Professor Jessie

Where Does Capital Come From?

Every firm — from a garage startup to a Fortune 500 giant — needs capital to fund operations, growth, and new investments. But the sources of that capital look radically different depending on the firm's size, life-cycle stage, and growth prospects. This chapter walks through the entire capital-raising journey, from personal savings to IPOs and bond underwriting.

The Three Pillars of Capital

Firms finance their assets using three fundamental sources, often in combination:

• Retained earnings — profits the firm keeps and reinvests rather than distributing as dividends. This is internal financing — no external parties involved.
• Debt financing — borrowed funds, typically bank loans or bonds. The firm must repay principal plus interest, but existing owners keep full control.
• Equity financing — ownership shares sold to investors. No repayment obligation, but dilutes existing ownership and control.

The right mix depends on where the firm sits in its life cycle. A brand-new startup has no retained earnings and no access to public markets, so it relies on personal capital, bank loans, and venture capital. A mature public corporation taps bond markets, equity markets, and its own retained earnings.

Funding for New and Small Firms

Small and new firms face a fundamental challenge: they need money to grow, but they have no track record to prove they'll repay it. Lenders and investors demand compensating evidence of commitment — usually in the form of the owner's own skin in the game.

Where Small Firms Look for Capital

• Personal capital — the owner's own savings. External lenders almost always require a significant percentage of the owner's personal funds to be invested first.
• Loans from friends and relatives — often the earliest external capital, based on personal trust rather than financial analysis.
• Commercial bank loans — the dominant source of formal debt financing for non-public firms, though harder to obtain since the 2008 financial crisis.
• Venture capital — equity investment from professional funds or wealthy individuals willing to back unproven, high-risk ventures.
• Government programs — the SBA and other agencies guarantee loans, reducing lender risk and expanding access.

Bank Loans: The Workhorse of Small Business Finance

Bank loans represent more than 60% of debt financing (and about 20% of total financing) for non-publicly traded firms. They are the single most important external capital source for private companies — but they come in several flavors with very different terms.

Loan Commitments vs. Spot Loans

Historically, firms borrowed spot loans — receiving the full amount immediately upon approval. Today, most business loans are structured as loan commitments: contractual agreements where the bank promises to lend up to a maximum amount at specified interest rate terms over a stated period, and the firm has the option to draw down funds as needed.

Banks charge two types of fees for this flexibility:

• Up-front (facility) fee — charged for making funds available through the commitment, paid at the start.
• Back-end (commitment) fee — charged on any unused balance at the end of the commitment period, incentivizing the firm to actually use the credit line.

Fixed-Rate vs. Floating-Rate Loans

The SBA and Crisis-Era Lending Programs

Small Business Administration (SBA)

Created in 1953, the SBA's mission is to "aid, counsel, assist and protect the interests of small business concerns." Its primary function is to guarantee loans made by private financial institutions to new and small businesses that cannot obtain reasonable long-term financing on their own. The SBA also offers direct loan programs in certain cases.

By guaranteeing a portion of the loan (often 75–90%), the SBA shifts risk from the bank to the government. This makes lenders willing to approve loans they would otherwise reject — a critical lifeline for startups and small firms.

The CARES Act Response (2020)

When COVID-19 shut down the economy in early 2020, Congress passed the Coronavirus Aid, Relief, and Economic Security Act, which created two new SBA programs:

• Paycheck Protection Program (PPP) — loans designed to keep employees on payroll during the pandemic shutdown. If the funds were used for payroll and approved expenses, the loans could be fully forgiven — effectively becoming grants.
• Economic Injury Disaster Loans (EIDL) — low-interest loans to cover working capital and operating expenses caused by the disaster's economic impact.

Venture Capital: Betting on the Future

Venture capital is a professionally managed pool of money used to finance new and often high-risk firms. Unlike banks, VC firms don't make loans — they purchase equity stakes in the companies they back, taking the same ownership rights and risks as any other shareholder. And they don't just write a check and walk away; VCs are actively involved in the business, often joining the board and helping shape strategy.

Types of Venture Capital Providers

What VCs Look For

Venture capitalists evaluate thousands of opportunities and fund only a tiny fraction. When they do invest, they're hunting for two things:

• High return — VCs expect most investments to fail, so the winners must return 5x–10x or more to compensate for losses across the portfolio.
• Easy exit — VCs need a path to cash out, typically through an IPO or acquisition within 5–7 years. Without a clear exit, even a profitable company may not attract VC funding.

The Decision to Go Public

When a private firm's capital needs exceed what private sources can provide, going public becomes the logical next step. An Initial Public Offering (IPO) is a private firm's first sale of stock to the public. Roughly 200 IPOs occur in the U.S. each year, and each one represents a fundamental transformation in how the company operates.

Benefits of Going Public

• Access to a vast new pool of equity capital — public markets can raise billions in a single offering, far beyond what private investors can provide
• Market valuation — the stock price provides a real-time, publicly visible measure of firm performance and value
• Broader investor base — public shares can attract thousands of new stockholders
• Employee incentives — managers and employees can be compensated with stock, aligning interests with shareholders
• Liquidity for founders — original owners can sell shares and diversify their personal wealth away from a single company

Costs and Downsides

• Expense and time — the IPO process is lengthy, complex, and expensive (often $5–15M in direct costs)
• Mandatory disclosure — the firm must reveal detailed operational and financial information that competitors can use
• Shareholder pressure — public shareholders demand quarterly results, transparency, and growth, creating short-term pressure
• Reputation risk — a failed or poorly priced IPO can damage the firm's reputation for years

Newer Paths to Going Public

Commercial Paper: Short-Term Borrowing for Big Firms

Once a firm is public and has established a strong credit rating, it gains access to capital sources unavailable to smaller companies. Commercial paper is an unsecured, short-term promissory note issued by a public corporation to raise cash quickly — often to finance working capital needs like inventory or accounts receivable.

Why Firms Love Commercial Paper

Firms with excellent credit ratings can borrow through commercial paper at lower interest rates than bank loans. Because it's unsecured (no collateral), only companies with top-tier credit can issue it. The market is large, liquid, and efficient — a hallmark of mature capital markets.

How Commercial Paper Is Sold

• Direct placement — the firm sells paper directly to investors using its own sales force. About 12% of issues in 2018 were direct.
• Dealer placement — sold indirectly through brokers and dealers (commercial banks and investment banks). About 88% of issues in 2018 went through dealers.

Credit Ratings for Commercial Paper

Because commercial paper is unsecured, the issuer's credit rating is absolutely critical. A downgrade from P1 to P2 can significantly raise borrowing costs — or shut the firm out of the market entirely. Investors in commercial paper are extraordinarily sensitive to credit quality.

Corporate Bonds: Long-Term Debt for Public Firms

Corporate bonds are long-term debt securities issued by public corporations. They make up about 23% of all outstanding long-term bonds in the market. The minimum denomination for publicly traded corporate bonds is $1,000, and most pay interest semiannually. We covered bond valuation in depth in Chapter 7 — here we focus on how they're issued.

How Corporate Bonds Reach Investors

The initial primary sale of a corporate bond issue occurs through one of two channels:

• Public offering — using an investment bank as a security underwriter to sell bonds to a broad group of investors. Larger firms tend to use large investment banks; smaller firms work with regional banks.
• Private placement — selling directly to a small group of investors, often financial institutions like insurance companies. Faster and less regulated, but limits the investor pool.

Three Underwriting Methods

Equity Financing for Public Firms

Public firms can also raise capital by issuing new shares of stock. This requires approval from both the board of directors and the firm's existing common stockholders — because new shares dilute existing ownership.

Primary vs. Secondary Markets

• Primary markets — where corporations raise funds through new issues of securities. This includes IPOs (first-time issues) and Seasoned Equity Offerings (SEOs) (new issues by firms that already have shares trading in the secondary market).
• Secondary markets — where existing shares trade among investors (e.g., NYSE, NASDAQ). The firm doesn't receive any cash from secondary market trades.

Most primary market stock transactions go through investment banks — firms like Goldman Sachs, Morgan Stanley, and J.P. Morgan — which serve as intermediaries between the issuing firm (which needs capital) and the ultimate investors (who supply it).

The Underwriting Syndicate

A single investment bank rarely handles a large equity issue alone. Instead, the lead bank forms a syndicate — a group of several investment banks that share the responsibility of selling and distributing the new shares. The originating house (lead bank) directly negotiates with the issuing firm on behalf of the entire syndicate.

The syndicate structure benefits everyone: the issuing firm gets a larger pool of potential investors (increasing the probability of a successful sale), and each bank limits its own risk by sharing the underwriting commitment.

Top Equity Underwriters (Q1 2018)

The Underwriting Process: How Securities Get Priced

When an investment bank underwrites a stock issue using firm commitment underwriting, the mechanics work like this:

• The bank purchases shares from the issuing firm at a bid price (also called net proceeds to the firm)
• The bank resells those shares to investors at a higher offer price (gross proceeds)
• The difference between gross and net proceeds is the underwriter's spread — the bank's compensation for expenses and risk

The spread is how investment banks earn their money on underwriting deals. For a large IPO, the spread can amount to 4–7% of the total offering — generating tens of millions in fees for the syndicate.

Top Debt Underwriters (Q1 2018)

The SEC Registration Process

Before shares can be sold to the public, the investment bank must obtain approval from the Securities and Exchange Commission (SEC) in accordance with the Securities Exchange Act of 1934. This process is designed to protect investors through full disclosure.

The Registration Statement

The process begins with a registration statement — a comprehensive document that includes:

• Detailed information about the issuing firm's business operations and financial condition
• Key provisions and features of the security being issued
• All material risks involved with the investment
• Background information on the management team

The entire focus of the registration statement is full disclosure — giving the public all the information needed to make an informed investment decision.

Key Documents in the Process

• Red Herring Prospectus — a preliminary version of the registration statement distributed to potential investors before SEC approval. It contains everything except the final offering price. The name comes from the red ink disclaimer stating the registration is not yet effective.
• Official Prospectus — once the SEC registers the issue, the red herring is replaced with the official prospectus, which sets the final selling price and describes the issue in its finalized form.

Shelf Registration

Shelf registration allows a firm to register a large block of securities once and then sell portions over a three-year period without re-registering each time. This provides flexibility — the firm can time the market and issue shares when conditions are favorable, with only a short-form filing required for each individual sale (typically 1–2 days).

Key Takeaways

• Capital comes from three sources: retained earnings, debt, and equity — the right mix depends on firm size, life cycle, and growth prospects
• Small firms rely on personal capital, bank loans, SBA guarantees, and venture capital
• Bank loans dominate small-firm debt financing; loan commitments with up-front and back-end fees have replaced spot loans
• Venture capital provides equity to high-risk startups; VCs seek high returns and easy exits — angels collectively invest more than institutional VCs
• Going public via IPO unlocks vast capital but brings disclosure costs, shareholder pressure, and significant expense
• Commercial paper offers short-term, low-cost borrowing for creditworthy public firms; credit ratings are critical
• Corporate bonds are underwritten via firm commitment, best efforts, competitive, or negotiated sales
• Investment banks form syndicates to distribute new securities; the underwriter's spread compensates for risk and expenses
• SEC registration ensures full disclosure; shelf registration allows flexible issuance over three years