How Firms Choose between Sources of Financial Capital

There are clear patterns in how businesses raise financial capital. These patterns can be explained partly by the fact that buyers and sellers in a market do not both have complete and identical information. Those who are actually running a firm will almost always have more information about whether the firm is likely to earn profits in the future than outside investors who provide financial capital.

Early-Stage Financing

Any start-up firm is a risk; indeed, some start-up firms are only a little more than an idea on paper. The firm’s founders have better information about how hard they are willing to work, and whether the firm is likely to succeed, than anyone else. When the founders put their own money into the firm, they demonstrate a belief in its prospects. At this early stage, angel investors and venture capitalists try to get all the information they need, partly by getting to know the managers and their business plan personally and by giving them advice.

Mature Firms and Broader Access to Capital

As a firm becomes at least somewhat established and its strategy appears likely to lead to profits in the near future, knowing the individual managers and their business plans on a personal basis becomes less important. Information about the company’s products, revenues, costs, and profits becomes more widely available as the business becomes more established. As a result, other outside investors who do not know the managers personally, like bondholders and shareholders, are more willing to provide financial capital to the firm.

Choosing Between Capital Sources

At this point, a firm must often choose how to access financial capital. It may choose to borrow from a bank, issue bonds, or issue stock. The great disadvantage of borrowing money from a bank or issuing bonds is that the firm commits to scheduled interest payments, whether or not it has sufficient income. The great advantage of borrowing money is that the firm maintains control of its operations and does not have to consider shareholders’ desire for a return on their investment. Issuing stock involves selling off ownership of the company to the public and becoming responsible to a board of directors and the shareholders.

Advantages and Challenges of Issuing Stock

The benefit of issuing stock is that a small and growing firm increases its visibility in the financial markets and can access large amounts of financial capital for expansion, without worrying about paying this money back. If the company is successful and profitable, the board of directors will need to decide upon a dividend payout or how to reinvest profits to further grow the company. Issuing stock for an IPO is expensive and complicated. It involves the expertise of investment bankers and attorneys, and requires following reporting requirements to shareholders and government agencies, such as the federal Securities and Exchange Commission.

As you can see, raising financial capital for a businesses becomes more complex when more options are available.