Raising capital is a key skill for business leaders, regardless of company size or maturity. This post addresses critical questions like the fastest ways to raise capital and simplifies the complex steps involved in raising capital, tailored for both emerging and established firms. Read about techniques like bootstrapping, crowdfunding, angel investors and venture capital that are often used by young, pre-revenue startups. We also explain options like bank loans, bonds, stocks and private equity that established firms rely on. With definitions of debt vs. equity financing and practical examples, you'll learn multiple ways companies can fund growth at any stage.
Defining Terms for Understanding Capital
Raising capital is something that you may have to do at any point in a business’s life cycle. Just as there are several reasons you may want to raise capital, there are also many ways to do a “capital raise.” We’ll begin with some definitions.
Financial capital, often simply referred to as capital, can be any resource that has monetary value and can be used to create revenue for the company. Financial capital should not be confused with economic capital, which has a much narrower definition related to risk management. There are two basic ways for companies to raise capital and many different sources and vehicles for raising money.
What Are Capital Raises?
A capital raise describes the act of seeking outside capital for business funding from current or prospective backers. Capital raises can be accomplished with public or private sources and different funding types.
Two Basic Methods of Raising Capital
Debt Capital: When you think about raising capital, the first thing that probably comes to mind is debt capital, which can include bank loans, private loans, and bonds. A bond is a type of debt capital often used by established businesses and governments. Debt capital is money borrowed with the expectation that it will be repaid to the lender at a later date, usually with interest.
Equity Capital: Equity capital refers to money raised through selling part of the business. Like debt capital, equity capital can come from public or private sources. Unlike debt capital, equity capital does not need to be repaid. With equity capital raises, a portion of ownership in the company is sold to an investor. Investors expect that the business will grow and their equity will increase in value.
Convertible Debt: Sometimes, businesses seek to raise money with convertible debt. A convertible loan is a hybrid of debt financing and equity financing that includes a provision for converting the debt to equity based on some agreed-upon trigger.
Business Reasons to Raise Capital
Growth: Startups and young companies often need to use capital raises to grow operations and for working capital until they become profitable. More established, mature companies may also fund growth with capital raising.
Acquisition: There are many different scenarios where it makes sense for a company to acquire all or part of another company. In such cases, the acquiring company may need to find additional capital to make the purchase.
Managing debt: Just as it might make sense for a homeowner to refinance a mortgage for a better rate, a business might want to raise capital to save on interest payments. If the company replaces debt capital with equity capital, this is often called rebalancing the capital mix.
Realizing investment gains: Entrepreneurs and investors participate in companies to make money. Sometimes, companies will need to raise capital for the early investors to realize their profits and possibly exit the company.
Private Funding Sources
Most entrepreneurs begin their operations with some amount of their own money. From there, they may seek either debt or investment funding through various means and specific sources.
The earliest investors in a business are often the entrepreneur's friends and family, who may take an equity ownership position based on their faith in the entrepreneur. Alternatively, these friendly funding sources may offer the business a loan at favorable interest rates.
Banks and Credit Unions
A business plan and financial documentation are required for loans from banks and credit unions, and the specifics will vary based on the maturity and assets of the business. Personal guarantees and good credit scores for business owners are typicaly required.
SBA loans are issued by individual banks and credit unions and partially guaranteed by the Small Business Administration of the U.S. government. Specifically intended to help small businesses cover startup costs, SBA loans are available for various business needs but are time-consuming to obtain and are generally not available to micro businesses or those in early start-up.
Sometimes, an early-stage company will find an angel investor. Angel investors are typically independently wealthy individuals interested in the company's field. They are likely to invest based on the company's business plan and their belief that they will make a good return on their investment. They typically seek to invest in companies with high-growth, high-return potential. If the company does well, the angel investor may become a lead investor in additional rounds of venture capital funding.
Venture Capital Firms
Venture capital firms manage and direct the investments of qualified individuals and institutional investors, including financial institutions and pension funds. Venture capital is a subset of private equity capital. Venture capitalists are typically involved in seed or early-round funding for companies that may not have access to the public market and can't support debt service with cash flow.
Venture capital firms take an equity position in the company, with the size of the equity position commensurate with the amount of financial risk to the venture capitalist. Like angel investors, venture capitalists and venture capital funds tend to specialize in specific fields in which they have developed expertise.
Venture capitalists often take an active role in shepherding their portfolio companies to profitability. They may require a business seeking funds to change management, marketing, supply chain operations or even physical location as a condition of making their investment.
Crowdfunding is a very public way to raise money from private investors that has become a popular option for startup companies seeking funding, particularly those developing new technologies. There are many variations on how crowdfunding works, so entrepreneurs will want to conduct their due diligence before signing up with a crowdfunding vendor.
The basic mechanisms for raising capital through crowdfunding are by offering equity or rewards, and soliciting donations or loans. Rewards-based crowdfunding offers typically promise the individual funders a product, service or another premium in return for their financial support.
Public Funding Sources
The stock and bond markets are the two "public" sources for capital raising. Stocks are a type of equity financing, while bonds are a type of debt financing.
The stock market includes many exchanges around the world. The several stock exchanges in the U.S. include the New York Stock Exchange, the American Stock Exchange and the Nasdaq. Bonds are sold "over the counter" and in the bond exchange.
Both the stock market and the bond market are extensively regulated. This post includes a basic introduction to these topics because of their capital-raising utility for mature businesses.
The Basics of Bond Financing
Bonds are issued for a finite time period and offer a fixed interest rate. They are essentially promissory notes issued to several individual investors who loan the bond issuer money. The bond offering includes a specific time to maturity, interest rate and payment schedule.
Corporate bonds are rated by bond rating firms based on their riskiness. They may be designated as investment grade, safe bonds or high-yield, 'junk" bonds. Investment grade bonds earn lower interest, while the higher yields of junk bonds are based on the riskiness of the debt.
The Basics of Stock Financing
When companies have their initial public offering or IPO, they offer shares of equity to individuals in a public market. IPOs are commonly used to allow venture capitalists and other early investors to realize their profits and exit the investment. Like a bond issue, an initial public offering is complicated and highly regulated.
Companies can issue preferred shares and common shares of stock. Both preferred and common stocks are equity instruments and offer investors dividends, or payouts on the company's profits, but there are many differences between the two. Common stock generally gives voting rights to the shareholder, while preferred stock doesn't.
Preferred shares offer several advantages to different types of investors, however. The first potential advantage is fixed dividend payments and payment priority over common shareholders' dividends. The second advantage is downside protection if the company fails. Common shareholders are the last investors paid out of company assets, behind debt equity holders and preferred shareholders.
The Financial Institutions and Markets and Investing electives in the University of Kansas online MBA program provide deep insights into these topics from both the business and the investor perspectives.
Capital Raising Strategies for Young and Mature Firms
Some strategies for capital raising, such as offering stocks or bonds, are really only practical for established businesses because of their complexity. Others require owners that have substantial personal assets or other successful companies in their portfolios.
Nonetheless, entrepreneurs start hundreds of thousands of businesses yearly, with roughly 30% surviving a decade or more. Almost a third of small business failures can be tied to cash flow problems, and the inability raise sufficient capital until the business becomes profitable.1
The struggle to obtain financing through traditional sources prompted the growth of the crowdfunding industry. Crowdfunding, personal debt and funding from family and friends are popular ways to bootstrap a young business until it is able to attract venture capitalists or angel investors.
In addition to raising funds through bank loans and issuing stocks or corporate bonds, mature companies might seek equity investments from individuals or private equity firms. Just as with venture capital investments, private equity capital often comes with stipulations about how and where the business operates.
Learn How to Raise Capital for Any Firm at KU
Raising capital can be necessary at any point during a company's growth. Whether you are just starting a new business or are running an industry leader, understanding the pros and cons of financing options available is essential for your career and your company. Learn more valuable business development techniques when you earn an online MBA at the University of Kansas.