External Financing: A Guide to Issuing Bonds

by David Dierking

4 min read

You might not qualify for a traditional business loan from a bank, but there’s no need to worry. Look beyond traditional business financing and you’ll find some compelling alternatives. Issuing stock, for example, can help you raise capital by selling shares of your company. There are disadvantages to selling off pieces of your company, though, which is why bonds could be a better alternative.

Stock Offerings

Small companies that want to stay small can attest to the impact of selling shares to public or private investors. Dilution, which happens when your company has many investors, reduces the value of existing shares by increasing the number of outstanding shares of a company. Your business may be valued at $1 million, for example. If 10,000 shares exist at a market value of $100 per share, issuing another 2,500 shares theoretically lowers the value of all outstanding shares to $80. Shareholders who have equity interest in a business typically have a say in how that company conducts its operations. Bringing such investors into the fold takes away some control from majority owners who may disagree with new shareholders views on how to conduct business. Outside individuals are concerned about share price appreciation. Their concern may create a difference of opinion on how appreciation might be achieved.

Issuing Bonds

Selling bonds to finance new projects creates the required capital, but unlike stock, bonds do not represent ownership in the company. Rather, you issue bonds at a par value of $1,000 with a promise to repay principal to bondholders at some point in the future. Along with the promise to return the debt to people who buy the bonds, investors, comes interest payments that represent the cost of borrowing from said investors. Interest payments are commonly known as coupon payments, as many physical bond certificates issued historically had a strip of paper attached, which could be stripped off and presented to the issuer in return for an interest payment. You make interest payments semi-annually, and in some cases, bonds do not require interest at all. You’d issue zero-coupon bonds at a deep discount to that par value of $1,000. The bondholder might purchase part of your debt for $800, and you’d promise to return the full $1,000 par value in 10 or 20 years. The appreciation realized by the bondholder at maturity, or the point at which your company promises to repay full principal, can be calculated over the life of the bond to determine an annual rate of return to investors. That return can be compared to the semi-annual interest payments of coupon bonds that pay a stated amount of fixed interest. If the issuer is a private entity, bond payments or capital appreciation of bond principal is taxable to investors.

What Determines Bond Interest Rates

You determine bond coupon rates by two main factors: the existing interest rate climate of the Canadian economy and the underlying strength or weakness of the company itself. Companies that have sound balance sheets and financial statements are typically able to issue bonds with lower coupon rates. Known as a credit rating, interest rates attached to bonds hinge on the company’s perceived ability to make timely periodic payments and fully repay the principal at maturity. Determining coupon payments is similar to accessing a person’s credit rating, in which the amount of existing debt and a history of sound financial decision making factors in. Startup companies or entities that have a lackluster track record of meeting financial obligations may still issue bonds, but these organizations can expect to pay higher interest rates on debt issues.

Other Bond Considerations

In high-interest rate environments, bond issuers may protect themselves from paying out high coupon rates as interest rates begin to fall. Executed by establishing call provisions, this strategy allows issuers to “call” a bond away from a debt holder. Issuers of callable bonds may elect to repay full par value of the bond prior to the original maturity date. For instance, a bond with a 10- or 20-year maturity may possess a call date of five years from purchase, at which point the holder must surrender the certificate in exchange for the $1,000 par value. Often, these bonds may have a premium or amount that exceeds the $1,000 value. This extra financial incentive exists to compensate bondholders for the inconvenience of surrendering the certificate prior to full maturity. As interest rates decline and corporate credit ratings improve, bond issuers that pay 5% interest on callable bonds may then issue new debt with coupons of 3%. Stock and bond offerings exemplify two viable means to raise capital. Issuing stock means continually having to answer to shareholders. Companies that relish exerting tight control over a long-standing vision may find that bonds represent the preferred funding option.

References & Resources

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