Finance fundamentals and applications

¶ … debt financing that confers a qualitative advantage is that debt is different from an ownership interest. Creditors neither vote nor control business operations, leaving entrepreneurs to make key strategic decisions. Debt is often easy to administrate and is free of complex equity financing reporting requirements. Debt provides motivation for firms to improve operations to meet these financial obligations. Conversely, debt is also associated with qualitative disadvantages. First, debt requires collateral that is vulnerable to the consequences of default, potentially resulting in liquidation or reorganization.

Companies assuming debt must consider lending criteria, including covenants or stipulations imposing restrictions on business operations. Excessive debt could impair credit ratings and revenue raising efforts in the future. Finally, debt financing may be limited to established businesses, since lenders always want security, making it difficult for unproven businesses to obtain financing.

One qualitative advantage of equity financing through common stock is that stock options are a useful motivational benefit that can also promote the alignment of employee and shareholder interests. Moreover, equity investments do not require collateral and businesses with strong equity inspire both lenders and investors confidence and guard against IRS scrutiny. Conversely, the qualitative disadvantages associated with stock options are that stockholders are entitled to ownership interest and voting rights, resulting in a diminution of control. In turn, that increases vulnerability to takeovers by other companies and proxy shareholder fights, possibly resulting in the replacement of existing management. Further, the wisdom of reliance on equity markets to finance acquisition is dependant on the market place, meaning that downturns in demand can threaten firm solvency. Finally, the conversion of equity to common stock requires companies to meet applicable state and Federal Securities and Exchange Commission regulations.

A third financing option is preference shares, one of whose principal qualitative advantages is no diminution management's interest in corporate growth or voting power (assuming that non-voting preferred stock issued). Also, any new equity sale requires the company to offer shares to preferred stockholders first to maintain their pro rata interest. This limits the flexibility to bring in new shareholders to influence operation systems. Meanwhile, preferred stock is always subject to the right to common stock conversion with its potential diminution of voting power and control. Likewise, 51-67% of preferred stockholders are required for sale, merger, liquidation, sale of shares with more privileges, issuance of debt over dollar amount, and increase in board size.