Chapter 1
Pitching Your Story for Money
FEverything that makes up a corporation and everything a corporation owns, including the building, equipment, office supplies, brand value, research, land, trademarks, and everything else, are considered assets. Believe it or not, when you start a corporation, that company’s assets aren’t just included in a Welcome Let- ter; you have to go out and acquire them. Generally speaking, you start off with cash, which you then use to purchase other assets.
Telling a Story with Numbers
For most new companies, this cash consists of a combination of the following:
» The owner’s own money: This money is considered equity because the owner can still claim full possession over it.
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» Small loans, such as business and personal loans from banks, business and personal lines of credit, and government loans: The money obtained through loans is considered a liability because the corporation has to pay it back at some point. In other words, these loans are a form of debt.
The combination of these two funding sources brings me to the explanation of the most fundamental equation in corporate finance:
Assets = Liabilities + Equity
The total value of assets held by a company is equal to the total liabilities and total equity held by the company. Because the total amount of debt a company incurs goes into purchasing equipment and supplies, increasing debt through loans increases a company’s liabilities and total assets. As owners contribute their own funding to the company’s usage, the total amount of company equity increases along with the assets. Note: Capital, assets, money, and cash are basically all the same thing at this point; after a company raises the original capital, or cash, it exchanges that cash for more useful forms of capital, such as erasable markers.
Unlike liabilities, equity represents ownership in the company. So, if a company owns $100,000 in assets and $50,000 was funded by loans, then the owner still holds claim over $50,000 in assets, even if the company goes out of business, requiring the owner to give the other $50,000 in assets back to the bank. For cor- porations, the equity funding varies a bit, however, because the owners of a cor- poration are the stockholders. The equity funding of corporations comes from the initial sale of stock, which exchanges shares of ownership for cash to be used in the company.
The rest of this chapter discusses the two main ways businesses raise capital.
Diving into Debt
When a corporation needs money, one of the primary options it has available is to borrow some. Now, I’m not talking about borrowing a few hundred bucks from a friend or family member; I’m talking about borrowing an amount of money suf- ficient enough to fund the startup of a new company, the expansion of an existing company, the purchase of expensive equipment, or the acquisition of another company. Loan requests are very much defined by the numbers being presented to lenders. How much are you asking, what percentage of the total are you providing yourself, what is the business’s history of revenues, how likely are you to repay the debt, and so on. The story you tell here must be entirely nonfiction, written strictly in numbers.
Regardless of what the money’s for, when a corporation wants a loan, it starts by putting together a proposal. For startup companies, this proposal comes in the form of a business plan, but anytime a corporation receives a loan significant enough to influence the capital structure of the company (not lines of credit), it has to present a proposal for the use of the funds. This proposal includes financial information about the corporation, including detailed predictions for future financial well-being, called projections, that prove the company can pay back the loan on time and without risk of default. For more information about business plans, which you can use in many forms of proposals, you may want to read Busi- ness Plans For Dummies (Wiley Publishing, Inc.) by Paul Tiffany, PhD, Steven D. Peterson, PhD, and Colin Barrow.
The following sections explain what a corporation must do after its proposal is ready to go, including where to go to ask for money and how to evaluate the worth of a loan and its terms.
Asking the right people for money
After the proposal is in place, corporations have a few options for where to go to ask for the money they need:
» Commercial banks: Banks are very common sources for corporate debt financing. These loans work very similar to any other loan, wherein your ability and planned use of the funds will both be evaluated in detail before the bank agrees to offer the loan. The findings of their investigation will deter- mine, in part, the interest rate they will charge, the amount they will loan, and the duration of the loan.
» Government loans: These loans are frequently available, but they’re often reserved for special types of corporations (usually in a field that the govern- ment is trying to promote), corporations with a special role in the nation (such as defense contractors).
» Issuance of bonds: Bonds, which basically act as IOUs, are possibly the most popular form of debt financing. A company goes through an underwriter to have bonds issued, and then private investors purchase those bonds. The company keeps the money raised as capital with a promise that it’ll pay back the bondholders’ money with interest. Bonds come in many different flavors; turn to Chapter 11 for more details.
After a potential moneylender receives the corporation’s loan application, an interview process typically occurs, along with an underwriting process during which the potential lender assesses the borrower for risk, financial ability to repay the loan, credit history, and other variables. If the lender approves the loan appli- cation, the money is deposited in the corporation’s bank account, making it avail- able for use by the corporation in a manner consistent with the original proposal.
Making sure the loan pays off in the long run
The responsibility for making sure a particular loan is beneficial to a company lies with that company. Every loan, except for those rare federally subsidized loans in which the government pays for the interest, incurs interest, meaning you and your company pay more money back to the lender than the lender originally gave you.
Here’s a quick look at how interest works:
B = P(1 * r) * t
This equation says that the balance (B) is equal to the principal amount (P) times the rate (r) exponentially multiplied by time (t). So, if your company borrowed $100 at an interest rate of 10 percent for one year without making any payments, then the amount of money your company owes at the end of that one year looks like this:
B = 1001 * 0.11
The answer, then, is $110 (because $10 is 10 percent of $100 and interest is accrued annually for only one year). When accepting a loan, the goal of every company is to make absolutely sure that it can generate more returns from spending the money borrowed than the interest rate being charged. After all, by keeping the loan, the corporation agrees to pay back interest as well as the principal. So, if your company spends the money it borrowed in the preceding example on a new machine, it has to generate more than 10 percent profitability from that single machine in order to make the loan worth the 10 percent interest rate. This is a simplified example that doesn’t take several real-world variables into consideration, but before you consider more realistic examples you need to learn about some additional topics.
If a company absolutely must raise capital but can’t generate enough value to pay back the interest rate, it’ll end up losing money on the loan. As a result, it might want to pursue an alternative option for raising capital, such as selling equity.
Looking at loan terms
You have a few different options available when choosing a loan for your com- pany. To make the best choice for your company, you need to be aware of the pros and cons of each loan type. If you’re not sure which one is best for you, ask a pro- fessional analyst — not the person trying to sell you the loan. Here are some terms you need to be aware of:
» Fixed versus variable rate: When you take out a fixed-rate loan, the percent- age interest you pay will always be the same. For example, if you take out a loan with 5 percent APR (annual percentage rate, which is your annual interest rate), then you will always be charged 5 percent interest per year. With a variable rate loan, the interest rate you pay will change; the amount of change depends on the type of loan. Variable rate loans come in many types, and their rates change based on another interest rate, a stock market index, your income, or some other indicator. Some increase gradually over time, while others start low and jump after a period of time (these are called teaser-rates).
While the wide variety of variable rate loan options is great news for the financially inclined, these types of loans can be very dangerous for beginners. The amount of information and the calculations involved in predicting the movement in variable interest rates can be a deceptively daunting task, even for experienced analysts.
» Secured versus unsecured: Secured loans are tied to some asset, which becomes collateral. Basically, you tell the bank that if you fail to pay back your loan, the bank can keep and/or sell that particular asset to get its money back. With unsecured loans, no assets are directly considered to be collateral to which the lender has automatic rights upon the borrower’s default of the loan. However, they can still hurt the credit history of the company, and a lender can still sue to get their money back.
» Open-ended versus closed-ended: Closed-ended loans are your standard loans. After your company gets one, it makes periodic payments for a predetermined time period, and then the loan is paid back, and you and the lender are both done. Think of a closed-ended loan like a mortgage, except that it’s not used to buy a house. Open-ended loans are more similar to credit cards. Your company can draw upon an open-ended loan until it reaches a maximum limit, and it just continuously makes payments for as long as it has a balance.
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» Simple versus compounding interest: Simple interest accrues based only on the principal loan. In other words, if a loan for $100 charges 1 percent interest, the lender will make $1 every period. On the other hand, compounding interest pays interest on interest. So, if the borrower doesn’t make any payments on a loan of $100 with 1 percent interest in the first year, then the loan will charge 1 percent interest on $101 rather than the original $100 the second year. This type of interest is far more common with bank accounts than loans. (Turn to Chapter 9 for more on these two types of interest.)
If a company were to go out of business, any money raised by selling assets will first go to pay lenders.
Schmoozing Investors
Raising money by selling shares of equity is a little more complicated both in theory and in practice than borrowing money using loans. What you are actually doing when you sell equity is selling bits of ownership in a company. Ownership of the company is split up into shares called stock. People only buy stocks when they are excited by the things they hear about them, so your story has to be par- ticularly good when compared to the relatively number-driven world of loans. Although it is illegal to say anything fictional, it is common to share a company’s vision of their future with potential investors, providing a bigger emotional impact.
When you own stock in a company, you own a part of that company equal to the proportion of the number of shares of stock you own compared to the total num- ber of stock shares. For example, if a company has 1,000 shares of stock outstand- ing (meaning that this is the total number of shares of stock that make up the entire company) and you own one share, then you own 0.1 percent of that com- pany, including any profits or losses it experiences (because profits belong to the owners of the company). So, when you sell equity to raise cash, what you’re really selling are the rights to a certain amount of control over how the company is managed in addition to your rights to the future profits of that company.
Selling stock to the public
When a company is getting ready to go public, meaning it’s opening up the pur- chase of equity to the public, it must first put all its records and reports in the proper format. The U.S. Securities and Exchange Commission (SEC) requires that all U.S. public companies follow specific criteria for keeping track of financial information and reporting it to the public. The company must also meet a number
of accountability requirements and other more minor requirements. In other words, before becoming a corporation, a business must act like a corporation. Often this includes hiring a consultant or an investment banker to help make sure everything is in order. Then, finally, the company can go through the process of becoming established as a corporation and selling stock.
The easiest way to become a corporation is to go through a full-service invest- ment bank. Often the investment bank can take a company through all the steps, including legally reorganizing the company as a corporation, registering with the proper regulatory authorities, underwriting, and selling stock on the primary market. The legal reorganization process alone is well beyond the scope of this book; I recommend just asking a lawyer.
During the underwriting stage, an underwriter evaluates the value of the company and estimates how much the company needs to raise, how much it should raise, and how much it’s likely to raise. That same person verifies that the company meets all the requirements for being a corporation and selling stock. After that, the company can have its first IPO.
An IPO, or initial public offering, occurs when a company sells stock to the public. The IPO is when selling stock raises money for the company. After all, the com- pany will use the money that people pay to own stock to purchase things the company needs to operate or expand. The people who buy stock from the company during the IPO make up the primary market because they take part in the initial sale of stock. After the initial stock is sold to the public, it can be resold over and over again, but the company itself doesn’t make any more money. The subsequent selling of stock is just an exchange of ownership between investors for a price negotiated between those same investors. The exchange of stock between inves- tors is called the secondary market; it doesn’t raise any more money for the company.
Any company, old or new, can have an IPO. All it means is that new stock has been created and registered and is being sold for the first time. If an old corporation decides it wants to raise more money and it thinks investors are willing to pay for more stock, then it can have another IPO to sell new stock that will just add to the total amount of stock the company has on the market.
Looking at the different types of stock
Like most aspects of corporate finance, stocks come in many varieties, but no matter which type of stock your corporation has, its value increases or decreases based on the performance of your corporation. Here are three of the main stock types, along with their distinguishing characteristics:
» Common stock: If you hold common stock in a corporation, you’re a partial owner, so you get to vote in any decisions regarding company policy, the board of directors, and many other issues. Keep in mind that to be brought to a vote, an issue usually needs to be instigated by one stockholder and then supported by others, at which point a voting form goes out to all stockholders of that company to fill out and return.
Holding common stock also gives you rights to a share of dividend payments (profits returned to the company owners) when they’re issued, although this is optional. In case of company liquidation (selling assets after going out of business), common shareholders get whatever value is left over after the lenders and preferred shareholders get what they’re owed. Finally, holding common stock gives you the right to receive specialized reports or analytics from the company.
» Preferred stock: If you hold preferred stock in a corporation, you get your dividend payouts in full before common shareholders get even a dime. That holds true for liquidation as well. As with common stock, being a preferred shareholder gives you the right to get information from a company. But the key difference between common and preferred shareholders is that preferred shareholders don’t have voting rights. So, although they have a right to the ownership and success of a company, they have no voice or control over the actions the company takes.
» Treasury stock: When a company issues common shares of stock, it has the opportunity to repurchase those shares on the secondary market as any investor does. When a company does so, those common shares become treasury shares. The stock itself hasn’t changed at all; it’s just owned by the company that the stock represents. So, in essence, the company owns itself, which is only one step away from becoming completely self-aware and destroying us all! Companies tend to do this (buy treasury stock, not destroy us all) because they can generate income in the same way that many inves- tors do, but buying treasury stock also allows them to manage their stock price more effectively.
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Another stock-related term you need to know, though it isn’t a type of stock per se, is stock split. A stock split occurs when a company takes all of its common shares of stock and splits them into pieces. For example, say a person had one share of stock worth $10 before a stock split. After the split, that person has two shares of stock each worth $5. Companies use stock splits to increase the liquidity of stock shares, making them easier to buy and sell and, in the long run, driving up the total value. Note that this process can easily backfire if there isn’t already a demand for a company’s stock from people who would buy it at the cheaper post-split rate.
Having Your Wish Granted
Depending on the type of industry you are in, and the interests of those with money, you might be eligible for grants. There are grants from different govern- ment organizations, grants from other businesses, grants from universities, grants from special interest groups, and so forth. Generally, they will tell you exactly the kind of work/project they are willing to provide grant function for, in addition to the requirements and process for applying. Ideally, you have an expe- rienced grant writer assist you, but if not, then be prepared to present extensive budgeting and operating information and explain how you can best meet the needs of the organization providing the grant money.
Options for raising money — like private investors, angel investors, crowdsourc- ing, and so on — are exciting and popular paths for small businesses to pursue, but provide almost no real opportunities unless you first develop relationships within those social circles. It’s best to stick with traditional methods of raising capital until your story becomes more well known among these unorthodox routes.