One of the critical questions facing organisations is finding the appropriate mix of Finance for their activities. Equity and debt are the traditional sources of Funding for most companies, while some choose blended or hybrid sources of Funding.
Equity and debt can be looked at with regards to access to ﬁnance and economic resources with which a business is operated for the purpose of generating returns.
How do you define capital?
The capital structure of a firm can be defined as the mix of a firm’s long-term funds (Brealy, et al, 2008). Finance options range from debt, equity and various shades of hybrid capital, and each type of capital has its advantages and disadvantages. As firms face different capital requirements, it has become important to evaluate the contribution of these options before embarking on any fundraising initiative.
What determines an appropriate mix of capital structure has been based on the arguments of the trade-off theory (Romano et al., 2000), the agency cost theory (Jensen and Meckling, 1976; Myers, 1977) and the pecking order theory (Myers and Majluf, 1984).
In taking a decision on whether to finance business by either Debt or equity, the nature of the business plays an important role. For example, the financial behaviour that non-family businesses would exhibit will be different from that of family businesses (López and Sánchez, 2007). The desire not to dilute control of the company over the course of generations places constraints on the financial resources of a family business. The decisions of family businesses are based more on how these decisions may affect family control of the company rather than on a comprehensive assessment of complex financial issues (Croci et al., 2011)
Equity ﬁnance can be viewed from the perspective of shared ownership which has been seen to attract more incentives. Debt has been seen to be less ﬁnancially constraining than equity for large projects, however, equity is more accessible to small projects.
Business Funding: Explained
Most studies of capital structures and business funding have focused on public corporations (Miguel and Pindado, 2001; Fama and French, 2002; Brav, 2009; Acedo and Ruiz, 2014) while a limited number of studies on capital structure have been conducted on privately held firms (Brav, 2009) and just a few studies on private family enterprises.
The work of Jensen and Meckling (1976) analyses the optimal capital structure when ‘‘agency costs’’ prevail between the ﬁnanciers and the managers. This shows that debt is less susceptible than equity to moral hazard in effort. However, if moral hazard concerns the risk choice of the project, equity ﬁnance is perceived to be less susceptible. Hence, the optimal capital structure of outside ﬁnance is obtained by minimizing the sum of the agency costs. The trade-off between the beneﬁts of risk-smoothing under equity and the incentive effects of debt is shown in Grossman and Hart (1982). Ho lmstrom and Milgrom (1991) analyse the optimal contract between the principal and the agent under moral hazard with multitasking and show that equity dominates as a result of pure risk equity. Innes (1990) considers moral hazard in the effort’s choice of a risk-neutral entrepreneur.
More recently, Hellwig (2009) re-examines the theory of Jensen and Meckling (1976) by considering two interdependent sources of moral hazard: risk and effort choices. This interdependence adds an additional dimension to the agent’s set of choices: concealing low effort behind a relatively high-return/high-risk project. Within this more general framework, Hellwig (2009) shows that, contrary to the standard literature on ﬁnancial contracting, an incentive ﬁnancial scheme which achieves the ﬁrst-best outcome does not exist if the entrepreneur has insufﬁcient funds. Besides, when it exists, such an incentive scheme does not correspond necessarily to a combination of debt and equity ﬁnance.
Debt versus Equity Funding
The capital structure of a firm can be defined as the mix of its debt financing and its equity financing (Brealy, et al, 2008). Another definition states that capital structure is
“the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.”(http://en.wikipedia.org/wiki/Capital_structure).
A more descriptive definition is provided by Investopedia.com as “a mix of a company’s long-term debt, specific short-term debt, common equity and preferred equity. Capital structure is how a firm finances its overall operations and growth by using different sources of funds.”
Financial gearing and leverage are used interchangeably to describe the relative proportion of debt finance that a business holds to its total equity finance.
What is debt?
Within the context of capital structure analysis, debt is money that is borrowed by one party from another. It is important to make this definition so as to make a distinction between borrowed funds and spontaneous liabilities (also known as spontaneous finance).
Spontaneous liabilities are those liabilities that accrue normally from the operational activities of a business, such as deposits made by buyers in advance to secure purchases or goods received on credit from the firm’s suppliers with an agreement to pay within a specified period. These do not count towards the analysis of capital structure.
The International Accounting Standards Board (IASB) does not use the word “debt” in the standards that govern the preparation and presentation of financial statements of public companies in the European Union, the term “financial liability” is used to describe what has been loosely termed debt in the context of corporate finance.
Examples of debt include term loans from banks, banker’s acceptances, debentures, commercial papers, finance leases and bonds.
What is equity?
Equity can be defined as the interest of the owners in the assets of an entity after all liabilities are settled. As defined by IAS 7, an equity instrument is “any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities”. Thus, it can be concluded that equity is the “residual interest in the assets of an entity after deducting all of its liabilities.”
Example of Equity would include the issued and paid-up share capital of the company, along with the balances of any share premium accounts as well as the cumulative retained earnings of the company.
How does hybrid financing work?
Some financing arrangements may have attributes of both equity and liability. In these instances, some residual interest that ranks pari passu with other holders of equity, is vested in the provider of the providers of debt finance. These are also called compound instruments. (Alexander, et al, 2009)
Examples of hybrid finance would include convertible bonds, which pay coupons at a predetermined rate and which also confer on the holders (the lender), the right to a determinable quantity of ordinary shares of the borrowing company.
Whilst companies traditionally classified instruments as equity or debt based on their legal form, the current and widespread adoption of International Financial Reporting Standards (IFRS) now compel reporting companies and other reporting entities to measure and present the equity elements and the debt elements of such hybrid financial arrangements separately based on their substance rather than their legal forms. (Alexander, et al, 2009); (IAS32); (IFRS 7)
Modigliani and Miller (1958) posit that within the agency and asymmetric information domains, the fundamental difference between private and public firms is their ownership structure and hence the degree to which control is valued by their shareholders. Where conflicts of interest exist, agency problems can arise and control is valuable. Consequently, firms controlled by a major shareholder should be reluctant to use equity financing when doing so causes the controlling shareholder to risk losing control (Amihud, Lev, and Travlos (1990), Stulz (1988). Since private firms are held by at most a few shareholders, each of whom enjoys significant control over the firm; whereas a public firm is held by many shareholders without anyone having major control over the firm, the cost of issuing equity is higher for private firms than for public firms.
In addition, given the separation between management and ownership that is more typical of a public firm than a private firm, managers of public firms may rationally seek to dilute the control of any single shareholder, further increasing the value of equity to managers of public firms relative to managers of private firms (Morellec, 2004). Finally, given private firms do not tend to offer minority shareholders the same disclosure and protections they would enjoy with public firms, minority shareholders may be less willing to purchase private equity, contributing further to equity issuance being more expensive for private firms than public firms.
In sum, a security that gives away control—equity—should be much more costly to issue for the manager of a private firm than for the manager of a public firm. Another important distinction between private and public firms is the level of information asymmetry between insiders and outsiders (i.e., transparency) at the time capital is raised. Since private firms are obviously more opaque to outsiders, and since the value of equity, being the more junior security in the capital structure, is more sensitive to information asymmetry than the value of debt (e.g., Myers and Majluf (1984), Noe (1988)), the cost of equity relative to debt will be much higher for private firms than for public firms and thus equity will again be less attractive than debt for private firms. Using this subsample, I show that firms with more dispersed ownership, as proxied by the number of shareholders in the firm, and firms that are more transparent, as proxied by whether they are legally allowed to issue securities to the public, are more likely to rely on equity financing and have lower debt ratios. It follows therefore that since private firms are subject to higher financing costs and when facing the debt– equity choice, private firms are less likely to use equity than public firms which in turn affect their financial policies; it is natural to ask how private firms’ relatively more constrained financial policies affect other aspects of the funding of the firm.
One of the common beliefs is that one important reason private firm’s go public is to obtain better and cheaper access to external equity capital hence the relative cost of equity to debt capital differ between private and public firms’ which result in differences between public and private firms’ level of leverage and likelihood of choosing debt versus equity financing. It follows that if private equity is more costly than public equity then the relative cost of equity to debt capital is higher for private than for public firms and that private firms will rely on debt financing compare to public firms.
Myers and Majluf (1984) in their pecking order theory predict that the more asymmetric the information between insiders and outsiders is, the less firms will rely on the information-sensitive instrument, equity, and the more firms will rely on the information-insensitive instrument, debt.
The trade-off theory predicts that the firm will continue to increase its leverage until the marginal cost of its equity is equal to the marginal cost of its debt. Therefore, at the optimal debt ratio, the decision to raise capital, debt or equity, in the external capital markets becomes more costly for private firms and hence they have a stronger preference for internal financing. Also, if private firms’ debt ratios are higher, their debt is more risky and more information sensitive as well. The pecking order theory therefore predicts that private firms’ preference for internal capital over external capital will be stronger compared to that of public firms.
Control considerations make equity financing more attractive for public than for private firms for three main reasons.
First, firms controlled by a major shareholder should be reluctant to use stock financing when this causes the controlling shareholder to risk losing control (Amihud, Lev, and Travlos (1990), Stulz (1988)). Since private firms are held by at most a few shareholders, each of which has significant control over the firm, whereas public firms are held by many atomistic shareholders, each of which has virtually no control over the firm, the cost of giving away control is higher for shareholders of a private firm than for those of a public firm. Indeed, maintaining control is probably a big reason for private firms to remain private, suggesting that value of control may be especially high for private firms that could have gone public but chose not to do so. Because equity gives away control, this implies that the cost of issuing equity is higher for private firms than public firms.
Second, Morellec (2004) shows that given the separation between management and ownership that is typical among public (but not private) firms, managers of public firms may rationally seek to dilute the control of any single shareholder, and as a result may find issuing equity especially attractive. Specifically, Morellec (2004) shows that absent a market for corporate control, the firm is generally under-levered as the manager’s empire-building desires distort the firm’s financing and investment policies. Third, given private equity does not offer minority shareholders the same disclosure and protections that they would enjoy with public equity, minority shareholders may be less willing to purchase private equity, thereby making it more expensive.
Another important distinction between private and public firms is the level of information asymmetry between insiders and outsiders at the time capital is raised. Since private firms are obviously more opaque to outsiders, and since the value of equity, being the more junior security in the capital structure, is more sensitive to information asymmetry than the value of debt (e.g., Myers and Majluf (1984), Noe (1988)), the cost of equity relative to debt will be higher for private firms than for public firms, and thus equity will again be less attractive than debt for private firms.
According to Faulkender and Petersen (2006) in their work among public equity firms, they claim that firms without access to the public debt markets are more restricted in their ability to borrow and therefore have lower leverage. Consistent with the sensitivity effect I find that public firms are more likely than private firms to visit the external capital markets, either to raise or to retire capital. Further, in an analysis of the determinants of debt ratios, I find that the leverage of private firms is more sensitive to operating performance but less sensitive to traditional trade-off theory determinants of capital structure such as proxies for growth opportunities.
Determinants of Optimal Capital Mix
Following from the arguments of the trade-off theory (Romano et al., 2000), the agency cost theory (Jensen and Meckling, 1976; Myers, 1977) and the pecking order theory (Myers and Majluf, 1984), there are many factors that may influence decisions about the financial structure.
In the first place, ownership structure plays a major role in taking a decision between debt and equity, various studies have found that family businesses tend to have less debt (Gallo et al., 2004; López and Sánchez, 2007; Ampenberger et al., 2013). They argue that an increase in debt could lead to a loss of family control and personal wealth. Debt increases financial risk of bankruptcy, which is correlated with loss of control. However, other papers have found that family firms are as likely to use debt as non-family firms (Anderson et al., 2003; Setia-Atmaja et al., 2009). In most cases family firms are reluctant to accept capital from non-family members because this would imply sharing family control; they rather prefer family and firm internal financing (Romano et al., 2000). Family members’ reluctance to open up the firm’s capital will increase debt levels; they tend to borrow more in order to maintain control (Matthews et al., 1994). Consequently, when internal funds have run out, family businesses will find the needed capital investment through debt (Hamilton and Fox, 1998). The same was corroborated by the pecking order theory (Myers and Majluf, 1984). According to this theory the existence of informative asymmetry between the company and the market means that businesses prefer internally-generated funds for financing to external financing. If internally generated funds are inadequate, debt financing will be used and, equities as a last resort, which have the highest information costs. According to Croci et al. (2011), the combination of the desire to maintain control and information asymmetries helps to explain the strong preference of debt over equity financing in family firms
Secondly, previous debt level and transaction costs will influence the debt – equity finance option. For instance, Firms partially adjust their actual debt level to the target level depending on the significance of the transaction costs. Firms that have already borrowed substantially may find it difficult to access more borrowing and will therefore be limited to equity as against further debt. Owner-manager involvement in a family business should reduce transaction costs due to the overlap of business and family, giving it more opportunities to gain access to resources from the lenders. Moreover, family firm balance sheets do not provide information regarding the personal collateral provided by the owners to obtain financing.
Another determinant of capital structure could be the existence of growth opportunities. The trade-off theory predicts that investment opportunities are generally associated with less leverage because they are associated with a lower free cash flow and less need for the disciplinary role of debt over manager behaviour (Jensen, 1986). Moreover, growth opportunities generate more agency conflicts between stockholders and lenders (risk-shifting substitution) (López and Sánchez, 2007). The pecking order theory however predicts that rapidly growing firms are likely to have insufficient earnings to finance all of their growth internally and they will seek external financing. Growth is likely to put a strain on retained earnings and push the firm into borrowing (Michaelas et al., 1999; López and Sánchez, 2007). On the contrary, with family firms, the aim of guaranteeing family control of the company limits its sources of potential financial resources, which is one of the major problems affecting the growth opportunities of family business (Romano et al., 2000). For example, a family business owner-manager may prefer to jeopardise growth in order to avoid losing control of the business as this would create management difficulties for the next generation (Le Breton-Miller and Miller, 2006).
Moreover, cost of issuance plays a role in the debt – equity choice. According to the pecking order theory managers have a preference for issuing debt when interest rates are low or when interest rates are expected to increase (Poutziouris et al., 2006; Barry et al., 2008). However, according to the trade-off theory, an increase in the interest rate makes debt more attractive because of its greater potential for tax deduction (Taggart, 1985). Previous research has suggested that family firms experience a lower cost of debt than non-family firms because lenders perceive lower conflict of interest with family firms due to their long-term orientation and undiversified portfolios (Anderson et al., 2003). The study conclude that the family ownerss interest in maintaining control of the firm in the long term reduces agency problems with creditors and the cost of debt financing compared with non-family firms.
Also, the age of the business or stage in life cycle will determine the funding structure. Literatures have established the theory that firms evolve through a financial life. As such firms rebalance their capital structure and within the context of limited liability and non-decreasing ﬁnancier’s payoff, debt is shown to dominate equity.
Another reason for the dominance of debt over equity as emphasized in the literature on debt ﬁnance optimality in the presence of costly state veriﬁcation, e.g., Townsend (1979) and Gale and Hellwig (1985) is the minimization of monitoring costs while monitoring under equity is deterministic. However, Al-Suwailem (2005) suggests that a random auditing strategy reduces the higher monitoring cost of the equity contract, and this leads to the predominance of equity over a speciﬁed range of the ﬁnancier’s opportunity cost.
Hellwig (2009) however criticizes the assumption of the ﬁnancier’s non-decreasing payoff by Innes (1990) which is required to show the optimality of debt. Instead, Hellwig (2009) shows that, for risk-neutral ﬁnancier and entrepreneur, the type of the incentive scheme does not matter if it provides the requisite payoffs and incentives in expected-value terms. Also, if in addition to risk neutrality and limited liability, the agent exerts efforts in multiple tasks, Dam and Ruiz-Pe ´rez (2012) show that equity, rather than pure debt, is the optimal contractual arrangement. Apart from the Pareto-optimality at the microeconomic level (taking into account the welfare of the principal and agent), it is important to compare equity and debt on the macro-level. There are few studies that point out the economic inefﬁciency of debt ﬁnance in the form of underinvestment (Gale 1990; Hubbard 1998; Dang 2010). In a two-period relationship between risk-neutral entrepreneur and ﬁnancier, Dang (2010) shows that debt leads to an inefﬁcient economic situation where some entrepreneurs, although endowed with positive net present value projects, are ﬁnancially constrained during the second period. According to Cressy (2002), the costs of bankruptcy associated with debt ﬁnance create a deadweight loss that both ﬁrms and banks wish to avoid. He adds that ‘‘one way this can be done is by the use of equity, since equity has no bankruptcy costs associated with it.
In conclusion, the nature of the business, ownership structure, costs, and the control framework will determine how a business is funded by debt or equity, and more importantly, most medium to big companies are funded through hybrid finance options
In practice, it is rare to find an all-equity or all debt funding businesses, most businesses are funded through a combination of debt and equity.