Types and Sources of Long-Term Funds
In this article, experienced CIMA tutor and Finance Pillar specialist James Griffiths walks you through the key concepts associated with long-term funding and finance.
In this article, we'll identify and explain a number of aspects of long-term financing. First, we’ll take a look at equity finance. We'll then explain debt finance by way of contrast. We’ll also elaborate the two classic ways of obtaining finance from a company point of view. We'll have a quick look at the stock and bond markets, and the role of advisors in that context (in a nutshell, advisors get involved in coordinating the financing process and helping to ensure the process is as smooth as possible). So in summary, we will be covering: equity finance; debt finance; stock and bond markets; and the role of advisors.
Equity Finance: Ordinary Shares
First of all, equity. We're talking about the issuance of finance, and specifically the issuance of shares. There are two types of shares: there are ordinary shares, and there are preference shares. We'll have a look at both of them, starting with ordinary shares. It's very important that we get our terminology right, so think of this from the point of view of a company. If a company wants to obtain financing, get some cash, it will do what's called “issuing” of share capital. It can issue an ordinary share, which is just a piece of paper with “share” written on it, and it's issued with an associated par value, which is sometimes called the nominal value, and that will be written on the share: $1, $0.5, $5 – whatever it might be. The company doing the issuing decides on the par value.
If shares are being issued for the first time, if this company has just been created, then the chances are the shares will actually be issued at their par value. They can be issued at a higher price, but that will typically be once the company has established a track record, has achieved some brand awareness and is generating income and profit. So, to start with, all the shares are issued at par value. Each share gives you the right to vote. So, one share, one vote. It's possible this might not be the case in certain circumstances, but one can assume with ordinary shares that it always will be. Ordinary shares will give you the right, but not the obligation, to participate, to get involved in the way in which the company is being run. This might involve helping to appoint directors, to suggest auditors, to talk about the long term strategy – that kind of thing. The ordinary shareholders are effectively the owners of the business and they can dictate what happens in that business. As a shareholder you can also receive a return on your investment. You can receive a dividend. Again, there’s no obligation to issue a dividend to shareholders. Ordinary shares can pay a dividend, but it’s up to the company to decide whether or not they do. There's a significant amount of risk associated with owning an ordinary share because you don't know whether you're going to get a return on your investment.
If the company that you invest in and that has issued your shares goes into liquidation (i.e. it gets wound up, divided up into bits, and sold off to cover its obligations to external parties), then the ordinary shareholders are entitled to receive a share of the assets at liquidation, what's left after liquidation. The amount they get will be restricted to the amount they invested in the first place. And they're actually, as we'll see later on, going to be quite low down in a big long queue of people that are waiting to be paid. So they only might receive their original investment in return. A lot of the time there's nothing left by the time it gets down to the ordinary shareholders.
So the key points to remember with ordinary shares are: (i) they confer a right (though not obligation) to vote; (ii) they confer a right to be involved in the running of the business; and (iii) they make it possible to receive a dividend.
Ordinary shares can be issued in a number of different ways, and there are three we’ll focus on here. This is the way in which companies can actually sell shares. They can issue them at market price/value (which hopefully will be going up and up!). In other words, shares are sold for cash value at the going market rate. A bonus issue is where shares are actually given away for free; there's no cash being received. Those shares still confer a right to vote, and to receive a dividend (wherever that is in place). Normally a bonus issue would be issued to existing shareholders in a proportion according to what they own already, as a “thank you” for investing in the company in the first place. Alternatively, there's a rights issue. Whereas a market price issue is cash being received for the full value, and a bonus issue is free shares given away, a rights issue is somewhere in between. With a rights issue, if the market value of the share was, say, $10, and the par value was $1, the rights issue could be set anywhere in between there. So, if the market price was $10, the rights issue might be set at perhaps $8, and the shares will be sold at $8. Again, rights issues are often offered to existing shareholders, as a “thank you” for their loyalty. They're not getting a share for free, but they're getting a share for less than it would normally cost at market value. Companies can decide whether or not to use market price issues, rights issues, or bonus issues.
Let’s look in a little bit more detail at a rights issue, because it's slightly more complex. The rights issue is an issue for cash, cash is indeed being received. The amount of cash being received, however, as we said above, is lower than it would be if you were selling the shares at market price. If that's the case, a rights issue will actually tend to drag the market price down a little bit. Whatever that market price is now, after the rights issue, theoretically – and probably in practice – the value of the share will come down. If the market price for the share before the rights issue was $1.60, and we have a one for two rights issue at $1.20 (that means one new share is issued for every two that exist already), we can then calculate what's called the “theoretical ex rights price”, or the TERP. Which is the price of the share, the market value of the share (in theory) immediately after the rights issue. So, for every two shares that already exist at $1.60 (i.e. a total value of $3.20 at two lots of $1.60), there's now one new one at $1.20. That means we've now got three shares at a total value of $4.40. If we then take that $4.40 and divide it through by the number of shares in each one of these little “blocks”, then we can work out the TERP, the theoretical ex rights price. We should expect it to be less than $1.60 and more than $1.20, and here it is: $1.47 (in this example, $4.40 divided by 3 shares). So, a rights issue will drag the share price down a little bit.
Preference Shares vs Ordinary Shares
Let’s take a look now at the next major category of shares: preference shares. Preference shares, like ordinary shares, will be issued with a par value, a face value written on them. Preference shareholders, the investors that buy the shares, do not get a vote. So, then that looks as though perhaps ordinary shares are better because in ordinary shares you get to participate, get to be involved in the running of the business. Preference shareholders, however, will necessarily receive a dividend, which maybe suggests that the preference shares are more beneficial than ordinary share after all! Because with ordinary shares, you don't necessarily get a dividend. It's actually really impossible to say whether preference shares or ordinary shares are better. It depends on your attitude and it depends on what your objectives are as a shareholder. But the important point is that the differences are: preference shares = no vote; preference shares = will receive a dividend, and that dividend will be a fixed amount. The obvious downside is that, if the company performs really, really well, the preference shareholders will get the same sized dividend as always – even if ordinary shareholders receive a much larger one-off dividend. The upside of course is that, if the company performs really, really badly, the preference shareholders still get the same amount of dividend. Preference shareholders are also entitled to a share of the assets of the company on liquidation. If the company ceases to exist, then preference shareholders, as the name suggests, take preference over ordinary shareholders. They get in first before the ordinary shareholders. They're still actually reasonably low down in the queue but they get paid back before the ordinary shareholders. So, in theory, there's less risk associated with preference shares.
In summary: Preference shares and ordinary shares are both issued at par value. The main differences are: Preference shares confer no right to vote. Ordinary shares carry a vote. Preference shares will receive a dividend and it will be fixed. Ordinary shares will not necessarily entail a dividend, and if they do, it will be variable. They both get a share of the assets of the company on liquidation, but the preference shareholders get their cash first.
Preference Shares: Equity or Debt?
A little bit more detail on preference shares now. We started this entry by talking about equity finance. Sometimes, preference shares are what we call “redeemable”. It will typically be specified whether they are redeemable or not at the time issuance. If they're redeemable, that means that they're issued and cash is received; but redeemable means repayable, so that means that the cash will be paid back later to the people that invested in the company in the first place. That means that redeemable preference shares are not strictly speaking equity finance; redeemable preference shares are actually technically debt finance and will be classified as a liability. If the preference shares are not redeemable (or irredeemable), that means that the cash is received and it is never going to end up being paid back to the person that paid in the cash in the first place (for as long as the business remains a going concern). In which case, there is no obligation to pay out cash later. Irredeemable preference shares are classified as equity finance. It will always tell you whether shares are redeemable or irredeemable.
Sometimes you will see preference shares being described as cumulative; other times you will see preference shares described as non-cumulative. If they are cumulative, it simply means that if in one particular year the company that has issued the shares cannot afford to pay the dividend, that dividend just gets rolled up and paid in the following period, so it will always get paid. So, if you can't pay the dividend in year one, you have to pay two dividends in year two, or three dividends in year three. If the preference shares are non-cumulative, that means that if the company cannot afford to pay the dividend in one year, then it does not actually pay that dividend or roll it up into the next year. As far as preference share capital is concerned, the chances are that in most cases it will be cumulative. Whether or not it’s redeemable or irredeemable, the most common case is redeemable – most preference shares will be classified as a liability. So bear that in mind! We're looking at shares, and you might be tempted to think that shares will always be equity. Well, equity is when there's no associated fixed cost which would be your ordinary share capital. But preference shares can be either!
Moving on to the consideration of types of debt. Let’s start with the basics: debt is where you have a fixed commitment to repay a borrowed amount of money at a later date – for that reason, redeemable preference shares were classified as debt. The other types of debt that we need to have a quick look at are as follows: bank loans, bonds, and convertible bonds. Now, remember this article is about long-term finance. So we're not thinking about bank overdrafts, which are short-term and repayable on demand. We're talking about bank loans, bonds, and convertible bonds.
Let’s address bank loans first. A bank loan is issued for a fixed amount. You agree to receive some cash from a bank or the bank agrees to give it to you. It is a fixed amount for an agreed period – it could be a number of years, it could be a number of months. But in the context of commercial loans, it's probably going to be a number of years (we should assume that when we're dealing with long-term finance). There will also be a cost associated with the bank loan. The loan is not “free”, that’s where interest comes in: you have to pay for the convenience of having access to the money now and not having to repay the “principal” (the amount received) until later (or in manageable, periodic repayments). You might have to pay the interest at the very end of the loan period; or you might have to pay it throughout the loan period. Either way, there will be interest associated. There will be repayment terms set at the time the debt is issued. You will be told in the agreement over how many years you're going to repay, whether you're repaying monthly, quarterly, weekly, or annually – whatever it might be. Most loans are what we call secured, or have security. Say for example a bank is going to lend you money to buy a house (as in the case of a mortgage), they may lend you money secured against your house. Which is to say, if you don't repay, they retain full title to your house. With companies, normally they would secure the loan against some of the assets that the company owns, like some property or some inventory. If the individual or the company defaults, i.e. doesn't pay the loan back, the bank can still recover their money indirectly by taking (or seizing) the assets and reselling them or bundling them with other assets for resale.
So in summary, with debt finance, there will typically be: a fixed amount, an agreed period, an interest cost, repayment terms, and security.
When it comes to security, you can have two different types. You can have a fixed charge, which covers a specific asset. So for example, you can have a loan secured against a specific building. Or you can have a floating charge, which means the loan is secured against all of the assets of the business.
Bonds are essentially just loans from other institutions that aren't banks. Bonds carry a fixed interest rate, and a fixed time period. Normally with a bond, it would say something like “a 2027 bond”, which tells you when you need to pay the cash back. And a bond will have a fixed redemption value – in other words, you know how much you're going to have to pay back. Bonds are typically not issued by banks, they're issued perhaps by other companies, or indeed by the government. You can get funds from lots of different places, don't think that you only get long-term debt finance from banks. Anyone can provide funds as long as they've got a reasonable track record and they're reliable. Bonds are redeemable, and as we saw above, redeemable means repayable. If you issue a bond and you receive cash, then you will have to pay that cash back at a later date. That is always going to be the case. The good thing with bonds over and above bank loans is that bonds can be marketable. That means that you can buy and sell them throughout their life-span. So, there's actually a market available for the acquisition of bonds and the selling of bonds.
So, we’ve looked at bank loans; and we’ve looked at bonds.
Another type of debt is the convertible bond. The convertible bond, simply put, is when you receive some cash in the same way as you would a normal bond, but then the bondholder – the person that you're going to pay the cash back to – can say to you at a later date: “We don't actually want you to pay us the cash back. We want you to give us some shares in your company instead.” So, the bondholder can ask for the cash back or they can ask for shares in your company in lieu of repayment. They are the ones that have the right to convert into ordinary shares, as a condition of the bond being issued. If they do not wish to convert into ordinary shares, then the bond is redeemed as normal instead (redeemed just means repaid).
So, we’ve looked at bank loans. We've looked at bonds. And we’ve looked at convertible bonds.
Stock and Bond Markets
We've looked at equity finance and debt finance. We'll now go on and look at the stock and bond markets.
Stock essentially means shares. So, the stock market simply means the “place” where you can buy and sell shares and bonds. (Remember what we said about bonds, bonds are also tradable). In the context of stock markets, we’re most often referring to the shares of “listed” companies.
So, let's have a think about why this might happen, why we have a stock market to buy and sell shares? We have a market to buy and sell shares for two reasons: firstly, and most obviously, to trade things so that if someone doesn't want something anymore, they can sell it to somebody else who does want it; but secondly, having a market is a really good way for companies to raise finance. What it will actually do is provide them with more opportunities to actually generate funds. In order to be able to trade on a market, you need to be “listed”, and there are two ways in which you can actually sell your shares on a stock market. You can just offer them to the public and sell them to anybody. So a company can make an initial public offering, or “IPO” for short. Or a company can do what's called “placing”. If you go for placing, then you allocate your shares to a small number of large investors, which is probably a bit more of an efficient way of getting rid of shares. So, having this trading market actually yields significant advantages. It means that companies can sell their shares on this open market, they have access to a wider pool of funding possibilities because there are more people – both independent shareholders and institutional investors – available to potentially buy their shares.
As mentioned, you need to be listed in order to take advantage of a stock market, which often means that you also need to comply with certain regulations in that stock market’s jurisdiction. You may also need to be a company of a certain size, standing and quality. Therefore, if you are on a stock market, it often has a beneficial impact on the public image of the company, its reputation, and its brand awareness, which in turn may translate into a higher valuation of the company and a higher share price. The disadvantages of stock and bond markets is that if you do want to be listed on one, and if you do want to take advantage of the funds and the trading opportunities that are available, these markets are regulated heavily. There may be lots of lots of compliances that you need to observe, reporting conventions to employ, and that can incur significant financial and/or opportunity costs. Public image is positive if you do things properly, but public image can be damaged if you fail to comply with the relevant regulations/guidelines or reporting conventions. As such, small companies may struggle to become listed companies.
Role of Advisors
So we’ve looked at debt and equity. We’ve looked a little bit at the stock and bond markets. Now let’s briefly talk about the role of advisors. This is relevant to stock and bond markets. If you're going to take advantage of such a market, and you're going to sell your shares on a market, then there are lots of groups of people out there that can potentially help you, that will enable you to do it more efficiently and effectively and make the most of the opportunities that are available to you.
First of all, there is a sponsor. The sponsor is the lead advisor on the market. It's the person that will help you with the overall coordination and execution of your IPO or your placement. They will give you advice and guidance as to how to operate in the market.
here'll also be a book runner. A book runner is essentially an underwriter. If you are an underwriter, then you guarantee something. So, the bookrunner will help raise finance, will help perhaps set the price of the shares that you're going to sell. The book runner will also, if some shares don't get sold, guarantee to buy any of the unsold shares. So, they are there to alleviate some of the risk.
There will be a reporting accountant. The reporting accountant will help you ensure that you're complying with the listing rules and regulations. Listing rules are the rules that you have to observe in order to be able to use the market. The reporting accountant will tell you whether or not you're doing things correctly.
There will be a lawyer. The lawyer will help you with any due diligence and evaluating the reasonable legalities of anything that you're going to get involved in, and the lawyers will obviously be there to give you any other legal advice that is required. Another thing that lawyers will do is a lot of the time when you issue shares on the open market in a listed exchange, you issue what's called a prospectus, you create a prospectus and the prospectus tells potential investors all about the share issue itself and how it's going to work, and there will be some legal speak in there, and the lawyers will help you making sure that that says what it should.
You will probably also hire yourself a PR firm, a public relations firm just to make sure that things run smoothly and you can market and you can advertise yourself properly. So, the role of advisors within a market as a sponsor, bookrunner, reporting accountant, lawyer, as a PR firm.
To review: We first looked at equity finance, which essentially is share capital – but remember, preference share capital is sometimes classified as debt. We then looked at debt finance. We briefly looked at the way in which the stock and bond markets work, and we looked at the role of advisors within those stock and bond markets. So, that concludes our article on sources of long-term finance.
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