There are many sources of funding for companies looking to raise
capital. However, the basic funding types fall into three very broad categories:
Each of the three has its own unique benefits and drawbacks, so it’s wise to consider the merits of each before pursuing a specific funding strategy. In basic terms, equity is a form of ownership, 
debt is an obligation, and debt-equity hybrids, as the name implies, represent a blend of the two.
Equity
Equity funding represents, in general, a direct capital commitment by an investor into an enterprise. Equity funding can be of various types and designs, but most frequently is subcategorized into either common or preferred equity – also referred as common stock/interest/units and preferred stock/interest/units, depending on corporate structure.
Common equity is the most customary and frequently used methodology for companies to obtain equity investments. Generally speaking, common equity comes with standard distribution, liquidation, and voting privileges. Most simple corporate structures deploy a single class of common equity. In such structures, the common equity’s value rises or falls in direct proportion to the economic success of the entity.
Preferred equity is a separate class, distinct from common equity, and is known as “preferred” because it carries with it certain preferential features compared with common equity. In virtually every case, preferred equity will have liquidation preference over common equity (in case of the company is sold or otherwise shut down). Oftentimes, preferred equity carries with it defined “floor yields or returns,” which could be in the form of dividends, etc. Any unpaid yields due on preferred equity generally have to be addressed before payments are made to holders of common equity. In addition, preferred equity may include features such as “super voting rights,” conversion privileges, and veto power regarding certain corporate decisions. In many cases, given a choice, an investor will orient toward preferred equity as an initial investment and, once the enterprise is growing and successful, will opt to convert to common equity at a future date if such conversion is available. The reason: Preferred equity will generally have a defined liquidation value whereas common equity can have (in theory) unlimited upside potential value.
Equity Funding Sources
Equity funding sources will frequently include but not be limited to:
Initial principals of the company are the most common of the equity investors. These owners frequently provide the money by which the rest of the company begins (and hopefully continues) its initial operation, and are usually given the “right of first refusal” in subsequent funding opportunities. As the company matures, however, these funding sources are used with less frequency.
Angel investors are generally individuals not directly involved with the company who have sufficient wealth and interest to invest in the enterprise. Most angel investors tend to invest early on in the history of the company’s capital structure. Generally, angel investors are “accredited,” – meeting the tests for minimum net worth/earnings. By using accredited investors, companies raising equity can minimize regulatory obligations as compared with accepting investments from anyone in the public.
Institutional investors are entities whose primary mission is to make investments in companies and transactions. Such investors can be small or large institutions, from small venture capital funds to major pensions funds, insurance companies, etc. This category of investor tends to be financially sophisticated and to be much more methodical in terms of completing due diligence before making an investment decision. Consequently, the time cycle for institutional investment is longer than for angel investors. In addition, institutional investors commit materially larger sums of money per each transaction funded.
Strategic investors are generally entities that have a particular interest in either the sector or the company in question. In many cases, strategic investors display a longer-term interest in potentially acquiring all or a majority control of the companies in which invest. Alternatively, strategic investors could see a particular investment as valuable if the company is a key supplier or complementary in some fashion to the strategic investor’s core business.
Debt
Debt financing presumes a future obligation of repayment. In short, the receiving entity must repay the funding source the principal amount of the money provided, plus any interest or other obligations pursuant to the agreed upon terms. Debt financing can be either “secured” or “unsecured” – repayment may or may not be guaranteed by some form of collateral. If secured, in most cases lenders will “perfect” their secured interest by some type of publicly recorded filing. Such filings could include mortgages (if real estate), UCC-1 filings (if equipment, inventory, receivables, etc.), assignment of titles (for example, vehicles), etc., which tells the public that these specified assets have already been unconditionally pledged to another funding source. This presumably eliminates new sources from providing money to a borrowing entity against assets already encumbered by another funding source. Oftentimes, personal guarantees are required from principals of the company.
Larger, established companies are sometimes able to borrow funds on an unsecured basis – that is, a lender will advance funds based solely on the general credit worthiness of the borrower.
Debt Funding Sources
Debt funding sources will frequently include but not be limited to:
Banks are government-chartered entities that provide a variety of services to taxpayers and that are obligated to follow defined regulatory protocols to protect the public’s interest. Banks have an inherent advantage relative to other lenders in the United States in that their source of money is the U.S. government, which provides funding via the FDIC at a rate that hovers at or around zero. Though banks have materially more regulatory restrictions on how they can lend money relative to non-government regulated sources, their compelling cost advantage makes them by far the most competitive source of lending in the U.S. However, banks in recent years have become a materially smaller part of the lending landscape due to their reluctance to finance all but “slam-dunk” type deals.
Contract/factoring/purchase order lenders specialize in a particular type of transactional lending, namely entities that have qualified contracts, purchase orders, or receivables. In most cases, the transactions represent very safe, defined lending opportunities that protect the lender by assigning the contracts, orders, or receivables in a very specific legal manner. As such, the lender is repaid upon the client’s customer making payment. Consequently, these types of financings are almost always short in duration.
Institutional sources of debt financing are non-bank entities specifically established for the purpose of making loans. They include but are not limited to pension funds, insurance companies, and sovereign wealth funds (outside the U.S.). In most cases, collateral requirements will not be materially more liberal than a bank’s, but other factors, such as ratio tests, credit scores, etc. will be significantly more relaxed than with a traditional bank. Thus, institutional entities in this environment are much more likely than banks to fund so-called “marginal” transactions.
Specialty finance companies fund particular subsets of transactions, for example a particular sector within a given geography. These groups are oftentimes the most aggressive within that sector and geography, but very restrictive on funding transactions outside of their core space.
Debt-Equity Hybrids
Debt-equity hybrid financing incorporates the fundamentals of a debt structure combined with an upside yield feature such that funders obtain a materially higher return expectation versus a standard senior debt lender. Though oftentimes the debt component is secured with standard types of collateral, the lender may be in a second position behind another funding source in the event of a default and liquidation. In other cases, there may not be specific collateral securing the loan – rather, the lender is counting on the general creditworthiness of the borrower. Since these structures are materially more risky than loans secured by first position collateral, lenders in this space require significantly higher yields relative to senior debt. These yield enhancements depend on some combination of higher interest rates, “points,” options or warrants to take an equity position in the borrower’s company, a percentage of profits of a project, etc.
Debt-Equity Hybrid Funding Sources
Most funders in this space are special-purpose entities or divisions that focus on these specific types of transactions. Most generally, these are referred to as “mezzanine” or “subordinated debt” lenders. These firms frequently accept “second positions” in collateral – for example, a second mortgage on a commercial office building.
Debt-equity hybrid funding sources will frequently include but not be limited to:
Mezzanine funds specialize in moderately higher-risk lending transactions that provide the repayment characteristics of debt coupled with yields that in many cases may approach equity- type returns.
Divisions of large financial institutions that make loans are operating components separately identified to focus on a defined business segment.
Distress funds are special-purpose financing entities established to take advantage of defaults in the commercial real estate or commercial debt sectors within the U.S. or a foreign country. The belief is that these funds will obtain extremely attractive yields relative to risk as generally the values of the assets in question have already materially depreciated, so there is a lot less downside risk value-wise to the lender.
Where to go from here?
This brief summary of commercial funding sources for the various types of international funding is by no means exhaustive. If you’re looking for more information and would like help achieving your capital-raising goals, contact us today. Collectively, we have more than 300 years of experience funding commercial real estate, contracts, farms, and other international projects, from $1 million up to $200 million for especially attractive opportunities.
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Dustin Watkins is a Senior Analyst at Wall Street Strategic Capital, Inc., a strategic financial consulting firm that arranges non-traditional debt financing, including asset-based bridge loans and contract financing.
