The Advantages & Disadvantages of Bonds Over Stock For Long-Term Financing

For businesses, deciding how to raise capital is important.

Jan 16, 2016 at 6:02AM

Businesses generally have two ways to raise the capital they need. They can borrow money, either from a financial institution or by issuing bonds on the open market. They can also issue stock in the business, giving investors an ownership interest. Each method has advantages and disadvantages that can make one form of financing more suitable than the other in certain cases.

Bonds and other debt
Borrowing money for your business can be a great way to raise capital. For smaller businesses, direct loans from banks or other funding sources are the most common method of capital-raising. As a business grows, it can get more access to capital markets, opening the possibility of issuing longer-term bonds to investors.

The primary advantage of bonds or borrowing is that the terms of the debt are set forth upfront, making the obligations of the business much clearer. The lender has no ownership interest in the business, and so if it is hugely successful, the borrower is able to keep all of the profits of the business, only repaying principal and interest to the lender.

There are a few disadvantages of borrowing to raise capital. First, you have to pay interest on time, with the consequence for failing to do so being defaulting on your debt. Depending on the interest rate, you might have difficulty paying ongoing interest and having enough leftover profit to grow your business or cover other necessary expenses. In addition, some loans impose ongoing obligations known as covenants on borrowers, and if the business breaches the covenants, it can give the lender rights against the business. For small business, lenders will often require a personal guarantee on business loans, which can potentially leave your personal assets at risk.

Issuing stock or other ownership interests in a company can also help you raise capital. The advantage of selling equity is that there's no obligation to repay the investor for the shares sold. If the business fails, the stock becomes worthless, but the company doesn't have to make the investor whole.

The downside of stock, though, is that the investor has certain legal rights that come with owning a piece of the business. Typically, stock investors have voting rights to elect members to the board of directors. They're entitled to a proportional share of any dividends the company pays. If the company is successful and receives a buyout bid, then all shareholders are entitled to receive payment from the acquiring company for their shares.

In the end, both bonds and stocks have their own risks and potential rewards. The right choice for your business depends on how much control you're willing to give up and how much risk you want to take.

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