Finance
1 Managing for value
Organisations should choose strategies which offer their major stakeholders the best value in exchange for the resources used. This is known as ‘managing for value’. In profit–seeking organisations this will mean maximising the long-term cash-generating capability of an organisation whilst taking account of preferences with regards to risk, stability of earnings and ethical considerations.
Choices to be made are:
What type of capital to raise? Broadly equity or loans, but there are now some more innovative forms of finance.
How to invest that capital?
How to control the company’s operations?
2 Types of capital
The main sources of traditional finance are equity and borrowings.
Equity is obtained from:
The first owners
Retention of earnings
Venture capitalists and business angels
Issues to the public – both the initial public offering (IPO) and then rights issues.
Venture capitalists and business angels specialise in providing equity finance for relatively small, young businesses. Typically a venture capitalist will invest up to 49% of the equity and will have a seat on the board so as to keep an eye on their investment. It is understood that this type of investment is high risk and that dividends are unlikely to be paid in the early years. A venture capitalist’s involvement with a company is likely to be for around 5 years after which they look for an exit that will provide their return. An exit is usually through the company obtaining a stock market listing (which allows the venture capitalists’ shares to be easily sold) or by a takeover by a larger company. To compensate for the high risk, venture capitalists typically look for an annual return in the order of 30%.
An IPO provides the route for a company to obtain a stock exchange listing. New shares are issued at the launch price to investors and this mechanism can make very large amounts of new capital available. There are considerable legal and advisory costs involved in IPOs, for example, to comply with the regulations governing prospectuses, the document which tells investors, in great detail about the company. Costs can account for around 10% of the capital raised.
A business’s founders should be aware that a listing means that:
Control of the company now has to be shared with new investors
There is greater public scrutiny of the company and its directors
There is the possibility of a hostile takeover
After the IPO more equity capital can be raised via rights issues where existing shareholders are given the opportunity to subscribe in more shares in proportion to their current holdings.
Take care with the two claims most often made about a rights issue. Because the offer is made to existing shareholders in proportion to their current holdings, control is only diluted for those shareholders who do not take up their rights — so neither “it dilutes control” nor “it does not dilute control” is right without that condition. And because the issue adds to equity, it does affect gearing, in the opposite direction to a loan.
Borrowings can be
Term loans and debentures
Overdrafts (repayable on demand
Leasing is also a form of loan finance.
Convertibles start as loans but can then be converted into equity. Convertibles allow a ‘wait and see’ approach. They start off as relatively safe loans, probably secured and promising regular interest payments. If the company seems to be doing well, investors can convert their loans to equity which allows the possibility of capital growth through rises in the share price.
Preference shares give constant, almost guaranteed dividends and are usually regarded as more like loans than equity.
3 Crowdfunding
This is the process of raising small amounts of capital from many people. It is typically organised through the Internet and social media so as to attract a large number of potential investors. In exchange for providing capital, investors expect something in return and this is commonly:
Shares - which might pay dividends or go up in value.
Loans (peer-to-peer lending) which should pay interest.
Rewards - for example, discounted products or services that the company hopes to make.
All forms of crowd-funding can suffer from poor regulation and poor investor protection compared to more conventional equity and loan finance.
4 Mix of capital
The real ownership of the company resides in the equity shares and these enjoy any capital gains arising from company success.
Loans and debentures are a cheaper source of finance than equity. They are less risky for investors (usually secured with constant interest) and borrowers enjoy tax relief. Therefore, some borrowing is good.
However, too much borrowing increases everyone’s risk as it becomes harder and harder to be sure interest payments can be met as gearing rises. Therefore, the average cost of capital starts to rise at high gearing levels.
So, gearing must be kept at reasonable levels.
5 Investing the capital
After finance has been raised, the company has to decide how to invest it. There are two categories:
Invest in current assets
Invest in non-current assets
Some investment in current assets (inventory, receivables and cash at bank) is necessary to provide the organisation with liquidity. The more cash allowed to sit in a current bank account, the less difficulty the company will have paying its current liabilities as they become due. However, leaving cash in current assets is not really profit-generating.
To generate profits, capital has to be invested in non-current assets.
The company has to decide on the right balance and also has to decide on appropriate types of finance for each type of investment.
6 Match capital to asset
In general, it makes sense to raise capital that matches the life of the asset it is funding. This is what we do personally when taking out mortgages to buy property (25 years), car loans (around 3 years) or for holidays (credit card). Too much short-term borrowing means that the organisation lives ‘hand-to-mouth’: a high-risk existence. Therefore, long-term capital is also used to invest in ‘permanent’ current assets.
Type of asset | Typical finance |
Offices, factories, machinery | Equity, debentures |
Equipment | Equity, debentures, term loans, leases |
Inventory, receivables, seasonal liquidity problems | Equity, debentures, overdrafts, factors, |
7 Over-trading
Businesses, particularly successful expanding ones can suffer from overtrading. As business increases more has to be invested in inventory and receivables and a business can find itself short of cash.
It is important to increase permanent capital as businesses grow.
8 Cryptocurrency technology
Cryptocurrencies, such as Bitcoin and Ethereum, make use of blockchain technology to record transaction and ownership. Blockchain technology allows data to be added to a set of records, but once added it cannot be changed without detection. The following is a simplified explanation.
Think of a bitcoin as especially constructed number. It takes enormous computing power to produce a valid number.
When you acquire a bitcoin your record of ownership is entered into the bitcoin’s blockchain and you are given a key (like a password) that will let you carry out transactions with the bitcoin.
If you pay someone using the bitcoin, the blockchain is updated with information about that transaction by adding another block. It will note you do not own it and that someone else does and the date and time of the transfer is noted too. You will not be able to spend that bitcoin again because the blockchain has recorded that you are no longer the owner.
Note that transfers of cryptocurrencies and software value tokens do not require an intermediary such as a bank. This makes transaction faster and cheaper. Effectively, they cut out the intermediaries.