Corporations can raise capital in one of two ways: by sharing ownership (selling stock) or by borrowing money (from a bank or through bonds). Each method has its advantages and disadvantages. Issuing bonds instead of selling stock may have several disadvantages under certain circumstances.
The issuer must pay interest on the bonds until the bonds mature. The interest rate is set at the time of bond issuance at the prevailing interest rates and cannot be changed later if interest rates decline. Interest payments deplete a company’s cash flow and take money away from other purposes. On the other hand, paying or not paying dividends is entirely at the discretion of the corporation, which may elect to pay them only when it has sufficient profits. Dividends can be paid, reduced, omitted and resumed at any time, and it’s up to the corporation how much to pay.
As a loan to a corporation, bonds must be repaid at maturity. A corporation may not have sufficient funds when the bonds come due or may have difficulty refinancing them because of its financial condition or general market conditions. A company’s inability to refinance maturing debt can jeopardize its operations. On the other hand, the capital that a company raises through a stock offering belongs to the company and does not have to be repaid.
Risk of Bankruptcy
If a corporation misses an interest payment or cannot repay a bond on time, bondholders can force it into bankruptcy--shut down its operations and sell off corporate assets to recoup their investment. Shareholders have no such right: If a corporation fails, shareholders simply lose their money. The more debt a corporation has, the more precarious its financial condition.
A corporation may be forced to pledge certain assets as collateral for bonds or agree to other bond covenants that may restrict its financial flexibility. For example, it may have to agree to maintain a certain capital structure or certain financial ratios. Stocks do not carry such limitations, as they are usually issued to raise capital “for general corporate purposes.”