How does a company raise cash for its own corporate needs? In general, there are two external categories - equity financing and debt financing. What follows is all quite a lot easier to understand if you assume firstly it is a small company faced with the funding choice; perhaps it owned entirely by one person. Then imagine a second company which is larger (or perhaps the same company at a later stage of its development).
I mention two external categories but there's always the possibility of funding new project internally, through the profits that the company itself makes. Not a lot of companies are in this fortunate position. Certainly some mature companies get to end up like this. But it is in the nature of many corporate projects that first you have to invest to build a potentially profitable line of business, and then slowly pay down the initial investment over the months and years that the line of business is operational (maybe over a longer or shorter time horizon too). Rarely do you find lines of business which have low up front costs and immediate positive profit. You can also sell off various assets your company owns in order to raise capital, with the approval, explicit or implicit, depending on local conditions, of the owners of the company. For example you might sell off assets from pre-existing lines of business whose profits don't meet a certain threshold, within the context of a re-structuring of your business. Kind of like selling a kidney to buy some weights to build up your muscles. You might think of these options as organic and cannibalistic internal funding.
Now, let's look at equity financing. Well, the new money could be self-funded - the owners could just inject capital directly into the company. Imagine a small one man operation, perhaps the owners of a crepes cart which serves up tasty French style crepes at local places where people gather. The owners may need a power generator, to power their oven and fridge on the go. The owners may just pay for it themselves and consider it an asset of the company. By virtue of them being the only owner of the company and all its assets, then still own 100% of the power generator. Of course the generator might depreciate in value, but that's another story. The cash they might otherwise have had in their pocket might be depreciating too through inflationary effects. The large-company equivalent of this is to go the share holders of that company and initiate a rights issue. This is where they go to the owners - i.e. the set of all holders of their shares - and ask them to contribute more cash to the company. This is disguised as the purchase of new shares, but assuming all the current owners take up 100% of their allocated rights, all that's happened is they seem nominally to own more numbers of shares, but just exactly the same percentage stake in the company. Rights issues in reality can get complicated, when there isn't 100% take-up, but that too is another story. If 100% is taken up, the net result is the set of original owners of the company still own the same fractions of the company they once did, but they've transferred additional cash into the company.
After you've tapped your owner (or owners) multiple times this way, eventually they become reluctant to hand over the required cash to the company for its ongoing new projects; then perhaps you can initiate that other kind of equity financing - the issue of new shares to the wider investor community. Here you really are diluting the original owner's fraction. Again, start with a one man band company. The crepes cart. He's the sole owner. But a friend from the local village offers to pay for the power generator, if he can become a 20% owner of the company. So with that cash, he in effect re-designs the ownership structure, so that there are now 5 shares. Whereas there was 1 share, 100% owned by the owner, there are now 4 shares owned by the original owner and 1 share owned by the new investor. So the original investor base gets diluted by the issuance of these new shares. The new owner has bought himself a fraction of that company by paying cash.
That's equity financing. And it happens a lot with growing companies. Private equity funds are specialist lenders in these circumstances. Angel investors another form. That's what happens with IPOs, when you market new shares to the wider investing public. But there must surely come a point where the owner becomes reluctant to dilute the ownership fraction of the original investor base (and in particular, his own ownership fraction) any more.
To see this dilution in action, let's see how many times he can dilute his original 100%, assuming there's a 20% dilution happening every time (you keep 4 for every 1 given away). You can decide yourself at what point you think selling fractions of your company is the best way to get a hold of some money for your company's projects.
- 100% owned at start
- 80% owned
- 64% owned
- 51% owned
- 41% owned
- 33% owned
- 26% owned
- 21% owned
- 16% owned
- 13% owned
Companies are assumed always have an ongoing need for cash to fund their various projects. Whilst this is not always true it is certainly true, almost by definition, with growing companies. It looks like you'd only need to make requests for corporate funding a measly ten times using this method before you'd given away a large fraction of the company, even assuming you find ten generations of new investors willing to invest in your company.
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