Companies that need more funds to grow their business, branch into new areas or finance their existing operations can turn to both debt and equity. Debt offerings place a greater financial burden on firms, because they must pay interest and repay the principal. The funds raised from equity offerings, however, do not have to be repaid. On the other hand, equity offerings create new shareholders, who will share the firm's profits.
While not all firms have debt, all companies have shareholders. After all, someone must own the firm. In most small companies, however, all stocks are held privately. To buy shares in such firms, potential investors must contact the individual shareholders and negotiate a private deal. The shares of publicly traded companies, on the other hand, are bought and sold easily on stock exchanges. Such transactions are completed through brokerage firms, and investors can purchase shares within minutes, if not seconds. When company officials talk of stock offerings, they usually are referring to selling shares to the general public to be later traded in stock exchanges. These transactions are referred to as initial public offerings (IPOs).
Although it is technically possible to carry zero debt, almost all firms owe some money. At the very least, payments usually are due on services or products purchased from other companies, such as raw material suppliers. When firms talk of debt offerings, however, they usually refer to the sale of bonds. Such bonds, much like stocks, can be traded among investors, and the holder of the bond is entitled to receive interest payments as well as repayment of the principal or face value of the bond. Bonds are not traded on public exchanges and usually cannot be bought as easily by small individual investors.
Pros and Cons of Stocks
When firms sell stock to raise cash, they essentially agree to share future profits in perpetuity. The downside is that existing shareholders will get a smaller slice of the pie going forward, because there will be more individuals to share the profits. Therefore, stock offerings only make sense for existing shareholders if the increase in profits realized with the investment of the new funds is large enough to offset this effect. The advantage for firms, however, is that when times are difficult, stockholders do not have to be paid anything at all. When firms lose money, no dividends are declared.
Ups and Downs of Debt
The primary advantage of raising funds through debt sales is that profits are not shared. If the strategy pays off and the additional profits realized as a result of debt sales far exceed the interest payment, all surplus profits go to existing shareholders. The downside, however, is that bond holders demand payment under all circumstances. So if the firm loses money and is forced to honor interest as well as principal repayment obligations, it can experience serious hardship. Forced sale of key assets or even mandatory bankruptcy proceedings are possible under such scenarios.