Companies can decide to raise capital for a variety of reasons, including to fund growth, make an acquisition, invest more in R&D, or for future financial flexibility and stability.

Companies can raise capital in four ways, each with different pros and cons. Let's examine each.

Short and Long-Term Debt

Short-term debt is what a company owes on loan interest or principal on bonds it has issued that is due within the next year. In our personal lives, this is similar to the debt expenses we owe on our credit cards.

Long-term debt is any interest or principal on bonds that is not due within the next twelve months. Think of a homeowner’s 30-year mortgage. Any mortgage payments scheduled beyond the next twelve months would fall into this category.

Short and long-term debt will often have the lowest cost on capital and is tax advantaged.

The downside is that this debt needs to be paid back on a fixed schedule, with few exceptions. Too much debt makes a company fragile and limits future financial flexibility.

Convertible Debt

Convertible debt is another important term investors need to know if they want to analyze a company’s balance sheet. It is debt that, in lieu of being paid off, can be converted into stock ownership at a certain date at an agreed-upon price.

Convertible debt allows the company to raise capital at a lower interest rate than other types of debt, but it can be very dilutive.

Preferred Stock

Preferred stock, or preferred shares, is equity that gives its shareholders certain rights. For instance, preferred shareholders have a higher claim on a company's assets and earnings than common shareholders (but still less than bondholders).

Preferred debt comes with a lower cost of capital than common stock and its dividend payments can be flexible. However, it is more costly than debt, and preferred shareholders must be paid before common shareholders.

Common Stock/Paid-In Capital

Common stock can be issued at different stages of a company's life.

For instance, at its initial public offering (IPO), the event that enables a private company to go public, new shares are sold to the public for the first time.

After a company is public, it may perform a secondary or follow-on offering, issuing new shares that are sold to the public.

Common stock does not have to be paid back and comes with no interest payments. It is a low-risk option for businesses.

However, it is dilutive to existing shareholders, especially when issued at low valuations.

Key Takeaway

Companies have several options for raising capital, each with its own advantages and drawbacks.

Short- and long-term debt offer low-cost financing with tax benefits but require fixed repayment schedules that can limit flexibility. Convertible debt and preferred stock provide unique features like lower interest rates or flexible dividend payments but can dilute ownership or incur higher costs. Finally, common stock is a risk-free way to raise capital for the company, but it dilutes existing shareholders, particularly when issued at lower valuations.

Understanding these methods helps investors evaluate a company’s financial strategy and its impact on long-term value.