The initiation of any successful business can be split into three stages; firstly the birth of the idea, secondly finding the capital to finance that idea, and finally, the entrepreneur must sell that idea to have a commercially viable business. This article will be focusing on the second stage – the raising of capital.
Capital can be raised in one of two ways; equity capital or debt capital. Raising capital via equity is normally more expensive than debt capital since equity investors (shareholders) demand a higher rate of return on their money due to the higher risk they expose their capital to when compared to debt capital (such as bank loans, bonds and other forms of debt instruments).
When companies raise capital one of their main objectives would be to minimise the overall cost of the capital they are seeking to raise. Be it equity capital or debt capital, the businesses will seek to achieve either the lowest level of dilution, or the lowest rate of interest on the debt instrument – or, even more likely, both.
Raising capital can be as simple as using a bank overdraft facility or as complex as designing a whole capital raising programme which would finance both current operations as well as future growth plans. It is always advisable to plan well in advance for such programmes so as to reduce any chance of jeopardising the business due to lack of finances.
Such programmes would typically be characterised by both debt and equity. The key is to achieve the right debt-equity combination which would minimise the overall cost of capital and hence maximise shareholder wealth. Furthermore, this combination should also be suited to the company’s existing and future expected cashflows in order to ensure longevity of such a programme.
Before progressing any further, since most capital structures include debt capital, we need to introduce the term leverage. Leverage is the amount of debt/borrowings entrepreneurs make use of for every one unit of equity capital invested in the balance sheet of the company. Therefore, if a company has two units of debt for every one unit of equity, the company is said to be twice leveraged.
In such scenarios, businesses will be financed with borrowed capital (bank loans and / or bonds) twice as much as with equity capital.
This is normally perceived to be an aggressive capital structure and hence investors lending this capital would demand a higher rate of interest due to the higher risk exposure.
However, if these same businesses were to raise equity capital (either through capital savings or via the equity market) bringing the leverage down to 0.5x (meaning that the equity injection would quadruple the equity capital in the company’s balance sheet), then the company would be able to pay a lower rate of interest on borrowed capital since the level of risk would be reduced. But, this capital restructuring may be quite costly for the founders of the company. Why?
When entrepreneurs inject more equity into the company’s balance sheet, this could be either their own capital or that of third party investors via an equity issue. This is where the element of dilution comes into play for the entrepreneur. In the former scenario, the founders of the business experience no earnings dilution since they are the ones investing the additional equity capital; however, this is not always the case.
In the latter scenario, where third party investors enter the equation, the founders are no longer the sole equity holders and hence have to share the profits of the company according to the new shareholding – earnings dilution. Furthermore, the required rate of return on equity capital is usually higher than the interest rate banks and bondholders demand on their capital.
Therefore, the whole capital raising programme should seek to achieve the lowest possible overall cost of capital without jeopardising the long-term viability of the business. Hence, achieving the ideal debt-equity balance must always be a vital objective. If the business has too much debt capital then chances are that the business is paying a very high rate of interest on its borrowings due to the increased level of leverage. On the other hand, too much equity capital would reduce the overall return on equity.
Furthermore, the right debt-equity mix would enable the business to access many more potential new business opportunities which would be profitable for the business. The lower the cost of capital the higher the number of new profitable markets and business ventures the company can consider.
In conclusion, the correct pricing and structural design of such instruments is of extreme importance for any business. This may sometimes be overlooked. Additionally, a number of other factors must also be considered such as the company’s tax situation and operating leverage amongst others. Hence, it is always recommended to bring in the auditors and corporate investment advisors to analyse the specific situation.
This article has been prepared by Karl Micallef, an investment executive at Curmi and Partners Ltd, and is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business. Should you wish to discuss this article in further detail, feel free to contact the author on 2342 6127.
www.curmiandpartners.com
Mr Micallef is an investment executive with Curmi & Partners Ltd.