Sunday, March 7, 2010

A common form of corporate ownership - Introduction

A business needs start-up capital, working capital, capital to expand. Public and non-public corporations can raise this capital in various ways. The two most often used forms of raising capital are debt and equity financing.

Debt financing we addressed under ‘fixed income’. It is borrowing money from various sources. Basically the money is ‘rented’ and the rent or interest and principal are paid and repaid, respectively, through various arrangements that we will discuss in later postings.

Equity financing is done by selling a portion of the corporation’s ownership usually through shares. The thus sold equity gives the investor a say in how the company is run, provides the right to elect a board of directors that is to look after shareholders interest in the company, including the hiring of management. Finally equity holders share in the corporate profits, hence the name shareholder.

Investing in equiy also entails sharing of risk. If due to economic circumstances and/or poor management decisions, the profits of a company decline, so will the shareholders portion of the corporate profits. Just like in real estate, corporations use leverage or loans and when the value of a company increases over time this value increase will go to the shareholders, while lenders will only receive a repayment of principal.

On the other side of the equation is the possibility that a company’s value may decline and the shareholder’s equity may then decline accordingly all the way to zero. In some cases the company’s value is less than its debt and then lenders may take control of the company in order to recover their loans, while equity investment value has declined to zero. The losses of shareholders in public companies is normally restricted to the funds invested, however, in non-public corporations, owners and management may be held responsible for debt repayment beyond their original equity investment.

No comments:

Post a Comment