Venture Capital And Private Equity

Published Date: 02 Nov 2017

This chapter deals with the decision regarding the capital structure, that is, the mix of debt, equity, and hybrids. The main objective is to determine the optimal capital structure such that the firm value is maximized.

The starting point of this study is a frictionless financial environment, in which there are no taxes and transaction costs, and contracts are costless to design and enforce. In such environments the value of the firm is not affected by its financing mix and, therefore, the value of the shareholders is not affected by policies that change only the firm’s capital structure, such as borrowing to repurchase stock or issuing new stock to retire debt. In the real world, however, there are many frictions that affect the firm’s capital structure, such as laws, regulations and taxes. Because these frictions differ from country to country and change over time, it is impossible to find a single optimal financing mix that applies to all firms.

In this chapter I give an overview of financing possibilities available to a firm. Then, I turn my attention on the fundamental theories that are currently employed to explain the capital structure of the firm: trade-off theory and pecking order theory. At the end, I look at the historical behavioral of the firm financing choices.

Types of Financing

For every company there is a set of two possible instruments that allow raising funds – debt and equity. In this section I discuss the characteristics of each type and then I look at the range of vehicles available within each of these categories.

Equity

Equity is the first instrument that allows a firm raising funds. It can take a various form depending on whether the firm is privately owned or publicly traded and on firm’s growth and risk characteristics. Private firms have fewer choices available because they cannot issue securities to raise equity. Consequently, they have to make use of the owner or a private entity in order to get the equity needed to keep the business operating and expanding. Publicly traded firms, on the other hand, have a wider array of choices since they have access to capital markets.

There are five possible vehicles available to the firm that might be used for raising firm’s funds with equity:

Owner’s equity

Consist of all funds brought in by the owner of the company and provides the basis for the growth and eventual success of the firm, particularly to new and small firms.

Venture capital and private equity

A venture capitalist and private equity investor provides equity financing to startup ventures or small companies and often risky businesses in return for a share of the ownership to the firm. These investors are typically wealthy enough that can afford to take the risks associated with funding young, unproven companies which appear to have a great idea and management team. Venture capitalists invest in such companies because they can earn a massive return on their investments if these companies succeed. But they experience major losses when their picks fail.

Common Stock

In order to raise equity a firm can issue common stock [1] at a price the market is willing to pay. For a newly listed company, this price is estimated by issuing entity (such as an investment banker) and is called the offering price. For an existing publicly traded company, this price is based on the current market price of the company.

Warrants

A warrant is a derivative security that gives the holders the right to buy shares in the company at a fixed price within a certain time frame. Because their value is derived from the price of the underlying common stock, they have to be treated as another form of equity.

A firm might prefer to use warrants rather than common stock for several reasons. First, warrants are priced based on the implied volatility assigned to the underlying stock; the greater the volatility, the greater the value. Second, warrants by themselves do not create a financial obligation at the time of the issue. Consequently, issuing warrants is a perfect instrument for high-growth firm to raise funds, especially when current cash flows are low or negative. Third, for financial officers who are sensitive to the dilution created by issuing common stock, warrants do no create any new additional shares while they raise equity investment funds for current use.

Contingent Value Rights

A contingent value rights provide investors with the right to sell stocks at a fixed price and thus derive their value from the volatility of the stock and the desire on the part of investors to hedge away their losses.

There are several reasons why a firm may choose to issue CVR. The most obvious is that the firm believes that it is significantly undervalued by the market. In such scenario, the firm offer CVR in order to take advantage of its belief and provide a signal to the market of the undervaluation.

Debt

Debt is the second instrument that allows firms raising their funds. This option creates a fixed obligation to make cash flow payments and provides the lender with prior claims if the firm is in financial difficulties. In order to borrow money a firm can choose among three possibilities:

Bank Debt

Bank debt is the primary source used from a large number of private firms and many publicly traded firms to borrow money. It provides several advantages. First, it can be used for borrowing relatively small amounts of money. Second, it provides a convenient mechanism to convey information to the lender that will help in in pricing and evaluating the loan.

Besides being a source of both long-term and short-term borrowing for firms, banks also often offer a flexible option to meet unanticipated or seasonally financing needs, which is called line of credit. In most cases, a line of credit specifies the amount that firms can borrow and links the interest rate on the borrowing to a market rate. The advantage of having a line of credit is that it allows firms to access to the funds without having to pay interests if the funds remain unused. In many case, however, the firm is required to maintain a compensating balance on which it earns either no interest or below market rates.

Bonds

Bonds are the primary source to borrow money for larger, publicly traded firms. They provide firms several advantages. The first is that they usually carry more favorable financing terms than equivalent bank debt because risk is shared by a larger number of financial market investors. The second is that bond issue might provide a chance for the issuer to add on special features that could not be added on to bank debt.

Leases

A lease is a contract that lay out the details under which one party agree to rent property to another party. It guarantees the renter (the lessee) the right to use the asset and the owner of the asset (the lessor) regular payments from the lessee for a specified period. These fixed payments are either fully or partially tax-deductible, depending on how the lease is categorized for accounting purposes.

A lease agreement can be categorized as an operating lease or a capital lease. For an operating lease, the term of the agreement is shorter than the life of the asset, and the present value of lease payments is generally much lower than the actual price of the asset. At the end of the agreement, the asset reverts back to the lessor, who will offer to sell it to the lessee or somebody else. The lessee has the right to cancel the contract and return the asset to the lessor. Thus, the ownership of the asset in an operating lease resides with the lessor, with the lessee bearing the risk if the asset becomes obsolete.

A capital lease, on the other hand, lasts for the life of the asset, and the present values of lease payments are equal to the actual price of the asset. A capital lease generally cannot be cancelled, and can be renewed at the end of its life at a reduced rate or the asset acquired by the lessee at a favorable price. In many cases, the lessor is not obligated to pay insurance and taxes on the asset, leaving these obligations up to the lessee; the lessee consequently reduces its payments, leading to net leases.

Choosing the Right Financing Instruments

In the section above I presented a variety of possibilities in which firms can raise debt and equity. In this section, I lay out a sequence of steps by which a firm can choose the right financing instruments. This analysis is useful not only to determine the type of securities should be issued to finance new instruments, but also to highlight limitations in a firm’s existing financing choices. The first step of this analyses consist in the examination of the cash flow characteristics of the assets or project that be financed; the objective is to try matching the cash flows on the liability stream as closely as possible to the cash flows on the asset stream. Then, I impose a series of considerations that may lead the firm to deviate from or modify these financing choices.

Matching financing cash flows with asset cash flows

The first and most important characteristic a firm has to consider in choosing the financial instrument in order to raise funds is the cash flow patterns of the assets to be financed.

Why match asset cash flows to cash flows on liabilities?

Let the firm value be defined as the present value of the cash flows generated by the assets owned by the firm. This value will vary over time, not only as a function of firm-specific factors (such as project success) but also as a function of broader macroeconomic variables, such as interest rates, inflation rates, economic cycles, and exchange rates. The figure below represents the firm value of a firm, where all the changes are assumed to result from changes in macroeconomic variables. (Applied Corporate Finance – A. Damodaran, page 476)

[Figure goes here – Firm value over time with short-term debt]

The firm can choose to finance these assets with any financing mix it wants. The value of equity at any point in time is the difference between the firm value and the value of outstanding debt.

Assume that the firm chooses to finance the assets using a very short-term debt and that the value of this debt is unaffected by changes in macroeconomic variables. The figure below provides the firm value, debt value, and equity value over time. As we can see, there are periods when the firm value drops below the debt value, which when suggests that the firm is technically bankrupt. Therefore, the firm will borrow less. (Applied Corporate Finance – A. Damodaran, page 477)

[Figure goes here – firm value over time with long-term debt]

Consider now that the firm finances the assets with debt that matches the assets in terms of cash flows and in terms of sensitivity of the debt value to changes in macroeconomic variables. The figure below provides the firm value, debt value, and equity value for this firm. (Applied Corporate Finance – A. Damodaran, page 478)

[Figure goes here - firm value over time with long-term debt]

Because debt value and firm value move together, the possibility of default is eliminated. This, in turn, will allow the firm to carry much more debt, and the added debt should provide tax benefits that make the firm more valuable. Thus, matching liability cash flows to asset cash flows allows firms to have higher optimal debt ratios.

Matching liabilities to assets

The first step to be considered by a firm in making the right financing choices is to understand how cash flows on its assets vary over time. In this section, I considered five aspects of financing choices.

Financing maturity

Firms can issue debt with different maturity, ranging from short-term to very long-term. In making this choice firms should be guided by the maturity of the cash flows on their assets. In this section I will examine how to assess the life of assets and liabilities, and then consider alternative strategies to matching financing with asset cash flows.

Measuring the cash flows lives of assets and liabilities

The duration of an asset or liability is a weighted maturity of all the cash flows on that asset or liability, where the weights are based on the timing and the magnitude of the cash flows. In general, larger and earlier cash flows are weighted more than smaller and later cash flows.

A simple measure of the duration of a bond can be computed as follows:

where:

N – maturity of bond;

T – period when coupon payments are due;

c – coupon payments;

FV – face value;

r – interest rate.

What does the duration tell us? First, it provides a measure of when, on average, the cash flows of a bond come due. Second, it is an approximate measure of how much the bond price will change for small changes in interest rates.

This measure of duration can be extended to any asset with expected cash flows. Thus, the duration of a project or asset can be estimated by:

where:

– the after-tax cash flow on the project in year t;

TV – the terminal value (measure the project worth at the maturity date).

One limitation of this analysis is that it keeps cash flow constant while interest rates change. On real projects, the cash flow will be adversely affected by the increasing interest rates and the degree of this effect will change from business to business. Thus, the actual duration of most projects will be higher than the estimates obtained by keeping cash flows constant.

Duration matching strategies

In the section above I have only considered how to estimate the duration of assets or liabilities. The basic idea is to match the duration of a firm’s assets to the duration of liabilities. This can be done in two ways: by matching the individual assets or liabilities, or by matching the assets of the firm with its collective liabilities.

Although the first approach provides a precise matching of each asset’s characteristics to those of the financing used for it, it has several limitations. First, it is expensive to arrange separate financing for each project, given the issuance costs associated with raising funds. Second, this approach ignores the interaction between projects that might make project-specific financing suboptimal for the firm. Consequently, it is useful to use this approach only for companies that have very large, independent projects.

The fixed/floating rate choice

One of the most common choices firms face is whether to make the coupon rate on bonds (and the interest rate on bank loans) a fixed rate or a floating-rate, pegged to an index rate such as the LIBOR or the ten-year Treasury bond rate. In making this decision, I take into consideration the characteristics of the project financed with the debt.

Uncertainty about future project

The duration of assets and liabilities can be synchronized if assets and projects are well identified, interest rate sensitivity can be estimated, and the appropriate maturity of financing can be ascertained. For some firms, this estimation is too difficult. Firms may change their business mix by divesting themselves of some assets and acquiring new ones. Or, the industry to which firms belong might be changing. In such cases, firms may use short-term of floating-rate loans.

Cash flows and inflation

Floating-rate loans have interest payments that increase as market interest rates rise and fall as rates fall. If the firm has assets whose earnings increase as interest rates go up and decrease as interest rates go down, it should finance those assets with floating- rate loans. This rate will lead to high interest payments in periods when inflation is high and low interest payments when inflation is low. Firms whose earnings increase in periods of high inflation and decrease in periods with low inflation should also use floating-rate loans.

The currency choice

Many of the points we made about interest rate risk exposure apply also to the currency risk exposure. If a firm’s assets or projects create cash flows in a different currency from that in which equity is denominated, there exists a currency risk. Therefore, the firm should issue debt in these currencies in order to reduce this currency risk.

In recent years, firms have used more sophisticated variations on traditional bonds in order to manage foreign exchange risk on investments. There are in principal three types of instruments used by firms: dual-currency bonds, exchange rate-linked securities (PERLSs) [2] , and bonds embedded with foreign currency options called indexed currency option notes (ICONs) [3] .

The choice between straight and convertible bonds

Firms vary in terms of how much of their value comes from projects or assets they already own and how much comes from future growth. Firms that derive the bulk of their value from future growth should use different types of financing and design their financing differently from those that derive their value from assets in place. This is so because the current cash flows on high-growth firms are relatively low w.r.t. the market value. These cash flows are expected to grow over time as the firm invests in new projects. Accordingly, the financing approach should not create large cash outflows early.

Straight bonds do not quite fit the bill, because they create large investments payments and do not gain much value from the high-growth perceptions. Furthermore, they are likely to include covenants designed to protect the bondholders, which restricts investments and future financing policy. Convertible bonds, on the other hand, create much lower interest payments, impose fewer constraints, and gain value from higher growth perception. They might be converted into common stock, but only if the firm is successful.

Tax implications

As firm becomes more creative with its financing choice, structuring debt that behave more like equity, there is a danger that the tax authorities might decide to treat the financing as equity and prevent the firm from deducting interest payments. Because the primary benefit of borrowing is a tax benefit, it is important that firms preserve, and if possible, increase this benefit.

It is also conceivable that the favorable tax treatment of some financing choices may encourage firms to use them more than others, even if it means deviating from the choice that would be dictated by the asset characteristics. Thus, a firm that has assets that generate cash flows in Japanese yen may decide to issue bonds in dollars in order to finance its assets if there is a large tax benefit from issuing dollar debt than yen debt.

The danger of structuring financing with the intention of saving on taxes is that changes in the tax law can render the benefit moot and leave the firm with a financing mix unsuited to its assets mix.

Financing Behavior

In the first section I analyzed the different financing choices available to a firm. They both represent external financing. Many firms, however, meet the bulk of their funding needs internally with cash flows from existing assets.

In this section I present the distinction between internal and external financing and the factors that affect how much firms draw on each source. For this, I will make use of two fundamental theories: trade-off theory and pecking order theory.

Internal versus External Financing

In analyzing the capital structure decision, it is important to distinguish between internal and external financing. Cash flows generated by firm’s existing assets are categorized as internal financing. They are called internal equity because the cash flows belong to the equity owners of the business. Cash flows raised outside the firm, whether from private sources or from financial markets, are categorized as external financing.

The decision process that takes place within a corporation is usually different for internal and external financing. For a well-established firm which does not undertake any major expansion, financing decision is a simple routine and almost automatic. Financing policy in this case consists of deciding on a dividend policy and maintaining a line of credit with the bank.

If a company has to raise funds from external sources, in order to finance a major expansion, it is necessary to undertake a more complicated process since the outside providers of funds are likely to require a detailed plans for the use of the funds and will want to be convinced that the investment project will produce sufficient future cash that justify the expenditure. They will scrutinize the plans and are likely to be more skeptical about the possibilities of success than company’s managers. External financing, therefore, subjects the company more directly to the discipline of the capital market than internal financing.

A firm may prefer internal to external financing for several reasons. For private firms, external financing is typically difficult to rise, and even when it is available it is accompanied by a loss of control. For publicly traded firms, external financing may be easier to rise, but it is still expensive in terms of issuance costs (especially in the case of new equity). Internally generated cash flows, on the other hand, can be used to finance operations without incurring large transaction costs or losing control.

Despite these advantages, there are some limits to the use of internal financing to fund projects. First, firms have to recognize that internal equity has the same cost as external equity, before the transaction cost differences are factored in. The cost of equity, computed using a risk and return model, such as the CAPM or APM, applies both to internal and external equity. Second, internal equity is limited to the cash flows generated by the firm on its operations. Even if the firm does not pay dividends, these cash flows may not be sufficient to finance the firm’s projects. Depending entirely on internal equity can therefore result in project delays or the possible loss of these projects to competitors. Third, managers should not make the mistake of thinking that the stock price does not matter just because they use only internal equity for financing projects. Stockholders in firms whose stock prices have dropped are much less likely to trust their managers to reinvent their cash flows for them than are stockholders in firms with rising stock prices.

The Trade-off Theory

The trade-off theory refers to the idea that the firm capital structure choice results from an arbitrage between costs and debt benefits. It predicts that there exists an optimal target financial debt ratio which maximizes the value of the firm. This optimal point is attained when the marginal value of the benefits associated with debt issues exactly offsets the increase in the present value of the costs associated with issuing more debt (Myers, 2001).

The Benefits of Debt

In the broadest terms, debt provides two differential benefits over equity. The first is the tax benefit: interest payments on debt are tax-deductible, whereas cash flows on equity are not. The second is the added discipline imposed on management by having to make reasonable judgments on debt capacity.

Tax advantage

Tax advantage can be presented in three ways. The first two measure the benefit in absolute terms, whereas the third measure it as a percentage cost.

In the first approach, the dollar tax savings created by interest expenses can be computed by multiplying the interest expenses by the marginal tax rate of the firm.

In the second approach, the present value of tax savings can be computed, arising from interest payments over time, on the basis of three important assumptions. The first is that the debt is perpetual, which means that the dollar savings are a perpetuity. The second is that the discount rate of the cash flows is the interest rate on debt, because it reflects the riskiness of the debt. The third is that the expected tax rate for the firm will remain unchanged over time and that the firm is a tax-payment position.

In the third approach, the tax benefit from debt is expressed in terms of the difference between the pretax and after-tax cost of debt.

Added discipline

There are many firms that have substantial free cash flows and/or low debt. Managers in these firms have such a large cushion against mistakes that they do not have any incentive to be efficient in either project choice and project management. A possible way to control this process is to force these firms to borrow money. This will create the commitment to make interest and principal payments, increasing the risk of default on project with substandard returns.

The argument that debt adds discipline to the process also provides an interesting insight into management perspective on debt. Based on management preferences, the optimal level of debt may be much lower than that estimated based on shareholder wealth maximization. The corollary to this argument is that the debt ratios of firms in countries in which stockholder power to influence or remove managers is minimal will be much lower than optimal, because managers enjoy a more comfortable existence by carrying less debt than they can afford to. Conversely, as stockholder acquires power, they will push the firm to borrow more money, and increase their stock prices.

The Costs of Debts

Borrowing money has its disadvantages. In particular, (a) it exposes the firm to default and eventual liquidation, (b) increase the agency problems arising from the conflict of interests, and (c) reduce the flexibility of the firm to take actions now or in the future.

Bankruptcy costs

The primary disadvantages concerns in the increasing bankruptcy costs. The expected bankruptcy cost can be calculated as a product of the probability of bankruptcy [4] and the direct [5] and indirect [6] costs of bankruptcy. It follows that, there emerge some interesting implications for capital structure decision.

Firms operating in businesses with volatile earnings and cash flows should use debt less than similar firms with stable cash flows.

If firms can structure their debt in such a way that the cash flows on the debt increase and decrease with their operating cash flows, they can afford to borrow more.

If an external entity provides protection against bankruptcy, by providing either insurance or bailouts, firms will tend to borrow more.

Because the direct bankruptcy costs are higher, when the assets of the firm are not easily divisible and marketable, firms with assets that can be easily divided and sold should be able to borrow more than firms with assets that do not share these features.

Firms that produce products that require long-term servicing and support generally should have lower leverage than firms whose products do not share this feature.

Agency costs

The conflict between bondholder and stockholder interests appears in three different aspects of corporate finance: (A) deciding what projects to take (making investment decisions), (B) choosing how to finance these projects, and (C) determining how much to pay out as dividends.

Risky projects

The conflict of interests, generally, arises when a firm has to decide on investment decision. A project that earns a return that exceeds the hurdle rate, adjusted to reflect the risk of the project, should be accepted and the firm value will increase. However, if the firm chooses projects that are riskier than expected, bondholders will lose on their existing holdings, because the price of the holdings will decrease to reflect the higher risk.

Subsequent financing

The conflict of interests also arises when new projects have to be financed. The equity investors in the firm may favor new debt, using the assets of the firm as security and giving the new lenders prior claims over existing lenders. Such actions will reduce the interest rate on the new debt.

Dividends and stock repurchases

Dividend payments and equity repurchases also divide stockholders and bondholders. In general, bondholders prefer that the firm retain the cash, because it can be used to make payments on the debt, reducing default risk. Whereas stockholders prefer that the firm’s cash is paid out as a dividend or used to repurchase stock. It should not come as a surprise that stockholders, if not constrained, will pay the dividends or buy back stock, overriding bondholder concerns. In some cases, the payments are so large that the default risk of the firm increases dramatically.

Reduced financial flexibility

Firms value financial flexibility for two reasons. First, the value of the firm may be maximized by preserving some flexibility to take on future projects as they arise. Second, flexibility provides managers with more breathing room and more power, and protects them from monitoring that comes with debt. Thus, although the argument for maintaining flexibility in the interests of the firm is based on sound principles, it is sometimes used as camouflage pursuing their own interests.

So, how can we evaluate the financial flexibility? If flexibility is needed to allow firms to take advantage of unforeseen investment opportunities, its value can be derived using two variables, the access to capital markets and the potential for excess returns on new investments.

The Pecking Order theory

The pecking order theory developed by Myers (1984) is an alternative to the trade-off theory. It starts with asymmetric information – a fancy term indicating that managers have more information about their future prospects and risk characteristics than do financial markets. This asymmetry in information creates frictions when firms want to raise their funds affecting the firm’s choice between internal and external financing and between new issues of debt and equity.

According to this theory a firm is financed first with internal funds, reinvested earnings primarily; then, if internal funds are not sufficient, they make use of external finance by issuing the safest securities first. That is, they start with debt, then possibly hybrid securities such as a convertible bonds; and finally with new issues of equity.

In this theory, there is no a well-defined target equity-debt mix, because there are two types of equity, internal equity (the one at the top of the pecking order) and external equity (the one at the bottom of the pecking order).

The pecking order explains that most profitable companies generally borrow less, not because they have low target debt ratios, but because they do not need outside money. Less profitable firms, on the other hand, issue debt because they do not have internal funds sufficient for their capital investment programs and because debt financing is on the top list of external financing.

In the pecking order theory, the attraction of interest tax shields is assumed to be a second-order. Debt ratios change when there is an imbalance of internal cash flow, net of dividends, and real investment opportunities. Highly profitable firms with limited investment opportunities work down to low debt ratios. Firms whose investment opportunities outrun internally generated funds are driven to borrow more and more.

Trade-off vs. Pecking Order theory: empirical evidence

In 2012, Atiyet published a study explaining the explanatory power of the pecking order theory (POT) and the static trade-off theory (STT), using a sample of 88 French companies belonging to SBF 250 over a period from 1999 to 2005 [7] . Basing on the previous studies made by Shyam-Sunder and Myers (1999), they show that the estimation of both empirical models explaining the financial structure favors the POT on the French companies, whereas STT does not fit to explain the issuance of new debt issue in French firms. The evidence from POM suggests that the internal fund deficit is the most important determinant that possibly explains the issuance of new debt. The models they used to test were proposed by Shyam-Sunder and Myers (1999).

The pecking order model:

where:

– is the amount of debt issued or retired by firm i at time t;

– is the funds flow deficit, given as:

where:

– dividend payments;

– capital expenditure;

– net increase in working capital;

– current portion of long-term debt at start of period;

– operating cash flows, after interest and taxes.

The simple pecking order model predicts that the firm will only issue or retire equity as a last resort. It fill its deficit only by using debt, therefore, it is assumed to have and .

The Static Trade-off model:

where:

- is the target debt level for the firm i at time t.

They proposed that the hypotheses to be tested are , indicating adjustment toward the target, and implying positive adjustment costs.

Ramdani and Vigneroni (2012) extend this analysis using a sample of 335 firms which were part of SBF 250 at least once during the period 2001-2010 [8] . They use linear and non-linear specifications of the relationship between the firm’s debt variation and financial deficit to deal with this difficulty. To undertake this analysis, they first replicate the classical versions of pecking order theory tests by financial deficit and trade-off theory by target adjustment through mean reversion. Then, they consider differences in debt financial behavior in constrained and unconstrained firms.

In the classical linear context, they finding shows that trade-off theory dominates pecking order for constrained firms whereas pecking order theory dominates trade-off theory for unconstrained ones.

For un-linear specification more specifications are needed. That is, it is difficult to distinguish which theory is a better first order explanation of capital structure.

How firms have raised funds?

After noting the set of choices available to the firm for raising money and studying the theories that explains the capital structure of the firm, I move my attention at the historical behavior of the firms during last decades.

[Figure goes here – external and internal financing at U.S. firms]

The figure above illustrates the proportion of funds from equity, debt, and internal funds, for U.S. corporations between 1975 and 2007 (Applied Corporate Finance – A. Damodaran, page 344 – check whether it is possible to extend the time horizon, maybe till 2012). We can notice that, in general, U.S. firms have relied more heavily on internal financing to meet capital needs than on external financing. Furthermore, when external financing is used, it is more likely to be new debt rather than new equity or preferred stock.

There is a wide difference across U.S. firms in how much and what type of external financing they used. Fluck, Holtz-Eakin, and Rosen (1998) looked at several thousands of firms that were incorporated in Wisconsin; most of these firms were small and private businesses. They find that firms, in order to cover their capital needs, are based almost entirely on internal financing, owner’s equity, and bank debt. The proportion of funds provided by internal financing increases as the firms became older and more established. A small proportion of private businesses manage to raise capital from venture capitalist and private equity investors. Many of these firms plan on going public, and the returns to private equity investors come at the time of public offering.

When I compare the financing patterns of U.S. firms to those in other countries, we can notice that U.S. firms are much more heavily dependent on debt than equity for external financing than their counterparties in other countries. The figure below illustrates new security issues in the G-7 countries between 1984 and 1991. (Applied Corporate Finance – A. Damodaran, page 345 – Check whether it is possible to analyze the same problem for a larger horizon, maybe from 2000 to 2012)

[Figure goes here – financing patterns for G-7 countries: 1984-91]

Net equity refers to the difference between new equity issues and stock buybacks. Firms in the United States bought back more stock than they issued during the period of this comparison, leading to negative net equity.

In addition, a comparison of financing patterns in the United States, Germany, and Japan reveals that German and Japanese firms are much more dependent on bank debt than firms in the United States, which are more likely to issue bonds [9] . The figure below provide a comparison of bank loans and corporate bonds as sources of debt for firms in the three countries, as reported in Hackethal and Scmidt (1999). (Applied Corporate Finance – A. Damodaran, page 346)

[Figure goes here]

There is also some evidence that firms in some emerging markets, such as Brazil and India, use equity much more than debt in order to finance their operations. Some of this dependence can be attributed to government regulation that discourages the use of debt by requiring that debt ratios of the firm be below specified limits or by limiting the deductibility of interest expenses for tax purposes.