When a company wants to raise capital without selling a portion of ownership in the company and without going to a bank for a loan, it will usually do one of two things: offer investors corporate bonds or preferred stocks. Should a company declare bankruptcy, bondholders are paid ahead of preferred shareholders, who in turn are paid ahead of common shareholders.
While both investments are sensitive to interest rates, preferred stocks pay investors fixed dividends, while bonds offer interest payments.
Investment Options for Companies
When a company wants to raise capital, it generally has several options available. A private company, like a sole proprietorship or partnership, can bring in additional partners in exchange for an infusion of cash. A private company also has the option to go public, by registering with the SEC and issuing stocks. A company that has already gone public may be able to issue more stocks. All of these options, of course, dilute ownership in the company, which is not something the current owners are always willing to do.
Another option is to borrow money. Going to a bank for a loan may be an obvious option, however, banks usually only offer loans with fixed rates of only five years. And because banks are in the business of making money themselves, they tend to charge higher interest rates, particularly if the company doesn't have a stellar credit rating.
For companies that don't want to dilute ownership in the company or go to a bank, they will generally select one of two options: the issue of bonds or preferred shares.
How Bonds Work
When a company issues bonds, it usually arranges one master loan agreement and then offers bonds through that loan. Suppose, for example, you wanted to borrow $100,000, you could write a loan agreement for that amount, with 1,000 bonds for $100 each. The master loan agreement is called a bond indenture, which contains information such as:
- How much the company is borrowing in total.
- The interest rate the company is going to pay.
- What the company is using for collateral, if it is.
- When the bonds will mature (i.e. when the company will pay back investors).
- Whether the company or the investors can shorten the bond's maturity date.
Almost any company is entitled to issue bonds, however, there can be restrictions based on whether or not it is a private or public company. Convertible bonds, for example, which can be converted into a portion of the company's underlying equity, cannot usually be issued by private corporations. This is because bonds are converted into common stocks and a private corporation doesn't have common stocks to offer.
Advantages and Disadvantages of Issuing Bonds
When corporations want to raise capital, they can issue bonds directly to investors without dealing with banks as the middlemen, making the transaction more efficient and less expensive. Banks need to ensure that the rate they offer for loans will be more than the cost of their funds. For this reason, they seldom offer fixed rate loans longer than a five-year period. When a company wants to borrow money for a longer term, issuing bonds is often the best way to go.
A corporation can borrow a large amount of money through a single transaction. When it issues a bond, it creates a single master loan agreement. Then it offers investors an opportunity to participate in that loan. If an investor wants just one bond or 1,000 bonds, the agreement with the corporation is the same.
A disadvantage of issuing bonds is that they are higher risk investments compared to government bonds. Investors may be skeptical of investing unless the corporate bond offers a better interest rate than government bonds. Furthermore, investors will also look at the company's credit rating, which is often the only indicator of whether or not the bond will be repaid. This can be problematic for a company with a poor credit rating, which may need to offer even higher interest rates to make the bonds attractive, or it may have to offer some of its physical assets as collateral.
How Preferred Stocks Work
Selling stocks means selling partial ownership of a company to investors. There are two kinds of stocks a company can issue: common and preferred. Common stocks, purchased by common stockholders, have all the rights of partial ownership in a company, including the ability to elect a board of directors and vote on company decisions.
Preferred stockholders also have partial ownership of the company, however, these rights are limited, as preferred stockholders can't vote. Preferred stockholders have a priority over common stockholders when it comes to getting paid. Their dividends are a priority and usually pay higher dividends than common stock. If the company is liquidated, they are paid before common stockholders are. If interest rates rise, the dividends of preferred stocks should go up, and if interest rates decline, so will the dividends of preferred stocks.
Advantages and Disadvantages of Issuing Preferred Stock
Preferred stocks, like bonds, are usually callable, which gives the issuing company the right to call back the shares. Should interest rates fall, the company can call back the preferred shares and then issue new ones based on the lower rate.
For the issuer, preferred stocks can be more advantageous to stocks if the company runs into financial problems. Interest payments on bonds are legal obligations that are payable before taxes, while stock dividends are not. If the stocks are non-cumulative, the issuer doesn't have to pay those dividends in the future, however, if the stocks are deemed as cumulative, they will have to be paid back eventually.
Investors may be more skeptical of preferred stocks compared to bonds because they have a lower claim on company assets in the event of liquidation. Related to this higher risk, preferred stocks usually pay more, resulting in a higher cost to the company. Institutions, however, do like to invest in preferred stocks because, unlike the interest earned on bonds, 70% of dividend income can be excluded from corporate income tax.
Issuing preferred stocks is often seen as a sign that a business has a lot of debt. Companies can be limited in the amount of additional debt they can raise, leaving preferred stocks as one of their few options. With the exception of financial and utility companies, which routinely issue preferred stocks, investors are often hesitant to buy them.
Understanding Hybrid Financing
Any investment offering that combines both debt and equity, like convertible bonds and convertible preferred stocks, is referred to as hybrid financing. The debt portion of these investments, of course, is due to the company raising money from these investments in return for paying interest or dividends. The equity portion comes from the ability of investors to potentially exchange the investment for a voting (common) share in the company.
The advantages and disadvantages of hybrid financing include those that apply to non-convertible bonds and preferred shares, with additional complications. Because of these complications, many investors shy away from hybrids. In order to attract investors, the issuer may then have to offer better returns than it otherwise might have to pay.
On the plus side for the issuer, if the company runs into financial problems, it can defer interest payments on convertible investments. On the other hand, of course, investors can then take a stake in ownership. For the majority of owners of small public companies, this could potentially result in losing controlling shares in the business.