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Obtaining Capital: Methods of Long-Term Financing > Types of Financing
Types of Financing
• Financing Life Cycle of the Firm
• Venture Capital
• Long-Term Debt
• Common and Preferred Stock
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Obtaining Capital: Methods of Long-Term Financing > Types of Financing
Financing Life Cycle of the Firm
• In the first stage, a new company's external financing needs (EFN) are high, since
it needs money to develop its idea but lacks retained earnings. They are usually
financed through debt, but may find investors who are willing to take on risk if
projected growth is high.
• In the growth stage, a firm's initial EFN is high relative to its current value; it needs
significant funds for growth. It can be financed through venture capital or issuing
equity.
• Growth eventually slows and the firm enters the mature stage. These firms can be
financed by equity or debt. If they have no new projects, EFN is relatively low.
• The firm may go into decline as their product becomes obsolete or a competitor
Firm Life Cycle
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outperforms them. In this case, they have very low external financing needs.
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Obtaining Capital: Methods of Long-Term Financing > Types of Financing
Venture Capital
• Young companies with high growth potential turn to venture capitalists for funding
because they cannot issue debt or raise capital in public markets.
• Venture capitalists assume high risk by investing in small, unproven companies,
rationalizing that successful investments will have so much growth that their
returns will far exceed any failed investments.
• By agreeing to fund a start-up company, the VC firm gets the potentials of high
future returns, significant control over company decisions, and a portion of the
company's ownership.
• Because a VC firm's returns are contingent on the company's performance, it is in
their interest to take an active role in company decision-making.
Structure of a Venture Capital Firm
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• A company receiving venture capital goes through several rounds of funding,
roughly corresponding to stages of company development.
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Obtaining Capital: Methods of Long-Term Financing > Types of Financing
Long-Term Debt
• Debt financing takes the form of loans that must be repaid by the borrower over a
specified period of time, usually with interest.
• Generally, debt financing is most appropriate for firms who are in the start-up
phase or have progressed to the maturity phase. For young companies, debt
financing usually takes the form of bank loans, while mature companies may
issue bonds.
• When investors buy a corporate bond or the bank loans to a small business, they
must have faith that the company will have the means to repay them. Riskier
investments will require compensation for the lender in the form of higher interest
rates.
Bank loans as a means of financing
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• Bonds may be an attractive alternative to getting bank loans or issuing stock
because it can have less restrictive loan terms and better interest rates than
loans, and it doesn't dilute equity or ownership as stock does. It also has
considerable corporate tax advantages.
• Costs of debt financing include: bankruptcy costs (in the event of inability to cover
payments to lenders) and increased uncertainty about future financing needs.
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Obtaining Capital: Methods of Long-Term Financing > Types of Financing
Common and Preferred Stock
• Firms using equity financing gain financial capital from investors, in exchange for
ownership stakes in the firm in the form of common and preferred stocks.
• The main advantage of equity financing is the lack of an obligation to pay back all
investors in the event of poor company performance, while the main disadvantage
is diminished control and business autonomy.
• In the event of liquidation and dividend payments, preferred stock has priority
claims to assets. Common stockholders must wait until all preferred stockholders
have been paid in full.
• In the event of bankruptcy, common stock investors receive any remaining funds
after bondholders, creditors (including employees), and preferred stock holders
Participating Preferred vs. Non-Participating
Preferred
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are paid.
• Common stockholders often have voting rights, exercising some measure of
control over company board elections and corporate policy, while preferred
stockholders usually lack these rights.
• Preferred stock is divided into a number of sub-categories including: cumulative
preferred stock, non-cumulative preferred stock, participating preferred stock, and
convertible preferred stock.
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Appendix
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Obtaining Capital: Methods of Long-Term Financing
Key terms
• bond A documentary obligation to pay a sum or to perform a contract; a debenture.
• Common stock Shares of an ownership interest in the equity of a corporation or other entity with limited liability. Holders of this
type of stock are entitled to dividends. Importantly, the financial rights for holders of this type of stock are junior to preferred
stock and liabilities.
• debt Money that the borrowing entity owes or is required to pay to a lender.
• debt Money that the borrowing entity owes or is required to pay to a lender.
• external financing needs Additional funds needed from sources outside the firm, in order to support firm operations.
• IPO An initial public offering (IPO) or stock market launch is a type of public offering where shares of stock in a company are
sold to the general public for the first time. Through this process, a private company transforms into a public company.
• Preferred Stock Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common
stock. It also has priority to common stock in liquidation.
• venture capital Money invested in an innovative enterprise in which both the potential for profit and the risk of loss are
considerable.
• venture capital Money invested in an innovative enterprise in which both the potential for profit and the risk of loss are
considerable.
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Obtaining Capital: Methods of Long-Term Financing
Firm Life Cycle
Firms progress through stages of development, indicated by their changing profits over time.
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Obtaining Capital: Methods of Long-Term Financing
Participating Preferred vs. Non-Participating Preferred
This graph shows an example of a liquidation event, illustrating how assets will be divided up between common, participating preferred, and nonparticipating preferred stock holders. All preferred stockholders are paid first, before common stock holders. Participating preferred stockholders can
"double dip", and are entitled to both their money back, as well as the leftovers for common stock, proportionate to the amount of common stock for
which their preferred stock can be converted into.
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Obtaining Capital: Methods of Long-Term Financing
Structure of a Venture Capital Firm
The venture capital firm pools capital from investors and allocates it to venture efforts deemed worthy of investment.
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Obtaining Capital: Methods of Long-Term Financing
Bank loans as a means of financing
A promissory note dating to 1926 from the Imperial Bank of India, Rangoon, Burma for 20,000 Rupees, plus interest.
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Obtaining Capital: Methods of Long-Term Financing
A company has developed a successful strategy and its sales are
steadily increasing despite an increase in competition. Which of
the following types of financing should the company consider?
A) All of these answers.
B) Obtain funds from a Venture Capitalist.
C) Pursue equity financing.
D) Offer its stock to the general public on a security exchange.
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Obtaining Capital: Methods of Long-Term Financing
A company has developed a successful strategy and its sales are
steadily increasing despite an increase in competition. Which of
the following types of financing should the company consider?
A) All of these answers.
B) Obtain funds from a Venture Capitalist.
C) Pursue equity financing.
D) Offer its stock to the general public on a security exchange.
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Obtaining Capital: Methods of Long-Term Financing
A company is looking for funding through a venture capitalist. The
company is selling its product but it is not profitable yet and needs
the additional investment as working capital. The company is in
which funding stage?
A) Start-up.
B) Seed money round.
C) Second-round.
D) Expansion financing.
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Obtaining Capital: Methods of Long-Term Financing
A company is looking for funding through a venture capitalist. The
company is selling its product but it is not profitable yet and needs
the additional investment as working capital. The company is in
which funding stage?
A) Start-up.
B) Seed money round.
C) Second-round.
D) Expansion financing.
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Obtaining Capital: Methods of Long-Term Financing
Which of the following statements regarding how companies use
long-term debt is correct?
A) From a tax perspective, debt financing have some advantages over
equity financing.
B) Riskier businesses are required to pay higher interest rates.
C) All of these answers.
D) Most corporate bonds are fixed-rate bonds.
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Obtaining Capital: Methods of Long-Term Financing
Which of the following statements regarding how companies use
long-term debt is correct?
A) From a tax perspective, debt financing have some advantages over
equity financing.
B) Riskier businesses are required to pay higher interest rates.
C) All of these answers.
D) Most corporate bonds are fixed-rate bonds.
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Obtaining Capital: Methods of Long-Term Financing
A company issues preferred stock that gives the shareholders
rights to dividends. If the company does not pay any dividends in
a given year, the preferred shareholders cannot claim those
unpaid dividends in the future. What type of stock is this?
A) Non-cumulative preferred stock.
B) Cumulative preferred stock.
C) Participating preferred stock.
D) Convertible preferred stock.
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Obtaining Capital: Methods of Long-Term Financing
A company issues preferred stock that gives the shareholders
rights to dividends. If the company does not pay any dividends in
a given year, the preferred shareholders cannot claim those
unpaid dividends in the future. What type of stock is this?
A) Non-cumulative preferred stock.
B) Cumulative preferred stock.
C) Participating preferred stock.
D) Convertible preferred stock.
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Obtaining Capital: Methods of Long-Term Financing
Attribution
• Wikipedia. "Startup company." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Startup_company
• Wikipedia. "Product life-cycle management (marketing)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Product_lifecycle_management_(marketing)
• Wikipedia. "Seed funding." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Seed_funding
• Wikispaces. "Lifecycles08 - Business growth." CC BY-SA http://lifecycles08.wikispaces.com/Business+growth
• Wiktionary. "venture capital." CC BY-SA 3.0 http://en.wiktionary.org/wiki/venture+capital
• Wiktionary. "debt." CC BY-SA 3.0 http://en.wiktionary.org/wiki/debt
• Boundless Learning. "Boundless." CC BY-SA 3.0 http://www.boundless.com//finance/definition/external-financing-needs
• Wikipedia. "Venture round." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Venture_round
• Wikipedia. "Venture capital." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Venture_capital#Financing_stages
• Wiktionary. "IPO." CC BY-SA 3.0 http://en.wiktionary.org/wiki/IPO
• Wiktionary. "venture capital." CC BY-SA 3.0 http://en.wiktionary.org/wiki/venture+capital
• Wikipedia. "Common stock." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Common_stock
• Wikipedia. "Preferred stock." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Preferred_stock
• Wikipedia. "Preferred Stock." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Preferred%20Stock
• Wikipedia. "Common stock." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Common%20stock
• Wikibooks. "Investing/Bonds." CC BY-SA 3.0 http://en.wikibooks.org/wiki/Investing/Bonds
• Wikipedia. "Bankruptcy costs." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Bankruptcy_costs
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Obtaining Capital: Methods of Long-Term Financing
• Wikibooks. "Principles of Finance/History." CC BY-SA 3.0
http://en.wikibooks.org/wiki/Principles_of_Finance/History#Debt_Financing
• Wikipedia. "Tax benefits of debt." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Tax_benefits_of_debt
• Wikipedia. "Bond (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Bond_(finance)
• Wiktionary. "bond." CC BY-SA 3.0 http://en.wiktionary.org/wiki/bond
• Wiktionary. "debt." CC BY-SA 3.0 http://en.wiktionary.org/wiki/debt
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