As a continuation from our previous article that shared the basics of the capital markets, we would like to give you an insight of the advantages and disadvantages of raising capital from the capital markets. As you will find here below, financing decisions will differ from company to company and from owner to owner, depending on their expectations, preferences, and the actual situation the company is in.
It is therefore very important to explain the basic advantages and disadvantages of the various ways of financing through ownership instruments (shares).
The advantages include;
- The business is not bound to a fixed cost – all that the new investors earn are dividends, but remember that dividends do not have to be paid on a specific date or after a specific period.
- The cost (dividends) only appears if the company makes a profit in the form of profit distribution. Consequently, this model of financing is considerably more stable and less risky for the company.
- There is no maturity term – as a rule, investments in shares are investments in permanent capital that cannot be withdrawn and whose return from the company cannot be requested. In this sense, there is an advantage for the company, which has no obligation to return or pay, if it has business problems or registers negative financial results.
- Fresh capital improves credit rating for a business – By issuing shares, a company acquires new, fresh, permanent capital that strengthens its business position, making it stable. As new capital enters the company, its leverage improves and debt indicators decrease, improving its credit rating and opening up new possibilities for financing through debt instruments like borrowing from the banks.
- Easier sale – a good and stable company can sell shares far more easily than bonds, since the market is wider. A well-developed secondary market opens up possibilities for investors to acquire both dividends and capital gain and to liquidate their capital fast through the financial market.
Some of the disadvantages of financing through the capital markets include;
- If a company opts for financing by share issue, their number will increase – increasing the amount of capital and decreasing existing owners’ percentage ownership. This is largely known as “dilution”. It should be clear to you that there is no “dilution” with bonds, but there is with shares.
- A more expensive source of financing – the considerably higher risks faced by investors in ownership instruments entail an obligation to pay higher compensation. In other words, the company distributes the net profit among capital owners.
- Unfavorable tax treatment – this way of financing lacks tax incentives. The dividend is paid out of net profit after taxes, and is thus not a tax shelter from profit tax. Investors also have to pay tax when profits are transferred to their accounts, so that there is no tax incentive there either.
- Unknown obligation – the dividend is paid based on business performance, and the investor does not know when and how much they will profit from a given share, while the issuer also does not necessarily have full control over payment of profit to shareholders. The decision on the amount of the dividend is made at the AGM.
In business, every decision needs a careful thought and any mistake will cost the entrepreneur heavily. It’s important that you evaluate your business and possibly consult a licensed professional for advice on the businesses opportunities and how to also cover for the possible negative outcomes.
In the final part of this series, Brian will go into detail about the different aspects to consider when choosing to invest (either as an individual or a company) on the Securities/Stock Exchange and raising finances through the Capital Markets.
Brian is the Managing Director at BLEGSCOPE®, and has over 9 years of management consultancy experience notably in the finance and banking industry, MSMEs, FMCG companies and in the service industry. You can follow him on twitter: @BrianAhabweK