What do a startup, a mid-size business securing funds to build, buy, and partner, and a large company in search of corporate loans all have in common? They all require capital funding to propel and maintain corporate development.
Capital funding is a foundational component of business development and also a key function of VCs in the capital markets, but how can companies access and use it? In this article, we examine the question of what capital funding is, the pros and cons of common channels companies use to raise it, and how it is used by different types of businesses.
What is capital funding?
Capital funding describes financial resources a company receives through investors, which can be directed towards both immediate and long-term objectives. This capital is obtained through the sale of both bonds and stock, which represent debt and equity financing, respectively.
Though all companies must pursue capital funding to remain operational, the way that they go about it can vary greatly based on their goals and values. For example, a team that places great importance on autonomy and doesn’t want shareholders to control its decisions may limit the amount of funding it receives from equity and instead choose to take on more debt. Conversely, companies that are more concerned with their ability to pay off loans may be more willing to give up ownership to lower the amount of interest they take on.
Though teams will preferer one form of financing over another, all companies ultimately generate capital funding through some combination of both debt and equity to balance the advantages and disadvantages of stocks and bonds. The difference, therefore, lies in the company’s chosen debt to equity ratio, known as capital structure. Companies are continuously trying to balance and optimize capital structure; it is a useful company health metric and indicator of its positioning within its industry.
Types of capital funding
Companies access capital funding by either trading away partial ownership through stocks or taking on debt through bonds. These two modes of financing both operate on the premise that, in exchange for the capital they receive, the company will generate some kind of return, either in the form of interest and dividends or the stock appreciating in value. Here is a look at the through two main types of capital funding in greater detail:
Stock issuance
Type: Equity
Summary: The company seeking capital funding will sell partial ownership in the form of shares, either privately through venture capital or publicly through an initial public offering (IPO).
Advantage: Stock issuance allows companies to limit the amount of debt they take on and provide liquidity to shareholders.
Disadvantage: Selling stocks has the potential to expand the number of shareholders and their influence on company decisions.
Debt issuance
Type: Debt
Summary: The company seeking capital funding will issue bonds to investors or take out a loan from a financial institution.
Advantage: Debt issuance allows companies to retain ownership and appeal to more risk-averse investors.
Disadvantage: Companies will need to make repayments and accrue interest, which is not the case for equity.
Venture capital and other forms capital funding
Bond sales and IPOs are some of the most common ways investors to participate in capital funding, but there are plenty of other investments that might support a company’s corporate development, such as venture capital and corporate loans.
Digging deeper into the equity side of the equation, we know that IPOs mark a company’s transition into the public markets and the first time that individual investors are able to purchase an equity stake. However, if this process takes place at the end of a company’s time in the private market, how does it fund operations leading up to this point? Enter private equity firms.
Barring any startup capital that a team may be allocating towards the business, private equity firms are a company’s main form of receiving capital funding while still remaining private. In this asset class, we see both private equity firms that invest in capital funding as part of a larger strategy and firms that focus on it exclusively. Within the latter group, there is the added level of separation between generalists that offer capital funding to multiple types of private companies and specialists that focus on a specific criterion, like industry.
Perhaps the most notable example of these PE specialists are venture capital firms, who target companies based on growth stage- in this case, startups. Indeed, venture capital firms present a significant source of equity for companies in the private market, which may preclude the need to IPO.
On the debt side, we see bonds parallel public offering stocks as a small unit of debt financing, typically for public companies. For businesses that want to remain private, another option for debt capital funding is corporate lending. Unlike bonds, which are a form of retail lending available to the individual investors, corporate loans are normally issued by banks and constitute much larger sums of capital.
Examples of recent capital funding deals
To help illustrate the capital funding process, we present stock and bond issuance examples, a startup and a larger company in the same industry.
Data as of 3/8/2024
Stock Issuance
California-based genetic medicine company Metagenomi went public on the Nasdaq stock exchange in February 2024. Their IPO raised $93.75 million, selling 6.25 million shares at $15 each. This sale accounted for 16.65% of the company’s equity equity and put its post-money valuation at $562.92 million.
Debt Issuance
AbbVie, a drug discovery firm headquartered in Chicago, raised $15 billion in debt financing in February 2024. The company issued seven senior unsecured bonds, with the intent of using the proceeds to fund M&A efforts. As of this transaction, AbbVie has raised a total of $92.06 billion to date.
How capital funding is used
The resources obtained through capital funding can be used in whatever way the company sees fit and aren’t controlled by the lenders or equity holders. As such, capital funding can be applied to multiple areas at once, such as extending a company’s runway and paying operational costs while also funding research and development for new product offerings.
The uses of capital funding also vary based on the stage and size of the company receiving it. For example, a startup will likely need capital funding to secure office space, equipment, and materials. Meanwhile, a more established business may seek out capital funding to support a hiring push or rebalance its capital structure by reducing debt. In the case of even larger companies, capital funding can be used to fund M&A efforts and expand into new regional markets.
Capital funding and corporate development
Capital funding has many potential applications, from immediate concerns such as hiring a team and producing a prototype to show to investors, to more long-term and aspirational goals such as market penetration. Given this wide range of uses, it may feel as if investors lack the information and visibility they need make an informed decision. In other words, how can lenders and equity holders feel assured that they’ll see a return on investment if they don’t even know for certain how their capital funding will be used?
An investor’s understanding of how a company will allocate its funds will largely depend on how transparent the company is in its pitches and foundational business documents like its company white paper. Knowing that standards for transparency can vary by company and that proposed uses for capital may end up looking different in execution, there is another framework that we can try to use to understand it.
Fundamentally, all capital funding can be broken down into one of two types of capital based on how it is used. Fixed capital encompasses a company’s resource allocation to fixed assets, which is property such as equipment, land, and facilities that the company will own and derive profits on for a long period of time. Conversely, working capital is used to pay for more variable, ongoing expenses, like renting office space and paying employee salaries.
Looking at companies from the perspective of what capital they’re most likely to use their funds towards can help investors make more informed decisions that align with their risk tolerance. For example, investors supporting the capital funding of a startup can safely anticipate some amount of fixed capital expenses since this new company will likely need to equip its staff and new working space. Meanwhile, a more established company that has already taken care of these upfront costs is more likely to use capital funding in the form of working capital. Finally, there are companies at the enterprise side of the spectrum, which are expected to have both significant growth and operational costs, requiring them to use funds as both types of capital.
Costs of capital funding
Capital funding is far from a monolithic entry in a company’s records; it comes in through multiple sources and can be allocated to various parts of a business, which makes tracking and determining its worth a nuanced effort. One metric companies apply to measure the usage and effectiveness of their capital funding is weighted average cost of capital (WACC). This calculation seeks to aggregate the costs of all sources of capital funding — both debt owed to lenders and the costs that equity sales may have had on the business.
WACC often comes into play when a company is evaluating a potential capital funding plan and possible capital structure changes. It provides a concise statistic that can be measured against projected return on invested capital (ROIC). If returns exceed the costs calculated through WACC, then a company knows that it can move forward with its strategy for capital funding. However, if WACC is above ROIC, then the company must reconsider and either lower its amount of capital funding to reduce costs or find adjustments that can lead to greater returns.
Conclusion
Capital funding is vital for new businesses and remains an important consideration as these businesses mature and try to fund new objectives. This influx of capital is derived from a combination of debt and equity financing, usually in the form of stocks and bonds, which impact the company’s capital structure. Capital funding can be used to cover operational costs, support internal and external growth strategies, and propel efforts to achieve a more desirable debt to equity ratio. Once these potential sources of funding and their intended uses have been determined, companies can assess the viability of a potential capital funding plan using metrics like WACC and ROIC.
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