Financing the Corporation
In the context of a corporation, one of the most pivotal tasks of management is to ensure that adequate funds are available. Funding is required not only for the daily operations of the business, but also for the growth and expansion of the firm. Whether the goal is expansion of current business lines, entering new markets, or purchasing other firms in order to enter those markets, the expansion of a business is critical to a firm’s survival over time, and can only be accomplished through the spending of funds to that end.
In some instances, funding for business operations can be achieved through internal funding, via operating cash flows (i.e., profits from the company’s business). If the company is small enough, funding for expansion might come from a bank loan. If no such bank funding is available or if a large amount of cash is required, funding might be accomplished through an issuance of some sort of note (such as a bond). If substantial funding is required and the timing is right, then the company might consider entering the securities markets – either for its initial round of funding known as an “Initial Public Offering” (IPO) or through the issuance of shares or a new class of new shares.
EXAMPLE: Emerging, Inc. had been in business for several years and had consistently earned strong operating profits. The company had undertaken a new expansion program to diversify and to spread its business operations into new areas. Initially, the company sought funding from its own operating profits. However, the company was given an extremely good opportunity to buy a competitor, which would accomplish the expansion program in one transaction. Initially, the company tried to raise funds from a syndicate of banks. However, there were not enough such banks that were willing to lend funds to Emerging. The company then tried to raise funds through a group of wealthy private investors. However, no group could be found that would be willing to accept the promissory note that the company wanted to issue on the terms that the company was prepared to offer. Finally, the company determined that its only chance to accomplish its desired goal was to prepare and complete an initial public offering (IPO). Given the status of the company and its strong track record, the company felt that it would be able to raise a large amount of money through the IPO in order to finance its acquisition plans.
The type of funding that a company chooses to take will vary, not only based on its capital needs, but also based on the obligations it is willing to take on. The negative effects of any funding arrangement are that any such arrangement will alter the company’s balance sheet in such a way that the company either takes on more debt or further expands its shareholder base by issuing more shares. Both of these choices have consequences that may adversely affect the firm if all of the issues are not carefully considered before being undertaken.
1. Using Operating Funds
If the company chooses to use funds currently available to finance an acquisition or expansion, then the company is dipping into cash that may be otherwise required for operations or to deal with other financial problems. Additionally, the market may view such a decision unfavorably if the cash could have been otherwise distributed to shareholders as dividends, or if other, cheaper means of financing were available in the financial markets.
2. Bank Loans and Notes
Any type of bank loan, debenture, or other payable note is going to place debt on a company’s balance sheet. While it is not necessarily a bad thing for a company to have some amount of debt on its balance sheet, carrying too high a debt load can subject the company to severe financial problems if operating cash flows are not strong enough to handle the required debt payments.
EXAMPLE: While the company was expanding, Kinetic Co. had taken out a series of large bank loans to finance a group of small acquisitions. When the company took out the loans, interest rates were high, and the terms of the loans were such that the loans could not be paid back early. Due to a change in the markets, the company’s prospects soured and profits declined. As such, it was not long before the company was facing some severe financial worries due to the fact that it was having difficulties in keeping up with the required payments on its loans.
3. Public Issuance of Securities
As we have discussed previously and will continue to study in greater detail in this chapter, the final funding option is for a company to issue securities – i.e., stocks and bonds – either on a public exchange or to place them up for public trading. The issuance of stocks and bonds – stocks being ownership of a share of the company and bonds being loans from private people to the company – is an attractive option for companies that want to raise funding without having to secure a private loan or other private source of funding.
However, while public sale of stock may be an easy form to raise capital for a large, well known company with a sound financial history, there are some negatives involved with that process. First, any issuance – whether by a new company or a company that is already public - costs a great deal of money in legal fees and filing expense. Moreover, any time a company places a new security in the market, it is opening up its doors to public scrutiny and it subjects itself to the strict and complex regulations of the federal securities laws set forth in the Securities and Exchanges Commission (SEC) Acts. For information on the SEC Acts and their purposes from the SEC web site, click here.
In the end, however, the public markets provide the most promising source of funding for any large company that needs to raise a large amount of cash and do so quickly. In the remainder of this chapter, we will introduce ourselves to the public securities market – principally the market for stock securities – learning both how this market works and what your role will be as a legal professional in assisting a company intent on listing securities on those markets.