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There are many different types of instruments an emerging business may issue to finance its growth. In general, financing instruments fall into one of two categories — debt or equity.
Although there are certain exceptions, debt instruments generally represent fixed obligations to repay a specific amount at a specified date in the future, together with interest.
In contrast, equity instruments generally represent ownership interests entitled to dividend payments, when declared, but with no specific right to a return on capital.
Within each of these two general categories, there are a wide variety of rights, privileges, and limitations that may be established by the issuing company.
Common stock is the most basic form of equity instrument. It represents an ownership interest in a corporation, including an interest in earnings, that translate into declared dividends, as well as an interest in assets distributed upon dissolution.
Common stock may be voting or non-voting and may be divided into classes with special voting privileges assigned to each class. However, common stock is typically entitled to full voting rights, i.e., the right to cast a vote in the election of directors of the corporation.
Holders of common stock have the greatest opportunity to share in a company’s profitability because of the unlimited potential for dividends, appreciation in the value of their common stock, and realization of liquidation proceeds. However, common stock holders also bear the greatest risk of loss because they are generally subordinate to all other creditors and preferred stock holders.
There are several advantages to a company that issues common stock — there is no obligation to repay the amount invested, there is no obligation to pay dividends (thereby enabling earnings to be reinvested in the business as necessary), there is a right bestowed upon investors to share in the growth of the corporation, and investors are allowed the opportunity to influence management through their right to vote for directors.
Several disadvantages in issuing common voting stock include — a dilution of management’s interest in the corporation’s growth, an increase in the voting power of non-management stockholders, and investors must bear the maximum risk of losing their investment.
Preferred stock is another form of equity instrument. It represents a hybrid in the sense that it is an equity interest with certain features resembling debt.
Preferred stock has preference rights over common stock with respect to dividends and liquidation proceeds. In other words, it has priority when dividend payments and liquidating distributions are made. If desired, dividends can accrue at a pre-established rate and can be paid on a cumulative basis when cash flow permits. Also, preferred stock may be voting or non-voting or entitled to certain redemption rights.
Several advantages to issuing preferred stock include — no dilution of management’s interest in corporate growth or in voting power (if non-voting preferred stock is issued), and predictable dividend payments and preferences upon liquidation (for which investors may pay a premium).
Disadvantages include — a subordination of dividends to be paid on common stock and limitations on the use of corporate funds to the extent that pre-established dividend payments must be made.
Debt instruments, such as notes, bonds, and debentures, are generally entitled to receive payments which are senior in priority to preferred or common stockholders. Debt instruments may be secured by certain assets of the corporation or may be unsecured (i.e., backed by a simple pledge of the corporation’s credit).
Debt instruments generally have no right to participate in the overall appreciation in value of the corporation. Debt instruments may also be long-term or short-term in duration, and carry variable or fixed interest rates. Debt instruments may impose certain affirmative or negative obligations upon the corporation, including restrictions on the ability of the corporation to complete certain transactions (such as incurring other indebtedness or issuing capital stock).
Several advantages to issuing debt instruments include — predictability of payments to investors, no dissolution in management’s interest in corporate growth and voting power, and investors assume less risk of loss in their investment.
Disadvantages include — potential restrictions on operations, limitations on the use of working capital due to debt service obligations, and tying up assets through pledges as collateral.
Both debt and equity financing instruments may be convertible into different types of securities. Debt instruments may be convertible into either common or preferred stock and preferred stock may be convertible into common stock.
A convertibility feature attached to a debt or equity instrument may be attractive to an issuing company since it may bear a lower interest rate and dividend payment. Convertible instruments afford maximum flexibility to investors allowing them to shift the risks and rewards of their investment at some point in the future after initial investment.
There are numerous considerations involved in the planning process to issue debt or equity instruments to investors. The planner should take into account the various types of instruments which may be issued and the respective advantages and disadvantages of each type from both the viewpoint of incumbent management as well as prospective investors. Both near-term and long-term objectives for each should be maximized when developing financing strategies.