Why Are Stocks Important to Businesses?

The ability to issue stock is critical to a business because stocks reflect an important source of capital used to raise cash, which also provides an alternative to debt financing. Each industry has its own optimum capital structure, which refers to the mix of debt and equity (stock) financing a company uses. Therefore, the industry a company is situated in often will have some impact on the amount of stock it issues relative to its overall capital structure.

Alternative to Debt Financing

While debt financing is generally cheaper than equity capital in terms of returns demanded by investors, debt financing results in interest payment requirements. As a company's interest expense increases, its earnings decrease. Also, the increased level of debt on the company's balance sheet increases a number of the risks associated with the company. A company with increasing debt levels is subject to increasing interest rate risk, default risk, bankruptcy risk and balance sheet risk. As interest rates increase, so does the company's cost of debt, which leads to a direct increase in interest expense and lower earnings because interest payments are based on interest rates.

Increase Liquidity

Stock also is important to a business because it helps boost the overall liquidity associated with the company. Liquidity refers to the ability to convert an investment into cash quickly, and also can refer to the percent of a company's assets that are liquid (such as cash and accounts receivable) relative to less liquid asset such as machinery and equipment. The more stock a company issues and the more shareholders it has, the more liquidity is associated with the secondary market for its stock. Closely held businesses often have no ready markets for their stock, particularly very small businesses. However, as companies issue more stock, which funds growth of the business, secondary over-the-counter trading of the company's stock among existing shareholders tends to increase. This liquidity reduces the overall cost of capital of the company, which boosts its returns on equity.

Share-Based Compensation

Stock issuances also are important to companies that use various forms of share-based compensation to incentivize and reward employees. Share-based capital includes stock, warrants and convertible bonds, and can be issued very inexpensively while providing high levels of incentive to employees and management. Excluding a small amount paid to underwriters (the investment professionals who help companies issue their stock), there is very little cash outlay required for companies to issue new shares. Also, when stock and warrants become vested, employees often contribute cash to the company to purchase the stock, although typically at levels lower than its trading value.

Exit Strategy

Stock issuances also provide an important exit strategy to company founders, early-stage investors and employees. Typically, a company issues stock in various stages of private stock placements (small, private stock issuances to smaller groups of investors) during the growth phase of its life cycle, which is when the company needs cash to fund its high level of growth. When the company reaches a level of stability and growth that begins to attract outside investor interest, the owners can generate large cash paydays for themselves and employees by participating in initial public offerings (a company's first sale of stock on a public exchange). These IPOs have the added benefit of making the company's stock liquid, which tends to boost returns.