Corporate Funding Process

The basic goals of corporate finance are (A) fund the firm’s strategic plan and (B) provide enough liquidity to satisfy the firm’s obligations as they come due. This involves a process incorporating strategy, operations, capital structure, and capital markets timing. This is the stuff of the practice v theory of finance-cash flow budgeting not models usually not covered in detail in textbooks.

The following diagram highlights the process:

The steps in the process are as follows:

1)     Investment Opportunities/Requirements: matching product market opportunities with the strategic plan gives rises to the investment budget. I find it useful to use Porter’s Five Forces model to gauge investment opportunities. Your strategy determines how fast you plan to grow and investment needs-CAPEX, working capital investment (WCI) and operating expenses like headcount and R&D.

2)     Financing Need: based on cash flow available for debt service (CFADS) = Net Income ( after interest and taxes) +DA-(CAPEX+WCI) +/- (AS-AA + CND) with DA being depreciation and amortization; AS-AA representing asset sales or acquisitions; CND being changes in net debt. Mature firms with excess CFADS focus on shareholder distributions (sometimes prefunded debt financed share repurchases i.e. recapitalizations) while growth firms with negative CFADS need to raise cash.

3)     Funding Sources: selection of instruments depends upon market conditions and financing preferences.

a)     Capital market conditions: influenced by macro factors such as rates and economic growth. Just like ordering lobster -prices and availability are subject to market conditions. We saw an extreme example of this during the market crisis years of 2009-2012 when markets shut.  Some key factors include market depth, cost, terms, access, and disclosure. You can only take what the market gives.

b)     Financial strategy: the objective is to match sometimes conflicting financial preferences with market conditions in a cost effective manner to assure certainty of funding. Key factors include

Control-closely held firm will be reluctant to fund with equity if it upsets control positions

Dilution-equity financing impacts dilution and can be an impediment

Flexibility-growing firms need flexibility hence avoid debt with covenants and prepayment restrictions

Ratings-rating targets influence the debt versus equity choice and debt capacity

Cost-both absolute and relative cost among instruments

Public or Private-firms seeking confidentiality balance depth of public markets with disclosure requirements

Dividend Policy-high dividend policy constrains debt capacity

Investor Base-banks, private equity, hedge funds, etc.

Liquidity Needs-financial slack is valuable especially for growth firms as s#$% happens

Speed-how soon you need the funds determines which sources you seek

Currency Preferences-USD or others

Nature of Funding Need-one-off or on-going; if on-going focus on relationship type investors

Hedging Policy-for financial exposures like rates and currencies

Accounting Policy (on/off balance sheet)

Taxes

Maturity Structure

4)     Instruments: the funding instruments choice usually becomes apparent once you go thru the above process. The key is to customize the instruments to capitalize on investor segments to achieve the best terms. Most firms utilize a Pecking Order approach to minimize information asymmetry costs reflecting the following order:

Debt

Hybrids-convertibles and warrants

Equity-preferred and common

5)     Repeat Step 2 once the cash flow implications of the choices are determined. Reflect plan in cash flow budgets and use scenario analysis to ensure it works with a sufficient margin for error.

The funding decision is like playing with a Rubik's Cube trying to match up sometimes conflicting goals under time constraints in an uncertain dynamic capital market environment. Compromises are needed to ensure adequate funding under all states of nature-not just the current state. As a general rule- raise funds when you can and not when you must as many capital challenged firms learned the hard way during the great recession.

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Finance Debt Fetish?

The go-to recommendation from many consultants and academics is to lever up your firm to increase your tax shield, lower your WACC and fend off activists. This approach may fit for some mature firms. It is, however, less well suited for other firms.

A useful approach to setting debt policy as reflected in a firm’s actual or implied debt rating is based on a firm’s life cycle. Consider the following:

1)     Early and growth stage firms: most of their value is reflected in growth opportunities from assets not yet in place. They have negative free cash flow due to operating losses, high business risk and high CAPEX. Hence they need flexibility to complete their investment plan and maintain access to capital. Such firms have high financial distress costs. Furthermore, they have limited taxable income i.e. tax shields have limited value. Such firms should and do have low debt levels.

2)     Mature firms: generate more cash than they can profitably invest due to high operating income and reduced investment needs. Business risk has decreased and the need for financial flexibility is low as is business risk. Additionally, they have high taxable income in need of tax shields. Finally, agency/incentive issues become prominent regarding investment allocations. In these circumstances, increasing debt makes sense. Witness the “old” tech firms like Apple that have pressured by activist to increase debt level to reduce the risk of misallocated capital. Also confirmed by consumer non durable firms which spend time on tax planning, including use of debt related tax shields, to reduce their tax burden.

3)     Declining firms: here the emphasis shifts from value creation and taxes to value transfers among the firm’s various claimants. Debt holders, often purchasing the debt in the secondary market at a discount, are looking to squeeze-out shareholders and gain control of the firm’s assets in a disguised bargain purchase. Equity holders are seeking to protect their interests. The Caesar’s Palace’s bankruptcy has highlighted questionable transfers by PE firm Apollo to shield assets from creditors.

In addition to life cycle and taxes there are other reasons firms may favor debt. These include:

1)     Information asymmetry discount (AKA Pecking Order Theory ): debt is a contractual obligation v equity which is a residual claim. Hence, there is more informational uncertainty regarding equity, and equity investors require a higher discount to induce them to commit. Managers recognize this fact and exhaust internal funds and debt capacity before issuing additional equity.

2)     Ownership/Control: maintaining ownership and control (ownership v earnings dilution) is very important for private and smaller closely held public firms. Thus, equity is not a preferred funding instrument.

3)     Discipline: agency issues arise whenever management’s interests diverge from shareholders. Debt can provide the discipline needed to hold management’s feet to the fire. This is a driving force behind many LBOs (agency costs).

4)     Signaling: issuing equity for mature firms usually results in a stock price decline. Investors view the raise as a signal that future cash flows will be less than expected. Debt must be serviced (P&I). Management would not issue equity if they thought it was undervalued.  Conversely, management would not issue the debt unless it thought the firm could repay it.  Consequently, debt issues are viewed by investors as neutral.

5)     Value Transfers: see the declining firm discussion above. Creditors attempt to protect against this include seniority, security and covenants. Legal protections include substantive consolidation, fraudulent conveyance and equitable subordination.

The above framework can aid managers seeking to make capital structure decisions.

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