Most businesses understand that they can either sell stock, which creates an equity position for the new investor in the business or that they can get a loan from a lending institution. A loan does not dilute the current owner’s equity but creates a fixed monthly expense in the form of principal and interest payments. However, there are two other less common forms of capitalizing a business that may make sense under certain circumstances.
One option is for a business to issue a corporate bond. A bond is different from a loan in that the bondholder is paid only interest from the business for the term of the bond. At the end of the term the bond’s principle is returned and the transaction ends. Bonds are most appropriate when there is a lag between investment and payment.
When one of my service businesses was relatively small we were awarded a one year contract worth about one hundred thousand dollars ($100,000) per month in billings. Being a service-based business we would work a month, submit an invoice, and then have to wait another forty-five days to get paid. Therefore, the business had about ten weeks of expenses before it received the first payment from the customer. When the project ended and there were no more expenses there were still ten weeks of accounts receivable A/R. A bond could be used to fill the A/R pipeline. Interest could be paid while the money was in use. Then, when the project was over, the income with no expenses could be used to repay the principle.
Alternately, business could offer to pay investors a royalty. The difference between a royalty and a stockholders’ distribution is that a stockholders’ distribution is a result of subtracting business expenses from revenue to create profit, which is the source of the distribution. Also, stockholders have a voting voice in the direction of the business.
Stockholders’ distributions are better suited for smart money investors. Royalties are not based on profit, but on gross revenue. Often inventors who license their ideas to manufacture and distribution companies receive royalties since they are not interested in being equity partners.
Profit can be easily be manipulated by a business. Accordingly, some investors, and particularly dumb money investors may prefer to simply be paid a percentage of gross revenue.
Is issuing a corporate bond or making royalty payments an option for you?
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