindLaw 2013; Advani 2006; National Federation of Independent Business 2013; Nolo 2007; Berman and Knight 2009; Terjesen n.d.; Ivashina and Kovner 2008; Kokemuller 2013; Peavler 2013; SimplyFinance 2007; DCA Partners n.d.; Doidge et al. 2011; Krantz 2013; Gan and Applegate 2013). II. Sourcing Funding for the Firm A. Funding Opportunities There are various camps and schools of thought advocating either debt or equity as the preferred mode of funding that yields the most benefits to firms. On the one hand are arguments for debt being cheaper sources of funding, and being sources of funding that does not dilute the ownership stake of current shareholders. This favors the interests of the owners of this firm, who have valid concerns about loss of control tied to funding options (Berman and Knight 2009). On the other hand, there are schools of thought that tout private equity as being of greater overall benefit to firms in comparison to debt financing, for various reasons as well Arguments are tied to the cost of either source of financing, with debt requiring, in some cases, lower returns on investment in comparison to equity infusions, where investors may require of the current owners higher returns, as well as voting rights and ownership rights commensurate to their investments. The rest of this report explores the different options and their implications for the company as well as the issues of interest discussed above (FindLaw 2013; Advani 2006; National Federation of Independent Business 2013; Nolo 2007; Berman and Knight 2009; Terjesen n.d.; Ivashina and Kovner 2008; Kokemuller 2013; Peavler 2013; SimplyFinance 2007; DCA Partners n.d.). The table below details the key points to consider relating to using either debt or equity to finance the project at this company, as well as to source on-going funds moving forward (DCA Partners n.d.): Table Source: DCA Partners n.d., p. 4 The key differences relating to the concerns of the owners of this company are with regard to level of involvement, which is higher for equity financing options, as well as costs, which is lower for debt financing, together with the role of the providers of the capital in board-level decision making. This latter point relates to how much control the owners cede with equity financing and debt financing, which is in general greater for the former. There are fewer restrictions in equity financing too, in general, with the relationship being more of collaborators in comparison to debt financing (DCA Partners n.d., pp. 1-4). B. Power Reduction Issue, Mitigation As earlier discussed, there is the issue of loss of control and the reduction of power that is tied to some forms of financing, in particular equity financing. In equity financing, as discussed to some extent above, those who infuse equity into the company get to have a say in the way the business is run, indirectly or indirectly, in proportion to the amount of money that they infuse. In cases where the infused capital is greater than the capital infused by the original five owners of the company at present, those who bring in additional money may come to gain a greater amount of power in the running of the company under the law, to the detriment of the need of the current owners to continue to have control over their own company's destiny and day-to-day operations (FindLaw 2013; Advani 2006; National Federation of Independent Business 2013; Nolo 2007; Berman and Knight 2009; Terjesen n.d.; Ivashina and Kovner 2008; Kokemuller 2013; Peavler 2013; SimplyFinance 2007; DCA Partners n.d.). On the other hand, there is some agreement in the literature that where the risk of diminution of control are present for both debt and equity, there are ways to mitigate the risks for both, for example, by limiting the infusion of either debt or equity, or both, to manageable levels, and to levels that do not dwarf the equity of the current owners. The way to mitigate loss of control via debt is to limit debt to manageable levels. Similarly, one way to mitigate loss of control via equity financing is to limit equity financing to levels that are much smaller than the equity of the owners. There are also loan and equity infusion covenants or agreements that can be set in place so as to precisely determine who controls what and to what extent within the company. Taking a step back though, there is some agreement that between debt and equity, it is equity infusions that offer more opportunities for current company owners to lose substantial control of the company, and to end up paying larger amounts to the equity investors over time, in comparison to debt financing (FindLaw 2013; Advani 2006; National Federation of Independent Business 2013; Nolo 2007; Berman and Knight 2009; Terjesen n.d.; Ivashina and Kovner 2008; Kokemuller 2013; Peavler 2013; SimplyFinance 2007; DCA Partners n.d.). C. Equity vs. Debt: Pros and Cons Relating to On-Going Funding The previous discussions on loss of control and on funding opportunities touched on the pros of cons of debt financing as well as equity financing for the company. For equity financing, there are various pros going for it, including that under the law, the owners of the company are not compelled to pay back the capital infused into the firm, nor to pay interests on the infused monies (Terjesen n.d., pp. 1-2). Moreover, there is the advantage of not being in debt and not being compelled to spend substantial amounts to pay back the debt, which is of tremendous benefit to small enterprises, and firms that are just starting out, as well as companies that are generally debt-averse and are not experienced in managing debt. For the company at present, having been able to thrive without recourse to debt, this is the case. Equity financing, moreover, has the additional benefit of not guaranteeing equity investors of any returns, and of the company being able to choose equity investors who are willing to share the risks tied to the uses of the equity financing. In equity financing, investors share the risks. On the other hand, equity financing comes with its own disadvantages. Equity investors share the risks, but they also share the rewards of the business undertaking, in proportion to the amounts that they invest. With such risk and rewards sharing also come the ability of the investors to gain power and dictate to a certain extent where the company ought to go strategically. The owners become answerable to the equity investors in other words, reflecting a loss of autonomy, control and the ability to chart the course of the company without investors watching their backs, so to speak (Peavler 2013; Kokemuller 2013; SimplyFinance 2013; Advani 2006; National Federation of Independent Business 2013; DCA Partners n.d.). There are several advantages to debt financing meanwhile. One of them is that debt gives the company greater control of the firm in comparison to equity financing, which may entail loss of control. The profits that the company makes all go to the firm, rather than shared with equity investors. Moreover, interest payments on debts made by the firm go into computations for taxes, so that interest payments result in reduced tax burdens for the company moving forward. This is of course tied to the amounts of the loans involved, and the interests paid on the loans. At any rate, tax deduction inputs on debt are not available for equity. Another thing, with debt financing the providers of the debt require no more than the payment of the principal as well as the interest of the loan, and have no right to partake of any profits. Their interests and rights extend only as far as making sure that the company pays the agreed upon amounts in a timely manner. On the other hand, there are also disadvantages to debt financing. Debt financing, for one, gives the lending firms dibs on future earnings, in the form of committed debt repayment sums, together with interest. This limits the ability of the firm to reinvest earnings for growth, or to cash in on profits for the uses of the owners. This is because a part of profits and cash flow have to go to paying back the debt. One of the biggest disadvantages of debt financing is that the repayments are set in stone, regardless of how the company or the project fares. (FindLaw 2013; Advani 2006; National Federation of Independent Business 2013; Nolo 2007; Berman and Knight 2009; Terjesen n.d.; Ivashina and Kovner 2008; Kokemuller 2013; Peavler 2013; SimplyFinance 2007; DCA Partners n.d.). The table below details one summary of the advantages and disadvantages of debt (loans) versus equity (investments) (Nolo 2007): Table Source: Nolo 2007 D. Different Kinds of Debt and Equity Financing The most common type of debt financing for companies is what is called Senior debt, so called because it takes the highest precedence for payments among other kinds of debt as well as equity financing. This in contrast to what is called subordinated debt. Senior debt is backed up by collateral, in the form of company assets, including cash flow and physical assets, as well as other funding sources from the company whenever cash flow is not enough to service debt payments. Senior debt is often cheap, and cheaper than other forms of debt financing and equity financing (DCA Partners n.d., p. 2). A notch below senior debt is mezzanine debt or subordinated debt, whose name flows from the fact that in the capital structure of firms, this is secondary to senior debt in priority of payment and of retrieval of capital in case of debt default This in itself constitutes a higher risk for the lending entity, and as such mezzanine debt carries a higher demanded return on the loan in the form of higher interest rates, as well as demands in some cases for the loan to come in with equity thrown in as well, in order to make sure that the lenders are able to make profits from the investment commensurate with the risks. Moreover, many forms of mezzanine debt arrangements have the requirement that a part or the total interests on the loans be paid back either on a monthly basis or a quarterly basis. This arrangement constrains the ability of the borrowing firms to reinvest earnings and cash flow back for other projects and necessary expenditures. The higher interest rates for subordinated/mezzanine debt translates to higher costs to service the debt on an on-going basis (DCA Partners n.d., p. 3). Equity financing, as discussed earlier, involves investors infusing capital into the company in exchange for a stake in the ownership of the company, a say in the running of the firm via a board seat, and a share in the profits and losses, among other things. In the current case, with the owners in addition being averse to yielding control of the firm and are wary of such a scenario, equity financing makes even less sense in comparison to debt financing in some form (DCA Partners n.d., pp. 3-4). Meanwhile, the literature details different kinds of equity financing, depending on the stage of the need: seed financing, early-stage financing, expansion financing, and late stage funding (Terjesen n.d., pp. 1-2). E. IPO's Going Global, Implications Globalization and the rise of the Internet has spawned a new reality where companies wanting to raise funding via an initial public offering or IPO are able to do so in the markets that are best suitable for their aims and purposes. There has been a de-linking between where a firm is located on the one hand and where the IPO is held, on the other, with the rise of global investment banks and real-time communication via the Internet making all this possible. The new reality is underscored by data indicating that the level of IPO activity in the west has come to lag behind the rest of the world in terms of the share of such IPO activities to the total GDP of the countries involved, so that the company at present, wanting to raise funds via an IPO, may do so outside of the UK and still be successful. The plot below details how far the US and much of the west, in general, has fallen behind with the rest of the planet in terms of generating IPO activities and raising funds. The plot details the fact that while the rest of the world has upped its game in terms of money generated from IPO's as a percentage of their GDP, the United States and the Europe, including the UK, has fallen by the wayside. The differences plot is the plot at the lowest part of the chart, indicating that the chasm between IPO activity in the US and the west on the one hand and the rest of the world on the other has grown through the years (Doidge et al. 2011): Plot Source: Doidge et al. 2011 F. Implications of Different Funding Sources for Management Motivation It is clear from the previous discussions that we can place the differing funding options along gradients of cost, control and other issues relevant to the firm. For the company, which is concerned with loss of control and has no debt, the motivation is to cede as little control as possible, while being able to satisfy its need for funding the project and getting future funding for additional requirements. In this regard equity financing may be a demotivator rather than a motivation for the company at present. On the other hand, firms with larger financing needs, and are high-risk, may find motivation in actively seeking out equity financing over more limited debt financing options. Meanwhile, in terms of cost, both at present and in the long term, the lower costs of debt financing ought to be a motivation for this company, aiming to secure adequate financing for a project at viable rates, and with little to no loss of control of the company's destiny (FindLaw 2013; Advani 2006; National Federation of Independent Business 2013; Nolo 2007; Berman and Knight 2009; Terjesen n.d.; Ivashina and Kovner 2008; Kokemuller 2013; Peavler 2013; SimplyFinance 2007; DCA Partners n.d.). . III. Real-World Examples A. Funding Opportunities Google is debt-free, and completely finances operations and new investments with cash on hand as well as cash flow (Berman and Knight 2009). Microsoft, on the other hand, sources funding from a mix of internal funding from cash flow and cash on hand, as well as debt. Microsoft has also been able to source equity funding, successfully, in the stock market via an IPO. Its D/E ratio is 0.14, indicating that it has some debt equal to 14 percent of its total equity (Forbes.com 2013). At the other extreme are firms that have little equity in comparison to their mammoth debts. Some highly regarded and profitable firms, such as General Electric, have debt levels that are three times their total sales for a given year, indicating the wide range of funding options for companies along a gradient from pure debt to pure equity (Krantz 2013). B. Forms of Debt and Equity You'd expect that the major stocks identified earlier, when they employ some form of debt to finance their projects and operations, would do so using senior debt, including long-term debt. The stellar credit ratings of the likes of Microsoft means that they are moreover able to secure debt financing at very low rates (Forbes.com 2013). On the other hand, companies like Google employ no debt at all, and are comfortable using internal equity as well as cash flow in order to fund projects and operations (Berman and Knight 2009). General Electric, given its large debt relative to revenues, must employ a mix of equity, mezzanine debt, and senior debt to finance its projects and operations (Krantz 2013). C. IPO's Going Global That IPOs have gone global is evident from the chart presented earlier, indicating that the rest of the world has caught up with the west in terms of IPO activity; This is of course, relative, as the figures are for IPO monies as percentages of GDP (Doidge et al. 2011). In absolute amounts, the west still leads by a mile. On the other hand, companies have successfully raised money via IPO's in other global markets. A chart from Newsweek shows markets such as Malaysia garnering substantial IPO activity in 2012, indicating that moving forward UK firms may be able to successfully launch an IPO in other foreign markets (Gan and Applegate 2012). IV. Glossary Creditors/Partners These are people who either provide equity, or debt financing respectively (DCA Partners n.d., p. 4). Cost of Capital The interest rate on a loan or debt package, or the required return on investment. For equity partners, the share of the profits commensurate with the amount invested (DCA Partners n.d., p. 5). Payments Money given back to lenders or equity partners in exchange for the use of capital provided (DCA Partners n.d., p. 5) Maturity The date when a debt becomes due, or the set date by equity investors for leaving the company and liquidating their equity investments in the company (DCA Partners n.d., p. 5). V. Conclusion It is clear from the preceding analysis that for the company, equity financing is not as viable as debt financing for a number of reasons, chief among them that the company is wary of ceding control of the company to any outside investor, and rightly so. Debt financing totally avoids the issue of control, while offering the company access to funding for the project now and in the future at interest rates and overall costs that are lower in comparison to equity financing. Given the options moreover, and given that the company has zero debt, it makes sense for the company to pursue senior debt as the preferred mode of raising funds for the project at hand. This is also the viable mode of financing for future funding requirements (FindLaw 2013; Advani 2006; National Federation of Independent Business 2013; Nolo 2007; Berman and Knight 2009; Terjesen n.d.; Ivashina and Kovner 2008; Kokemuller 2013; Peavler 2013; SimplyFinance 2007; DCA Partners n.d.; Doidge et al. 2011). VI. Referencing and Presentation Advani, Asheesh 2006. Choosing Between Debt and Equity Financing. Entrepreneur [Online] Available at: http://www.entrepreneur.com/article/159518 [Accessed 11 January 2013] Bergman, Karen and Knight, Joe 2009. When is Debt Good? Harvard Business Review[Online] Available at: http://blogs.hbr.org/financial-intelligence/2009/07/when-is-debt-good.html [Accessed 11 January 2013] DCA Partners n.d. Understanding a Firm's Different Financing Options. DCAPartners.com. [Online]. Available at: http://www.forbes.com/2007/01/05/equity-debt-smallbusiness-ent-fin-cx_nl_0105nolofinancing.html [Accessed 11 January 2013] Doidge, Craig et al. 2011. The US left behind: The rise of IPO activity around the world. Vox. [Online]. Available at: http://www.voxeu.org/article/us-left-behind-rise-ipo-activity-around-world [Accessed 11 January 2013] FindLaw 2013. Debt vs. Equity- Advantages and Disadvantages. FindLaw.com. [Online]. Available at: http://smallbusiness.findlaw.com/business-finances/debt-vs-equity-advantages-and-disadvantages.html [Accessed 11 January 2013] Forbes.com 2013. Microsoft Corp Financial Ratios. Forbes.com. [Online]. Available at: http://finapps.forbes.com/finapps/jsp/finance/compinfo/Ratios.jsp?tkr=MSFT [Accessed 11 January 2013] Gan, Yen Kuan and Applegate, Evan 2013. The Global IPO Market, 2012. Bloomberg Business Week. [Online]. Available at: http://www.businessweek.com/articles/2012-12-12/the-global-ipo-market-2012 [Accessed 11 January 2013] Ivashina, Victoria and Anna Kovner 2013. The Private Equity Advantage: Leveraged Buyout Firms and Relationship Banking. Harvard Business School/ Federal Reserve Bank of New York [Online] Available at: http://www.sml.hw.ac.uk/ms75/group%20papers/G4_81.pdf [Accessed 11 January 2013] Krantz, Matt 2013. Many US companies have large debt. Chicago Sun-Times [Online] Available at: http://www.suntimes.com/business/5136893-420/many-u.s.-companies-have-large-debt [Accessed 13 January 2013] Kokemuller, Neil 2013. The Advantages and Disadvantages of Debt and Equity Financing. Houston Chronicle[Online] Available at: http://smallbusiness.chron.com/advantages-disadvantages-debt-equity-financing-55504.html [Accessed 11 January 2013] National Federation of Independent Business 2013. Debt vs. Equity Financing: Which is the Best Way for Your Business to Access Capital?. NFIB [Online] Available at: http://www.nfib.com/business-resources/business-resources-item?cmsid=50036 [Accessed 11 January 2013] Nolo 2013. Financing a Small Business: Equity or Debt? Forbes.com [Online] Available at: http://www.forbes.com/2007/01/05/equity-debt-smallbusiness-ent-fin-cx_nl_0105nolofinancing.html [Accessed 11 January 2013] Peavler, Rosemary 2013. Debt and Equity Financing. Business Finance About [Online] Available at: http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm [Accessed 11 January 2013] SimplyFinance 2013. Pros and Cons of Debt and Equity Financing. SimplyFinance [Online] Available at: http://www.simplyfinance.co.uk/articles/pros_cons_of_debt_financing.html [Accessed 11 January 2013] Terjesen, Siri n.d. Understanding Equity Capital in Small and Medium-Sized Enterprises. Qfinance [Online] Available at: SimplyFinance 2013. Pros and Cons of Debt and Equity Financing. SimplyFinance [Online] Available at: http://www.qfinance.com/contentFiles/QF02/gjbkw9a0/17/0/understanding-equity-capital-in-small-and-medium-sized-enterprises.pdf [Accessed 11 January 2013] [Accessed 11 January 2013] Read More