Debt Financing
Types of Debt Financing:
- Senior secured or unsecured Debt
A secured loan is a loan in which the borrower pledges some assets as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan. The debt is thus secured against the collateral — in the event that the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to regain some or the entire amount originally lent to the borrower. From the creditor’s perspective this is a category of debt in which a lender has been granted a portion of the bundle of rights to specified property.
The opposite of secured debt/loan is unsecured debt, which is not connected to any specific assets and instead the creditor may only satisfy the debt against the borrower rather than the borrower’s collateral and the borrower.
Generally speaking, secured debt may attract lower interest rates than unsecured debt due to the added security for the lender, however, credit history, ability to repay, and expected returns for the lender are also factors affecting rates.
- Subordinated Debt
Subordinated debt (also known as subordinated loan, subordinated bond, subordinated debenture or junior debt) is debt which ranked after other debts when a company fall into receivership or bankruptcy.
Such debt is referred to as subordinate, because the debt providers (the lenders) have subordinate status in relationship to the normal debt. A typical example for this would be when a promoter of a company invests money in the form of debt, rather than in the form of stock. In the case of liquidation (e.g. the company winds up its affairs and dissolves) the promoter would be paid just before stockholders—assuming there are assets to distribute after all other liabilities and debts have been paid.
Because subordinated debt is repayable after other debts have been paid, they are more risky for the lender of the money. It is unsecured and has lesser priority than that of an additional debt claim on the same asset.
Subordinated loans typically have a much higher rate of return than senior debt due to the decrease of money devolution and therefore a higher risk. Accordingly, major shareholders and parent companies are most likely to provide subordinated loans, as an outside party providing such a loan would normally want compensation for the extra risk. Subordinated bonds usually have a lower credit rating than senior bonds.
- Convertible bonds
A convertible note (or, if it has a maturity of greater than 10 years, a convertible debenture) is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features. Although it typically has a low coupon rate, the instrument carries additional value through the option to convert the bond to stock, and thereby participate in further growth in the company’s equity value. The investor receives the potential upside of conversion into equity while protecting downside with cash flow from the coupon payments.
From the issuer’s perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment. The advantage for companies of issuing convertible bonds is that, if the bonds are converted to stocks, companies’ debt vanishes. However, in exchange for the benefit of reduced interest payments, the value of shareholder’s equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares.
- Royalty Financing
Royalty financing is an alternative to regular debt financing and equity financing. In a royalty financing arrangement, a company would receive a specific amount of funds from an investor or group of investors and in exchange, the investors would receive a percentage of the company’s future revenues over a certain period of time, up to a specific amount. The investment can be considered an “advance” to the company, and the periodic percentage payments can be considered “royalties” to the investors.
Compared to equity financing, royalty financing enables entrepreneurs to obtain capital without giving up a significant ownership position in the company to outside investors. The founders of the company are thus able to preserve their equity position, which may help motivate them toward continued success.
Compared to debt financing, royalty financing provides more convenient payback terms and less severe penalties for default. In addition, the infusion of cash may help the company increase sales, which may make it a better candidate to obtain more financing later. Finally, royalty financing enables a company to keep its options open for later financing rounds. In contrast, a company that incurs significant debt or sells a great deal of equity in its early stages may find it difficult to attract investment later.
Equity Financing
An equity investment generally refers to the buying and holding of shares of stock on a stock market by individuals and firms in anticipation of income from dividends and capital gains, as the value of the stock rises. Typically equity holders receive voting rights, meaning that they can vote on candidates for the board of directors (shown on a proxy statement received by the investor) as well as certain major transactions, and residual rights, meaning that they share the company’s profits, as well as recover some of the company’s assets in the event that it folds, although they generally have the lowest priority in recovering their investment. It may also refer to the acquisition of equity (ownership) participation in a private (unlisted) company or a startup company. When the investment is in infant companies, it is referred to as venture capital investing and is generally regarded as a higher risk than investment in listed going-concern situations.
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