How are companies funded? 

There are basically two ways to get capital, which is funds for a company: you can borrow it or you can ask people for money.  Typically, if you ask people for money, they'll want something in return--an ownership interest in the company.  So by asking people for funds instead of borrowing, you can raise money be selling part of the company to other people.  These people are then shareholders.

Shareholders

Let’s start off with the following question—shares vs. stocks: what’s the difference in these terms?  They are often used interchangeably.  (I am amazed that the spell checker told me I got interchangeably correct on the first shot!)  The capital stock is the total money invested in a business—a corporation.  When you buy shares of a corporation, you own a portion of the capital stock of that corporation.  Hence the term “My stocks did well yesterday,” would be translated as “the shares I own in the capital stock of some corporations did well yesterday.”  It could also mean “my stock certificates did well (increased in value) yesterday.”  This definition will be touched on—from slightly different angles—again and again!
So, shareholders are the owners of a corporation; a single share (in the stock of a company) gives the owner certain rights.  For example, corporations hold an annual meeting—the shareholders meeting.  At this meeting a “board of directors” is elected.  The board of directors represents the shareholders and oversees the corporation.  This board appoints officers to run the company.  Examples of officers include a CEO (Chief Executive Officer), a CFO (Chief Financial Officer), and various vice presidents of the corporation.  Officers of the corporation and members of the board of directors are often referred to as “insiders,” as these people have “inside information” which is generally not available to the public at large.
So, let’s say you decide to form a company and you incorporate it—you create a corporation.  If you have enough money to fund the operations of the company, you are the sole owner of the corporation—in other words you own all the stock in this corporation: 100% of the shares belong to you.  Most people aren’t that lucky and they require others to help them fund the company.  There are two ways to get the funds that you need: borrow them or “buy” them!

Most companies are privately held: they're still corporations, still have shares of ownership interest in the capital stock, still have a board and appoint a CEO, etc.  However, they don't publicly solicit investors or try to have people trade their shares.  State and federal regulations restrict what people can do when it comes to finding investors for a corporation.  This issue will be touched on later.

Bonds and Liabilities

A bond is a form of a liability—something that you owe.  While shares are equity securities; bonds are debt securities.  Let’s say you don’t have the financial wherewithal to finance your company, but you do know people who have money.  You go to those people and say “If you lend me ten thousand dollars, I will pay you 2½% of that $10,000 at the end of each quarter for twenty years.  I will also return the $10,000 to you at the end of twenty years.”  If you both agree to these terms, then you have certain obligations to the lender.  You have to pay the lender $250 at the end of each quarter—forty payments in all over the life of this “note”; giving a total payment of $10,000.  You also agree to pay back the $10,000 at the end of year twenty.  That’s one way of raising money.  You can write a note, issue a bond.  That is, you can create a fixed obligation that you pay over time.

There are different types of bonds

You may have heard of a common type of bond called a “zero coupon bond.”  The term "face value" needs to be defined first: it's the value at which the bond may be redeemed when it matures.  Say a zero coupon bond has a face value of, say $1,000; a lifetime—ten years, for instance, but does not pay interest.  In this case, the purchaser of this bond might discount the face value—let’s say offer to buy it for $150—in lieu of receiving interest payments.

Now, the bonds may be callable.  You might be allowed to pay them off early, if you have the funds.  The bonds could also be convertible.  You could have a provision in your agreement with the lender that allows the bonds to be converted into a fixed number of shares of common stock.  We’ll talk about this point later when we touch on the topic of dilution.

Financing a company that will ultimately go public

Let’s say you don’t like the idea of being indebted.  You know your business will be successful, but you’re also going to have a lot of expenses for the first few years.  The idea of having to make interest payments every quarter could stifle the growth of your company—these payments are a form of risk.  So, you now have to think up some other creative way to raise the funds you need.

Well, if you can’t borrow the money, you decide to sell these rich guys something that they might value—part of your company.  This approach can take a bit of convincing.  You have to sit and show them your business plan, let them know why you think that this idea has every chance of success.  You describe the risks inherent in what you’re doing, but you also let them know that you have ways of at least addressing these risks.  The people who invest in your company will undoubtedly want to have over half of the shares—they want to control the company.  It’s their investment, so they want to protect it until they feel comfortable that the company will not only survive but thrive.

This private round of financing helps get the company off the ground.  If this stage is successful, a number of things can happen, but very often the investors want shares of the company made available to the public at large.  Going public allows broadening of the ownership interest and a potential windfall for the initial investors.  This point will be discussed later in the next few blogs.

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