Why a company would prefer selling shares rather than borrowing money?

Question

I hope this question doesn't sound stupid as I don't have much economic knowledge.

If I understand it right, the point of selling shares is that a company can finance itself. But usually small companies get a loan from the bank for this purpose. Why is that bigger companies can't (or won't) do that? Wouldn't it be better for them to pay the debt than giving profits to shareholders forever or even losing control of the company?

I thought that maybe is because the loan would be so big that banks wouldn't risk to give such a credit or couldn't afford that kind of business. But even if that's the case, companies could try to find a group of investors (such as the shareholders themshelves) and pay them back with interests, without selling part of the company.

Maybe I got something wrong and the question makes no sense, as I told you I'm not an expert on this field.

Thanks!

Answer 1

Your question can be rephrased as: 'why finance a company with equity, instead of with debt?'

Before answering, let's briefly define the terms:

Debt Financing is generally simplistic. If I loan a company money, it likely has a legal obligation to pay me a specific % of interest each year, with full repayment of my principal at a set point in the future. I will only lose my investment if the company goes bankrupt and becomes unable to pay all of its debtors.

So, my risk here is relatively low, but my return is also fixed.

'Equity Financing' is another way of saying funding received through the sale of shares. Someone who buys those shares becomes a 'shareholder', AKA a partial owner. A 'share' typically provides a few benefits to the purchaser (note that different 'share classes' can have different rights, but these are the typically present ones; look up "common shares vs preferred shares" for some frequent differences in share rights):

(1) It likely gives the shareholder a certain right to dividends;
(2) It likely gives the shareholder a certain right to money when the company closes; and
(3) It likely gives the shareholder a certain voting right, to elect the Board.

In short, if I buy a share, it doesn't give me as sure-fire a return as loaning the company money. BUT, because points #1 & #2 are typically proportional to a company's future earnings, then if the company does quite well, I stand to earn more than if I just loaned the company money.

So the trade-off to the investor, is essentially 'lower risk' with debt vs 'higher reward' with equity.

For the company itself, the choice is actually quite similar - remembering that the company is already owned by shareholders, so what we're actually talking about with 'what is better for the company' is 'what is better for the current shareholders'?

For the company, every $ of debt financing used for operations, is a guaranteed interest payment they need to make. So the more debt used to finance operations, the riskier the company becomes. Every $ of equity financing does reduce dividends for previous shareholders, but that's at the benefit of having a less risky company. For example, if the company has a loss in the year and can't pay its debt, it might need to declare bankruptcy. But if it has a loss in the year with equity financing, it likely just means there won't be dividends that year.

To take it one step further, if a company has a significant amount of debt relative to its assets, investors will expect that they pay a high rate of interest anyway, to compensate them for investing in a company that has a higher possibility of going bankrupt. If a company has entirely too much debt, or is already risky to begin with, ultimately the only way to get financing will likely be to offer equity financing, so that investors taking on higher risk can get compensated with higher reward.

Answer 2

I assume by "ask for credits" you mean "borrow money", and certainly companies do a mixture of both. There are benefits to both, and whole books on Corporate Finance deal with this topic.

Debt is (usually) cheaper than equity (and usually has tax benefits), but it requires periodic payments (interest/coupons) that cut into cash flow. Also, if a company is sold, debtholders MUST be paid out of the proceeds, which may leave nothing left for owners.

However, when selling equity, you have no real commitment to the shareholders other than a piece of the company in a liquidation (or sale). Many companies pay dividends once the company has grown to a significant size, and there are less way for them to spend cash, but they are not a requirement for common equity. So you can get cash upfront without any direct requirement to pay them back.

Smaller companies often find it easier to just borrow money, as it's less risk for the financier. As a company grows, venture capital or other investors will prefer equity as they have more risk but expect more return as a result. They'd rather take a risk that they get 20% or more on their equity investment than get a fixed 7% on a loan.