Can Companies Issue Stocks to Pay Debt?
Small companies have several options to raise money to fund operations and expansion. These options generally fall into two categories: debt and equity. Companies need cash flow to support the interest and principal payments that debt requires. However, equity, especially in the form of common stock, does not require any payments. When corporations need to reduce their debt, they can issue stock and use the proceeds to retire the debt.
Corporations are the only company type that can issue stock. Corporations are subject to federal and state statutes regarding their setup, administration and maintenance, including the issuance of stock to owners and investors. The Securities and Exchange Commission governs the issuance of stock to raise money. Except for those closely affiliated with the corporation, including owners, managers and family and friends of these individuals, stock purchasers must be accredited investors -- individuals who earn at least $200,000 annually or have a net worth of $1 million, not including the person's primary residence. For married couples, the annual income required to be considered an accredited investor increases to $300,000.
Companies may prefer debt because it has the lowest cost of capital. Companies must repay the principal borrowed and an interest rate -- typically between 5 and 18 percent, depending on the type of loan and the company's creditworthiness. For equity, however, companies must pay a proportionate share of the company's profits and, if and when the company is sold, a portion of the sales price to the equity holder.
Profitable companies with high operating cash flow have no difficulty maintaining a high debt load because they generate the cash internally to make the required payments. Most small business debt takes the form of loans -- lines of credit, term loans or mortgages. Although credit lines may be interest only, most term loans and mortgages fully amortize over the period of the loan. Companies generally make these principal and interest payments every month.
If the operating climate for a corporation experiences a downturn or the company loses a major customer, operating cash flow may no longer fully cover debt payments. To avoid defaulting on its loans, the company must obtain cash from other sources. Issuing stock to raise equity often is the best solution. Corporations can issue stock to friends and family or friendly accredited investors. Alternatively, a corporation can issue stock and raise money through more involved methods that generally require the use of an investment banker or financial consultant.
Say NM Services Inc. has $750,000 in debt. The company had no problem making the approximately $8,000 in monthly payments until it shifted its strategy to aggressively expand the business. NM Services needs money to fund this expansion. By retiring most of its debt, it can use more of its operational cash flow to fund expansion. It decides to issue $1.3 million in stock to retire $600,000 in debt and contribute $600,000 to funding additional expansion. The remaining $100,000 will pay the expenses involved in raising money.