Question

Suppose there is a startup Alpha founded last year in a very promising industry with a lot of growth opportunities.

(1) This year Alpha considers raising more funds for expanding its business and innovations, it could either choose to raise funds by issuing equities to some venture capitals or choose to issue some debts. Which way do you think is a better choice? Why?

(2) Suppose this year Alpha also earns considerable profit, what are the two ways to deal with the profit? Which way is better in this case, and why?

Answer 1

1. There are two ways of raising funds for companies. One is through equity, other is through debt. Both have advantages and disadvantages:

Equity: If the company raises funds through equity, there will not be any fixed payments to be made periodically. The capital needs to be paid at the time of liquidation. Due to this absence of payments periodically, the cost of equity is generally higher than debt.

Debt: The company needs to pay periodical payments called interest at the rate fixed. These payments need to be paid irrespective of losses incurred by the company. At the end of maturity, the company needs to repay the borrowed amount.

The factors to be considered before deciding the source of funds are:

- Cost of equity versus the cost of debt

- The projected or estimated profits of the company (sustainability of the same at least in the period of borrowing)

As the company is a startup, if the company has reasonable volume of sales and expected profits, it may borrow the funds. Cost of equity and cost of debt, both would be high as it is a start-up and hence, credibility cannot be established easily.

2. When the company earns profits, the company may employ those profits in two alternatives:

- To reinvest in the business – This is done by introducing the funds into business as capital, or accumulating them under Retained earnings, which can be used for business purposes in future.

- To distribute it – The company may distribute the profits in the form of dividends to capital providers. Also, it can use the excess cash to repay the capital, if it has excess capital. It may repay the debt as well, if the cost of equity is lower than cost of debt. The debt may be repaid, and capital can be raised through equity.

The company needs to consider the available growth opportunities. If there are growth opportunities or for expansion, the company may reinvest them in the business. Otherwise, the company may repay the capital or debt and reduce its fixed cost.