How Companies Raise Money through the Financial Markets

All businesses start small — whether it’s in a garage, a spare bedroom, or a rented office. As companies begin to grow, they often need more money (known as capital in the financial world) to expand and afford their growing needs, such as hiring more employees, buying computer systems, and purchasing manufacturing equipment. Companies can choose between two major money-raising options when they go into the financial markets: issuing stocks or issuing bonds.

Deciding whether to issue stocks or bonds

A world of difference exists between these two major types of securities, both from the perspective of the investor and from that of the issuing company, as the following explanations illustrate:

Bonds are loans that a company must pay back. Rather than borrowing money from a bank, many companies elect to sell bonds, which are IOUs to investors. The primary disadvantage of issuing bonds compared with issuing stock, from a company’s perspective, is that the company must pay this money back with interest. On the other hand, the business doesn’t have to relinquish ownership when it borrows money. Companies are also more likely to issue bonds if the stock market is depressed, meaning that companies can’t fetch as much for their stock.

Stocks are shares of ownership in a company. Some companies choose to issue stock to raise money. Unlike bonds, the money that the company raises through a stock issue isn’t paid back, because it’s not a loan. When the public (people like you and me) buys stock, these outside investors continue to hold and trade it. (Although companies may occasionally choose to buy their own stock back, usually because they think it’s a good investment, they’re under no obligation to do so. If a company does a stock buyback, the price that the company pays is simply the price that the stock currently trades for.)

When a company issues stock, doing so allows its founders and owners to sell some of their relatively illiquid private stock and reap the rewards of their successful company. Many growing companies also favor stock issues because they don’t want the cash drain that comes from paying loans (bonds) back.

Although many company owners like to take their companies public (issuing stock) to cash in on their stake of the company, not all owners want to go public, and not all who do go public are happy that they did. One of the numerous drawbacks of establishing your company as public includes the burdensome financial reporting requirements, such as production of quarterly earnings statements and annual reports. These documents not only take lots of time and money to produce, but they can also reveal competitive secrets. Some companies also harm their long-term planning ability because of the pressure and focus on short term corporate performance that comes with being a public company.

Ultimately, companies seek to raise capital in the lowest-cost way they can, so they’ll elect to sell stocks or bonds based on what the finance folks tell them is the cheaper option. For example, if the stock market is booming and new stock can sell at a premium price, companies opt to sell more stock.

From your perspective as a potential investor, you can usually make more money in stocks than bonds, but stocks are generally more volatile in the short term.

Categories: Investing