Methods of Equity Financing (Eigenkapitalfinanzierung)

Research Paper (undergraduate) 2003 22 Pages

Business economics - Banking, Stock Exchanges, Insurance, Accounting


Table of contents

Table of figures

1. Introduction

2. General Aspects about Equity Financing

3. Equity financing in context with the legal form

4. Several possibilities in provision of equity
4.1 External Financing
4.1.1 Private Equity
4.1.2 Venture Capital
4.1.3 Going Public
4.1.4 Further Possibilities and Variants Business Angels Trade Sales Industrial Obligations / convertible bonds Tracking Stocks Management Buy Out State Financing
4.2 Internal Financing (Retained Earnings)
4.2.1 Self-Financing Open Self-Financing Financing through Hidden Reserves Financing through accruals
4.2.2 Financing from Depreciation and Amortization
4.2.3 Factoring

5. Valuation of the different Equity Financing Instruments
5.1 External Financing
5.1.1 Private Equity
5.1.2 Venture Capital
5.1.3 Going Public
5.1.4 Further Possibilities and Variants
5.2 Internal Financing
5.2.1 Self-Financing
5.2.2 Financing from Depreciation and Amortization
5.2.3 Factoring

6. Trends and Forecast about getting Equity


Table of figures

Picture 1: Common financing-instruments in relation to the company’s stage

Picture 2: Segments of the German Stock-Market since the 24th of March 2003

1. Introduction

With the European economic and monetary union and the introduction of the Euro, a further step in the globalisation of the markets was made. This means more and more growing stress of competition for nearly every company, because trade and entrance barriers have been elimi- nated. On the other side, this also offers more chances for growth and extending the business. Both aspects of course have one in common: capital requirements and especially staying liquid. In critical economic situations it is more than ever important to stay liquid (having enough pos- sibilities to cover the short-term possibilities). That’s the task of financing and planning the finances.

There are two main sources of assessing capital: equity financing and outside or credit capital. It should be a strategic and well calculated decision, what the capital structure of a company should look like. The “leverage effect” plays an important role in this context. But it is often not easy to create this structure like it is wished. There are many factors which influence the “price” and the efforts for getting liquidity out of certain capital sources. One big example therefore is the “Basle 2” decision, which makes it more exertive for companies to gain loans of banks. This can also mean worse conditions of the loans. These circumstances make it inescapable to seek better alternatives - like for example getting equity.

Not only because of tougher times for gaining credit capital, but also because of the continuous intensification of competition, has equity financing become more and more important. One cause for that is the long-term oriented affiliation of equity capital to the firm. There are normally no “stressing” dates when it has to be paid back like is the case with loans from a bank. This elaboration will give a brief overview about the topic of equity financing. The most important and common possibilities will be presented and evaluated. But we will also have a look at some special forms and more or less unknown facts about this topic.

2. General Aspects about Equity Financing

Running a company always means looking for possibilities of how to get enough money for realizing the ideas and future visions. The demand for capital has to be covered by the right sources. But what is the right source? The market for financing a company offers many instru- ments. Each of them has its an own “character” with special advantages and disadvantages. To make the right choice, it is always important to have a detailed knowledge and overview of these instruments, but also of the own company. There is a strong relationship between the ac- tual status and maturity of a company and their possibilities of getting financed. So for example it is easier for a big and established company to find some investors as it is for a newly founded and “more risky” company.1

As mentioned, this elaboration focuses on the equity capital sources, because of its growing importance in times of globalisation, “Basle 2” and tougher competition.

Equity capital is long-term oriented capital. This means it has no certain duration or pay-back date like credit capital. Another difference in the comparison to credit capital is, that equity usually is conterminous with special rights and power over the company for the equity capital provider. These can be rights to vote or special options for equity owners like for example share-holders have it in form of the general assembly.

This long-term orientation of equity capital automatically means a certain security for the com- pany and for the creditors. The relationship between the amounts of equity capital and credit capital is always a relevant factor for the substantial situation of a company. The more equity capital is held (relatively) the securer the situation can be seen. In turn, this can be an impulse for potential investors or credit grantors. Many banks use the equity-ratio (“Equity / Total Capital”) as criterion for the credit rating. A recommendation of the State Ministry of Economic Affairs and Employment in Germany says that equity should minimally represent 20 percent of the total capital.

Equity can also be seen as a risk- and security-cushion against overextension. So, when all the equity of a company is “burned”, the company is heavily indebted. None of the shareholders has then a claim over the assets of the company. These then “belong” to the credit grantors, but overextension often is recognized to late and means tough negotiations and procedures.2

The idea of an investor, who offers equity, is normally making profits with it. The profit which is made with equity, or better said the profit of a company, can be used in two ways. Either the added value rests in the company (“retention of earnings”), because the firm’s aims are growth for example, or the profits are distributed among the shareholders / investors (“distribution of earnings”). Usually a mixture of both is done.

Distribution of earnings would mean an pay-out for the company what in the same time means reducing the liquidity. But compared to credit capital, where pay-outs exist as constant and fix payments of interest, a distribution of earnings can only be done when there is profit. That means in bad times, when liquidity is rare anyway and the company makes no profit, the com-

pany does not need to make any distribution pay-outs - but interest payments have to be paid

always, regardless of the situation of the company. Losses of the company mean no distribution and at the same time this means a value reduction of equity. The investor’s deposit loses value.3

There are several possibilities of admitting equity to the company:

- Deposits (money)

- Investments in Kind

- Rights.4

This assignment concentrates on the feed of equity in monetary form.

Equity financing can be structured according to the source or origin of the funds. There are two main categories:

- Internal Financing
- External Financing.

Within external financing there are two possibilities of applying equity to the company:

- from new participators
- from present participators

These numerated points are described and regarded in detail within the following chapters. Chapter three will give a first overview about the coherence of a company’s legal form and its possibility or chances for using certain equity financing channels.

3. Equity financing in context with the legal form

The possibilities of getting equity depend essentially on the legal form of the particular company. A distinction is drawn between issuable companies and non-issuable companies.

Non-issuable companies have no access to the stock market. So they often have problems in getting equity by external finance. These problems do not only come from the not-existing own capital market, but also from possible detractions of previous participators. For example, there is the low fungibility of the shares of the company, which are not easy to resell. Furthermore it is very difficult to evaluate the investor’s risk, because of the information problems of the out- siders. Another problem consists in the admission of new partners, which might reduce the au- thority to decide of the former participators5. Eventually, with the entry of new associates the division of undisclosed reserves degrades.6

For issuable companies there exist two possibilities of liability of the participators. Referring to the legal form, the participators are liable limited onto their capital brought in or they are liable unlimited, so even with their private means.7

For companies with access to the stock markets it is easier to get equity. In this case, the equity can get split into many parts of the total sum, which means that the individual investor does not have to pay a huge amount to get participator. For that reason, even people with only a small fortune can become stockholders of the company. Further, there is a higher fungibility in com- parison to the shares of a non-issuable company. The investor can resell them anytime without any problems. These companies also have the possibility to place an industrial obligation.8

It is not possible to answer the question about the optimal legal form, because the individual premises of each founder are different. But if one embraces the possibility of the integration of potential investors, the legal form of a public company would be the most advantageous. Especially for business partnerships it is often a problem to get equity capital.9 The advantages and disadvantages of the different methods of getting equity in context with the legal form will be discussed in the following chapters of this assignment.

4. Several possibilities in provision of equity

In the following chapters, different methods of getting equity are described. Picture one gives an overview about general financing methods in relation to the age / maturity of a company. It shows what instruments usually are or chosen or should be chosen in certain phases. The lifecycle of a company can be divided into three stages:

- Early-Stage
- Medium-Stage
- Later-Stage

To keep up the originality of the picture, it was left in the primarily German language:

Abbildung in dieser Leseprobe nicht enthalten

Picture 1: Common financing-instruments in relation to the company’s stage10

4.1 External Financing

Within the scope of external financing, the source of the equity is outside the company.

4.1.1 Private Equity

Private Corporations, business partnerships, limited liability companies, but also smaller stock corporations have no access to the stock exchange. For these companies there exists no highly organized capital markets at which they can get equity. That is a significant difference to marketable stock corporations.

Individual enterprises face the biggest problems in getting equity, because at the beginning they only have the capital of the founder. The owner can increase the equity by bringing his capital into the company, but he can also decrease it by taking it away from the company. The second chance for individual enterprises would be getting equity through self-financing, which is discussed in one of the following chapters.

Furthermore, there exists the possibility of taking in a new partner. If the company wants to keep its legal form, the new participator should be a silent partner. He has to make a deposit

which directly vests in the company. In this case, it is impossible for outsiders to realize how many partners participate at the company, because that fact is not represented in the balance sheet. The silent partner has to be participated at the gains of the company in a fair way. A typical partner gets his deposit back when he retires. In contrast to that, a silent partner participates also on the property growth when he retires.11

If new partners (except silent partners) join the company, the legal form changes into an ordi- nary partnership. A further possibility to get equity would be the change into a limited partner- ship. In this case, there is one general partner who is unlimited liable and some limited partners who are maximum liable up to the amount of their capital brought in. Because of the limited liability of the limited partners, it is often easier for the company to get equity, because the risk for the investors is not so high.

At a limited liable corporation, the liability of all participators is limited to the amount of their capital brought in. That is the reason why it is relatively easy for a limited liable corporation to get equity. The partner’s interest shares are tradable, although they are not very fungible. There exists no organized market place to trade with them.

4.1.2 Venture Capital

Venture capital companies invest in young and innovative enterprises. Giving equity to them often means taking a high risk for the venture capital companies, so they have to do a kind of risk management. But if only some of the innovative enterprises financed with the help of venture capital survive the first years and develops into prospering and lucrative enterprises, the venture capital companies are able to create gains when selling their shares.12

Venture capital financing occurs usually in a certain way with different phases along the so called venture capital lifecycle.13 At the beginning stands the seed-financing. That means fi- nancing of research and development processes. This phase is followed by the start-up- financing, which means financing the foundation of a company and the preparation for the pro- duction. During the first- and second-stage-financing, the rollout and the production growth are backed through venture capital. Thenceforward self-financing would be possible, because the company starts to make profits. Third-stage-financing means financing of an expansion. If the company wants to sell an issue, it would be easier with the help of bridge-financing, which means to give the company more equity. In this case, the equity ratio on the balance sheet grows, thus improves the chances for a successfully going public. In some cases, venture capital is also used to finance management-buy-outs.14

4.1.3 Going Public

Going public, which is equipollent to emitting company shares at a stock market, often means a huge milestone in the development of a company. With this method, the level of “Private Equity” is abandoned. It is a long-lasting and constitutional change of the capital structure which gives the possibility to nearly everybody to become an owner / share-holder of the company (“Public Equity”). This “tool” for getting equity is often used in a late stage of the expansion phase or at the beginning of the maturity phase.15,16

The normal way of going public (also called Initial Public Offer, “IPO”) begins with finding external partners like consultants, accountants, lawyers and representatives of investment banks. Usually the whole procedure is managed as a project with its responsible persons and a certain time frame. At the beginning, a feasibility analysis is inevitable. Besides formal de- mands like legal obligations, also the market usages and the maturity of the company for an IPO have to be considered. Maturity is depending on management skills, the strategic concept, the efficiency of the organizational structure and the market and innovation potential.17 Not only these internal factors are relevant for the success of an emission and the amount of the emission receipts, but also the current stock market situation and its future outlook - especially for the segment the company is in. In the year 2000, when nearly all of the stock-markets in the world were booming, many companies made their IPO’s. In nearly every case the emissions were strongly oversubscribed and the companies reached relatively high emission receipts. To- day, three years later, in a phase of “bear-markets” and falling share indexes, there are less IPO’s and it is harder to find acceptance about the “correct” value of the company. The big runs on new-emissions and their high prices are over.18

The usual way in start-phases of IPO’s is finding an investment house or a consortium of banks, which acts as an accompanist on the way to the listing. Image and research capability of the accompanying investment bank is important for the decisions of investors, so the choice should be well thought-out - often there are also differences about the costs of a partnership.19

Besides the formal preparations of an IPO it is also very important to convince and win poten- tial investors for the forthcoming applications for shares. That usually means promotion and presentations at exhibitions, advertisements via TV and direct contacting to potential financial bakers. Here, the share issue prospectus is playing an important role. It is a script or a brochure which should offer detailed information and future outlooks about the company to the public. This share issue prospectus has to be taken very serious, because the company can be made legally liable for the content. All of these marketing usually are planned and worked out together with a marketing agency.20

One important formal step which has to be considered for going public, is the legal form of a company. In Germany it is only possible for specific capital companies: that is the “Incorporated” and the association limited by shares. In Germany many potential stock market candidates predominately are business partnerships or limited liability companies. This means inevitably a change of corporate form, for which a time of six to twelve months can be calculated. New corporate organs have to be elected and an entry to the commercial register has to take place. This can happen after a positive audit by a certified accountant.

Now the company is in a good position to work out all the remaining tasks concerning the list- ing. This is for example the choice of the stock-market segment21, the stock-market intrinsically (Germany’s biggest stock-market in Frankfurt, with floor and computer trade, several regional stock-markets, which sometimes offer specific features, or a foreign market in another country), the special type of shares (for example “no-par shares” or “face value shares”, “common shares” or “preferred shares”, “name shares” or “bearer share”). Also very important is to find the most effective listing volume/price and method (keywords: “underpricing”, “book- building”, “green-shoe”).22

Picture 2: Segments of the German Stock-Market since the 24th of March 200323

Abbildung in dieser Leseprobe nicht enthalten


1 Compare Engelmann / Juncker / Natusch / Tebroke (2000), page 19f

2 Comp. http://www.bmwi.de/Homepage/Existenzgr%fcnder/Finanzierung/Eigen_Fremdkapital.jsp; 2003-04-04

3 Comp. Olfert (2002), p. 165ff

4 Comp. Olfert (2002), p. 165

5 Comp. Boemle (1993), p. 193ff

6 Comp. Perridon / Steiner (2001), p. 323ff

7 Comp. Wöhe / Bilstein, (2002), p. 35f

8 Comp. Lorch (2002), p. 26

9 Comp. Engelmann / Junker / Natusch / Tebroke (2000), p. 36f

10 Comp. Engelmann / Juncker / Natusch / Tebroke (2000), p. 45

11 Comp. Perridon / Steiner (2000), p. 328

12 Comp. Wöhe (2002), p. 823

13 See also chapter 2

14 Comp. Lorch (2002), p. 6

15 Comp. Engelmann / Juncker / Natusch / Tebroke (2000), p. 147ff

16 See also picture 1

17 Comp. Betsch / Groh / Lohmann (2000), p. 364f

18 Comp. www.aktiencheck.de; several analysis, 2003-03-31

19 Comp. Betsch / Groh / Lohmann (2000), p. 366

20 Comp. Rödl / Zinser (1998), p. 327ff

21 Look at picture 2

22 Comp. Rödl / Zinser (1998), p. 305ff

23 Comp. www.deutsche-boerse.de, 2003-04-04


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Methods Equity Financing Finanzierung




Title: Methods of Equity Financing (Eigenkapitalfinanzierung)