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What Are the Advantages and Disadvantages of Financing With Stocks or Corporate Bonds?

By Motley Fool Staff – Feb 28, 2016 at 12:05AM

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The capital-raising method a company uses has big implications for its future.

All new businesses need capital, and there are two ways to get it. A business can issue corporate bonds or obtain loans from a bank or other lender, or it can issue shares of stock to investors willing to pay for a stake in the business. Getting financing by issuing stock or bonds has advantages and disadvantages, and for some businesses, one method will make more sense than the other.

The advantages and disadvantages of stock financing
One of the most common ways that start-ups raise cash is by issuing stock in the business. The primary advantage of selling stock is that there's no obligation to repay the investor for the shares sold. That can be vital for a start-up, which has no credit history and therefore can find it next to impossible to get debt financing without the owners issuing a personal guarantee of the business loan. If something happens to the business that makes the stock worthless, the business doesn't have any obligation to repay the investor.

However, selling stock means giving up a piece of the business, including a portion of your overall profits down the road. If the business is highly successful, then the eventual value of that stake can be far higher than the capital you received. Moreover, shareholders have legal rights that can limit the flexibility of the business to take certain actions. With rights to proportional dividends and payments from would-be acquirers taking over the business, new shareholders take away some of the money that would otherwise go to existing investors.

The advantages and disadvantages of corporate bond financing
If the business has access to the credit markets, issuing corporate bonds can be a useful source of capital. Smaller businesses typically have to resort to direct loans from banks or other lenders, but the advantages and disadvantages are similar for both.

The best thing about issuing bonds is that everyone knows the terms of the bond, and so it's easy to understand the obligation that the business assumes with bonds. Bondholders don't have any right to anything beyond repayment of what's owed to them, and so any profits go to shareholders rather than to bondholders.

The disadvantage of bonds is that you have to meet their terms precisely, with severe consequences for failing to do so. Paying interest on time is necessary to avoid default, and some loans also require the business to adhere to bond covenants that if breached can also lead to default.

Regardless of whether a business gets financing through issuing stock or corporate bonds, there are always advantages and disadvantages. It's important to balance them for your situation in order to make the right decision for your business.

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