Financing

FINANCING CORPORATE GROWTH
By Bradford Cornell, University of California, Los Angeles, and Alan C. Shapiro, University of Southern California Rapid growth poses special problems for financial managers. They must raise large amounts of cash to fund this growth, often for risky and relatively young firms. Nonetheless, it is misleading to speak of “financial management for growing companies” as if it were a special subject unrelated to financial management in general. The ultimate goal of financial policy, whether a company is growing or not, is to maximize the value of shareholders’ equity. In addition, the set of financial instruments and policies available to a financial manager does not change just because a company is growing rapidly. It makes sense, therefore, to examine the financial tools available to all firms to boost market value before talking about the appropriate financial strategies for growing firms. Broadly speaking, there are two basic approaches for using finance to increase the value of the firm. Both these approaches can be illustrated by thinking of the firm as producing a cash flow “pie” — that is, total operating cash flow distributable to all investors (debtholders, stockholders, and others). The first approach takes the size of the cash flow pie to be independent of financial policy, so that the principal role of finance is to divide the pie into slices by issuing varying types of securities. The object of this division is to match the securities’ characteristics with the desires of investors so as to maximize the total proceeds from the sale of the securities. The second approach focuses on ways in which financial policy can increase the size of the value pie by affecting operating and investment decisions. Underlying this approach is the view that a company is a complex web of “contracts” tying together disparate corporate stakeholders such as investors, management, employees, customers, suppliers, and distributors. This approach assumes that the firm’s future operating cash flow may depend significantly upon the perceptions and incentives of the firm’s non-investor stakeholders. Financial policy can be used to increase the size of the cash flow pie by strengthening stakeholder relationships — for example, by improving management incentives or increasing the confidence of suppliers and customers. The next two sections of the paper examine each of these approaches in greater detail. Once the basic tools of financial management have been laid out, we turn in Section 3 to the issue of what constitutes a growth company. Sections 4 and 5 address the main questions of the paper: How are growth companies unique, and given these special characteristics, what financial management techniques are best suited for such companies?

Slicing the Pie
Even if corporate operating cash flow is unaffected by financial policy, it may be possible to sell claims to a given cash flow pie at a higher aggregate price by cleverly packaging claims. In this sense, corporate finance is analogous to marketing. The firm needs money to finance future investment projects. Instead of selling some of its existing assets to raise the required funds, it will sell the rights to the future cash flows generated by its current and prospective projects. It can sell these rights directly and become an all-equity financed firm. But the firm may get a

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better price for the rights to its future cash flows by repackaging these rights before selling them to the investing public. There are two basic situations in which such repackaging may add to firm value. First, since different securities are taxed in different ways, repackaging can potentially reduce the government’s share of the pie and thereby increase the cash flow available for eventual distribution to investors. Second, total revenue from the sale of rights to the pie may be increased if securities can be devised for which specific investors are willing to pay a higher price. There are four circumstances in which investors may pay more in the aggregate for claims to the cash flow pie: (1) the securities are better designed to meet the special needs and desires of a particular class of investors; (2) the securities are more liquid; (3) the securities reduce transaction costs; or (4) the security structure reduces the “credibility gap” between management and potential investors that exits whenever companies raise capital from outside sources. Tax Factors in Financing The uneven tax treatment of various components of financial cost introduces the possibility of reducing after-tax financing costs by reducing the government’s share of the cash flow pie. Most notably, many firms consider debt financing to be less expensive than equity financing because interest payments are tax deductible whereas dividends are paid out of after-tax income. As Merton Miller has noted, however, this comparison is misleading for two reasons.1 First, it ignores personal taxes. Second, it ignores the supply response of corporations to potential tax arbitrage. In the absence of any restrictions, the supply of corporate debt can be expected to rise as long as corporate debt is less expensive than equity. As the supply of debt rises, the yield on this debt must increase in order to attract investors in progressively higher tax brackets. This process continues until the tax rate for the marginal debtholder equals the marginal corporate tax rate. At that point, there is no longer a corporate tax incentive for issuing more debt. This process illustrates a key insight that underlies Miller’s argument: The supply of securities in the capital markets is almost infinitely elastic. As soon as there is a small advantage to issuing one type of security rather than another, alert financial managers and investment bankers quickly alter their behavior to profit from this discrepancy. They will continue to issue the cheaper security until the discrepancy disappears. For this reason, opportunities to create value through the issuance of new securities are small and unlikely to persist. Only in rare instances will a tax advantage persist “at the margin.” The example of zero coupon bonds illustrates one such case. In 1982, PepsiCo issued the first long-term, zero-coupon bond. Although they have since become a staple of corporate finance, zero-coupon bonds initially were a startling innovation. Zeros don’t pay interest, but are sold at a deep discount from par. For example, the price on PepsiCo’s 30-year bonds was around $60 for each $1,000 face amount of the bonds. Investors’ gains come from the difference between the discounted price and the face value they receive at maturity.

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Merton H. Miller, “Debt and Taxes,” Journal of Finance, May 1977, pp. 261-276.

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These securities appeal to those investors who like to be certain of their long-term return. The locked-in return means that investors know the maturity value of their investment, an important consideration for pension funds and other buyers who have fixed future commitments to meet. Normal bonds don’t provide that certainty, because the rate at which coupons can be reinvested is unknown at the time of issue. But despite the potential market for such bonds, they did not exist until PepsiCo’s 1982 issue. The pent-up demand for its $850 million face value offering gave PepsiCo an extraordinarily low cost of funds. The net borrowing cost to the company was under 10 percent, almost four percentage points lower than the yield at that time on U.S. Treasury securities of the same maturity. But zero-coupon bonds did not remain such a low-cost source of funds for long. Once firms saw these low yields, the supply of zero-coupon debt expanded rapidly. In addition, clever Wall Street firms discovered how to manufacture zeros from existing bonds. They bought Treasury bonds, stripped the coupons from the bonds, repackaged the coupons, and sold the coupons and the principal separately as a series of annuities and zero-coupon bonds. The increase in the supply relative to the demand for zeros resulted in a jump in their required yields, negating their previous cost advantage. The tax advantage — one which is associated with any original issue discount debt (OID) — remained. The tax advantage to a firm from issuing zeros rather than current coupon debt stems from the tax provision that allows companies to amortize as interest the amount of the original discount from par over the life of the bond. The firm benefits by receiving a current tax write-off for a future expense. By contrast, if it issues current coupon debt, the firm’s tax write-off and expense occur simultaneously. The tax advantage from OIDs, which is maximized by issuing zero-coupon bonds, translates into a reduction in the company’s cost of debt capital. But these tax savings don’t tell the whole story. Investors must pay tax on the amortized portion of the discount each year even though they receive no cash until the bond matures. Thus the tax advantage to the firm from issuing zeros has been offset by the higher pre-tax yields required by investors to provide them with the same after-tax yields they could earn on comparable-risk current coupon debt. As a result, corporations issuing zeros will only realize a tax benefit to the extent that the marginal corporate tax rate exceeds the marginal investor tax rate. At the extreme, if these marginal tax rates are equal, the tax advantage to an issuing corporation will be completely eliminated by the tax disadvantage to the investor. The initial purchasers of zero-coupon bonds were primarily of two groups: (1) tax-exempt institutional investors such as pension plans and individual investors (for their tax-exempt IRAs) who sought to lock in higher yields; and (2) Japanese investors, for whom the discount was treated as a non-taxable capital gain if the bonds were sold prior to maturity. Selling to the taxexempt segment of the market yielded maximum benefits to the issuers of zeros since the disparity in marginal tax rates was at its greatest. The supply of tax-exempt institutional money, however, is limited. Furthermore, the Japanese government has ended the tax exemption for zero-coupon bond gains; Japanese investors have accordingly demanded higher yields to compensate for their tax liability. The reaction by the Japanese government illustrates another important point concerning financial strategy: If one

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devises a legal way to engage in unlimited tax arbitrage through the financial markets, the government will eventually change the law. More limited tax arbitrage, however, may persist for some time. For example, companies with tax losses or excess tax credits can sell preferred stock to other corporations and thereby reduce investor taxes without a corresponding increase in their taxes. The reason is that corporate investors can exclude from taxable income 70 percent of the preferred (or common) dividends they receive. This means that a corporate investor in the 34 percent tax bracket faces an effective tax rate of only 10.2 percent (.3 x 34%) on preferred dividends. As a result, corporate investors are willing to accept a lower yield on preferred stock than on comparable debt securities. Hence, companies in low tax brackets (who are unable to make full use of the interest tax write-off) should be able to raise funds at a lower after-tax cost with preferred stock instead of debt. Similarly, leasing (rather than buying) assets enables low tax bracket companies to raise funds at a lower cost by passing along the depreciation tax deduction to investors in higher tax brackets in return for a lower effective interest rate. Financial Innovation To the extent that the firm can design a security that appeals to a special niche in the capital market, it can attract funds at a cost that is less than the required return on securities of comparable risk. But as we noted in the case of zeros, such a rewarding situation is likely to be temporary because the demand for a security that fits a particular niche in the market is not unlimited, and because the supply of securities designed to tap such niches is likely to increase dramatically once a niche is recognized. As one further example of this process, major investment banks are currently trying to create value by exploiting what they perceive as profitable niches in the mortgage market. Investment banks such as First Boston, Salomon Brothers, and Goldman Sachs have been purchasing mortgages and repackaging them into complex derivative securities which offer unique riskreturn combinations. To the extent that such unique securities are desirable to investors, the investment banks can sell them for more than the cost of the mortgages. Once a particular security structure proves to be profitable, however, other firms aggressively enter the business and drive profits down. In general, the high elasticity of supply means that repackaging a security’s payment stream so that it reallocates risk from one class of investors to another is unlikely to be a sustainable way of creating value. The only niche that is likely to persist as a profitable opportunity in the face of competitive pressure is a niche that involves the government. For instance, by substituting its credit for the credit of a ship buyer, the U.S. government, under the Merchant Marine Act of 1936, subsidizes the financing of U.S.-built vessels. Other subsidized loan programs include those administered by the Synfuels Corporation, Economic Development Administration, the Farmers Home Administration, the Export-Import Bank, and the ubiquitous Small Business Administration. However, even these governmental niches are not free from competition. For instance, when the government makes subsidized loans available to “small business,” it produces an incentive for firms to restructure to satisfy the criteria for being “small.” Furthermore, the government severely restricts the supply of securities that can take advantage of these loan subsidy programs. 4

Increasing Liquidity Liquidity or marketability is an important attribute of a financial security. One measure of a security’s marketability is the spread between the bid and ask prices at which dealers are willing to satisfy buyers’ or sellers’ demands for immediate execution of their trades. There is substantial empirical evidence that investors are willing to accept lower returns on more liquid assets.2 Other things being equal, therefore, a firm can increase its market value by increasing the liquidity of the claims it issues. There are a number of ways in which firms can increase the liquidity of their claims. The most important include going public, standardizing their claims (which includes the securitization of bank loans), underwriting new public issues, buying insurance for a bond issue, and listing on organized exchanges. Because most liquidity-enhancing measures entail significant costs (for example, legal and underwriting fees and reporting costs), however, the firm must trade off the benefits of increased liquidity against the costs. This cost-benefit calculation can best be formulated by expressing the value of increased liquidity as the market value of the firm’s equity multiplied by the percentage reduction in its required return. This expression implies that the advantages of liquidity enhancement tend to be greatest for large firms (which have higher market values) and for firms whose securities are already highly liquid. The latter implication also follows from the observation that low-liquidity assets tend to be held by investors who are willing to hold assets for longer periods of time. Thus, liquidity is less valuable to them than to investors in more liquid assets.3 Reducing Transaction Costs By reducing transaction costs associated with raising money, the firm can increase its net proceeds. The use of investment bankers to underwrite new security issues, shelf registration under Rule 415, and extendible notes are ways in which the costs of raising money can be reduced. Similarly, the use of secured debt and leasing can reduce enforcement costs by giving a lender or lessor clear title to the pledged or leased assets. Because the costs associated with repossessing assets are more likely to be incurred the higher the probability of bankruptcy, companies in shakier financial positions will find this particular benefit of leasing or secured borrowing more valuable than those in better financial shape. Bridging the Credibility Gap One of the key costs associated with issuing new securities arises from the financing problem caused by so-called informational “asymmetries.” In plainer terms, corporate management may have inside information about the company’s prospects that it can use to exploit potential

See, for example, Yakov Amihud and Haim Mendelson, “Asset Pricing and the Bid-Ask Spread,” Journal of Financial Economics, 17, 1986, pp. 223-249. 3 Liquidity may also have disadvantages in some circumstances. In situations where management, commitment is critical and uncertainty is high, such as leveraged buyouts and venture capital, management arguably should be “locked in” to the firm, at least for a while.

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investors by issuing overpriced securities.4 Recognizing management’s ability and incentives to exploit them by issuing overvalued securities, rational investors will revise downward their estimates of a company’s value as soon as management announces its intent to issue new securities. For example, on February 28, 1983, AT&T announced its plan to issue about $1 billion of new common stock. Investors took the equity issue as a bad sign and responded by reducing AT&T’s market value by $2 billion.5 For companies trying not to misrepresent the value of their assets, the credibility problem imposes a potentially large cost on the use of securities to raise funds. This cost should not be confused with the cost of capital — the return required by investors to hold the company’s securities. Rather the cost of issuing securities referred to here is an added discount at which these securities must be sold because of the potential for important inside information. The riskier the security being issued, the more important this credibility gap becomes, and the larger the discount applied by investors fearful of buying lemons. Conversely, if the firm can issue essentially riskless debt the discount will be zero because the return to the new debt does not depend on management’s information advantage. These observations imply that companies can overcome the credibility problem by raising funds in accordance with what Stewart Myers calls the financing “pecking order.”6 The most common corporate practice, as Myers observes, is to use the least risky source first — that is, retained earnings — and then use progressively riskier sources such as debt and convertibles; common stock offerings are typically used only as a last resort. Myers’s explanation for this pattern of financing preferences is that it reduces the security price discount imposed by investors when companies raise new capital. By using internal funds, companies avoid the credibility problem altogether. If companies must go to the capital markets, they face smaller discounts by issuing securities in ascending order of risk: first debt, then hybrids such as convertible bonds, and finally equity. This set of financing practices has two results: (1) it minimizes the amount of new equity that must be raised and (2) it forces companies to issue equity only when necessary. By limiting management’s discretion over when to issue new equity, adherence to the financing pecking order reduces investors’ suspicion that management is simply trying to “time” the market and “unload” overpriced stock. By reducing this credibility gap, then, companies get better prices for their securities. And when they are forced to issue new equity, where the credibility problem is most acute, all but the largest companies tend to use firm commitment offerings (rather than, say, shelf registration or best efforts). Besides providing distribution channels for new issues, underwriters also perform

The problem of informational asymmetry is discussed in Stewart C. Myers and Nicholas Majluf, “Corporate Financing and Investment Decisions When Firms Have Information Investors Do Not,” Journal of Financial Economics, 1984, pp. 187-221. 5 For information on the events surrounding this issue, see “American Telephone and Telegraph Company (1983)” in Butters, Fruhan, Mullins, and Piper, Case Problems in Finance 9th edition (Homewood, Ill.: Richard D. Irwin, 1987). 6 Stewart C. Myers, “The Capital Structure Puzzle,” Journal of Finance, July 1984, pp. 575-592.

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an implicit role of “certifying” to outside investors that the securities are fairly valued. They do this by putting their reputation on the line with investors when pricing new issues.7

Using Finance to Increase the Cash Flow Pie
The modern corporation, as we said before, is an interrelated set of contracts among a variety of stakeholders: shareholders, lenders, employees, managers, suppliers, distributors, and customers. Although these stakeholders have a common interest in the firm’s success, there are potentially costly conflicts of interests. To the extent that financial policy can reduce these conflicts, it can enlarge the cash flow pie and thereby increase the value of the firm. In this respect, recent research has identified three sources of conflict related to financial policy. The first problem stems from the separation of ownership and control. Professional managers who do not own a significant fraction of equity in the firm are likely to be more directly interested in maximizing their own “utility” than the value of the firm. This creates a conflict between managers and outside shareholders. A second area of conflict involves stockholders and bondholders. Because the value of common stock equals the market value of the firm (that is, total assets) minus the value of its liabilities, managers can increase shareholder wealth by reducing the value of the bonds. This possibility is at the root of stockholder-bondholder conflicts. Third, under certain circumstances, firms may have incentives to act in ways that conflict with the best interests of the individuals that do business with them. For example, an airline in financial distress may choose to reduce maintenance expense in order to improve short-run cash flow. Stockholder-Manager Conflicts Managers, like all other economic agents, are ultimately concerned with maximizing their own utility, subject to the constraints they face. Although management is legally mandated to act as the agent of shareholders, the laws are sufficiently vague that management has a good deal of latitude to act in its own behalf. This problem, together with the separation of ownership and control in the modern corporation, results in potential conflicts between the two parties. The agency conflict between managers and outside shareholders derives from three principal sources.8 The first conflict arises from management’s tendency to consume some of the firm’s resources in the form of various perquisites. But the problem of overconsumption of “perks” is not limited to corporate jets, fancy offices, and chauffeur-driven limousines. It also extends, with far greater consequences for shareholders, into corporate strategic decision-making. As Michael Jensen points out, managers have an incentive to expand the size of their firms beyond the point at

The certification role of investment bankers is discussed in Clifford W. Smith, Jr., “Investment Banking and the Capital Acquisition Process,” Journal of Financial Economics, 1986 and James R. Booth and Richard Smith, “Capital Raising, Underwriting and the Certification Hypothesis,” Journal of Financial Economics, 1986. 8 The agency conflict is discussed in Michael C. Jensen and William H. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics, October 1976, pp. 305-360.

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which shareholder wealth is maximized.9 Growth increases managers’ power and perquisites by increasing the resources at their command. Because changes in compensation are positively related to sales growth, growth also tends to increase managerial compensation.10 As Jensen has argued persuasively, the problem of overexpansion is particularly severe in companies that generate substantial amounts of “free cash flow” — that is, cash flow in excess of that required to undertake all economically sound investments (those with positive net present values). Maximizing shareholder wealth dictates that free cash flow be paid out to shareholders. The problem is how to get managers to return excess cash to the shareholders instead of investing it in projects with negative net present values or wasting it through organizational inefficiencies. A second conflict arises from the fact that managers have a greater incentive to shirk their responsibilities as their equity interest falls. They will trade off the costs of putting in additional effort against the marginal benefits. With a fixed salary and a small equity claim, professional managers are unlikely to devote energy to the company equivalent to that put forth by an entrepreneur. Finally, their own risk aversion can cause managers to forgo profitable investment opportunities. Although the risk of potential loss from an investment may be diversified in the capital markets, it is more difficult for managers to diversity the risks associated with losing one’s salary and reputation. Forgoing profitable, but risky, projects amounts to the purchase by management of career insurance at shareholder expense. Stockholder-Bondholder Conflicts An important feature of corporate debt is that bondholders have prior but fixed claims on a firm’s assets, while stockholders have limited liability for the firm’s debt and unlimited claims on its remaining assets. In other words, stockholders have the option to “put” the firm to the bondholders if things go bad, but to keep the profits if the firm is successful. This option becomes more valuable as company cash flows increase in variability because the value of equity rises, and the value of debt declines, with increases in the volatility of corporate cash flows. If there is a significant amount of risky debt outstanding, the option-like character of equity gives shareholders an incentive to engage in risk-increasing activities — e.g., highly risky projects — that have the potential for big returns. (Witness the behavior of many of the troubled Texas S & Ls.) Similarly, management can also reduce the value of pre-existing bonds and transfer wealth from current bondholders to stockholders by issuing a substantial amount of new debt, thereby raising the firm’s financial risk. Alternatively, if the firm is in financial distress, shareholders may pass up projects with positive net present values that involve added equity investment because most of the payoffs go to

Micheal C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,” American Economic Review, May 1986, pp. 323-329. 10 Evidence on this point is supplied by Kevin J. Murphy, “Corporate Performance and Managerial Remuneration: An Empirical Analysis,” Journal of Accounting and Economics, April 1985, pp. 11-42.

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bondholders. The failure to invest in such projects reduces the value of bondholder claims on the firm as well as the total value of the firm. Non-Investor Stakeholder Conflicts The potential conflict between a company and its non-investor stakeholders can best be understood by viewing stakeholders as buying a set of implicit claims from the company.11 For example, the manufacturer of a car, a pump, or a refrigerator is implicitly committed to supplying parts and service as long as the article lasts. Similarly, although managers typically have no formal employment contract, they often perceive an implicit contract that guarantees lifetime jobs in exchange for competence, loyalty, and hard word. Before deciding to carry a new product line, a retailer frequently receives promises from the manufacturer about delivery schedules, advertising, and future products and enhancements. Implicit claims are also sold to other stakeholders, such as suppliers and independent firms that provide repair services and manufacture supporting products.

Examples of Implicit Claims Bought by Stakeholders
CUSTOMERS: • continuing stream of service and parts • durability • performance/timeliness of delivery • availability of complementary products and services EMPLOYEES AND MANAGERS: • safe work environment • fair evaluation process • opportunity for advancement • lifetime employment in return for cmpetence and loyalty SUPPLIERS AND DISTRIBUTORS: • advertising • future products and enhancements These examples illustrate two key characteristics of implicit claims. First, they are too nebulous and depend too heavily upon external circumstances to be reduced to written contracts at reasonable cost. Second, because implicit claims cannot be reduced to writing, they cannot be unbundled from and traded independently of the goods and services the firm buys and sells. In general terms, the firm is processing its stakeholders that it will make a “best efforts” attempt to satisfy them whatever happens in the future. This implicit claim clearly cannot be reduced to a legal agreement, but stakeholders’ assessments of what such claims are worth are likely to be a key determinant of, for example, how much customers will pay for the company’s products and the effort that employees, suppliers, and other stakeholders will make on behalf of the company.

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This section is based on Bradford Cornell and Alan C. Shapiro, “Corporate Stakeholders and Corporate Finance,” Financial Management, April 1987, pp. 5-14.

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The price stakeholders will pay for implicit claims depends on their expectations of future payoffs. In forming these expectations, stakeholders understand that it may turn out to be in the company’s interest to renege on such claims after the fact; that is, absent other information about a firm, they will expect the firm to promise the maximum payout ex ante, but only to deliver the amount that maximizes the value of the firm ex post.12 Firms can engage in this type of behavior because implicit claims have little legal standing. Typically, the firm can default on its implicit claims without going bankrupt. This means that corporate stakeholders such as customers, suppliers, and employees must look to the firm, not the courts, for assurance that their implicit claims will be honored. Under these circumstances, stakeholders are frequently willing to pay a substantial premium for the claims of firms they trust. For example, IBM computers are purchased not because they offer the latest technology, longest warranties, or lowest prices, but because customers value the wide variety of implicit claims that IBM sells with its machines more highly than the implicit claims of smaller, competing manufacturers. Because the payoffs on implicit claims are uncertain, even when the possibility of bankruptcy is remote, stakeholders who purchase implicit claims from the firm will seek to determine whether the firm has the organizational structure, management skills, and financial strength to make good on its implicit claims. Thus the value of these claims will be sensitive to information about the firm’s financial condition. Financially healthy firms typically have a strong incentive to honor their implicit claims. Myopic behavior on the part of the firm — for example, improving cash flow today by defaulting on implicit claims sold in the past — will damage the firm’s reputation for quality products and reliable service, and thereby lower the price at which it can sell future implicit claims. Nevertheless, a firm having difficulty scraping up enough cash to pay its creditors may be tempted to cut corners in service and products. For such a firm, the long-run value of a strong reputation may be less important than generating enough cash to make it through the next day. Recognizing these possibilities, stakeholders will pay less for the implicit claims of financially troubled firms. In practical terms, this means that a company in financial distress, or even one that may wind up in financial distress, will have to discount its product prices, pay more to its employees, and receive worse terms from its suppliers and distributors.13 The net result is that companies that have difficulty convincing stakeholders of their ability or willingness to honor their implicit claims may be placed at a competitive disadvantage relative to their more financially secure rivals. Thus, firms have clear-cut incentives to find ways of assuring the market that they will not engage in opportunistic behavior. Such mechanisms include things like the following: providing managers with incentives, such as stock options, to act in accordance with shareholder interests; bearing monitoring costs in the form of audits, specific reporting procedures and other

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Rational economic behavior implies that the firm will do whatever is in its self-interest to do after the fact. If all goes well, it will generally be in the firm’s best interest to honor its commitments. 13 The costs of financial distress are elaborated on in Alan C. Shapiro and Sheridan Titman, “An Integrated Approach to Corporate Risk Management,” Midland Corporate Finance Journal, Summer 1985, pp. 41-56.

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surveillance methods; and including various restrictive covenants in bond and bank loan agreements. The firm can also use its capital structure as a conflict management tool. Unfortunately, a financial policy designed to reduce one source of conflict often opens the door to other conflicts. For instance, one way to lessen the opportunity of management to waste the firm’s free cash flow is to reduce the scope of management discretion by issuing additional debt. Issuing more debt, however, increases potential stockholder-bondholder conflicts and also raises the probability of financial distress. On the other hand, adding equity to the capital structure will reduce conflicts between stockholders and bondholders but increase the likelihood of conflicts between management and stockholders over the disposition of free cash flow. It may also increase the government’s share of the pie. In short, any change in capital structure is likely to mitigate some problems and aggravate others. Managers must attempt to balance these effects in light of the firm’s special characteristics. It is in this sense that it is meaningful to speak of financial policy for a growth company. The special characteristics of rapidly growing companies mean that some costs and conflicts are greater and others smaller than in the case of mature companies. Therefore, it makes sense first to discuss the distinctive features of a growth company and then to suggest how those features affect the choice of financial policy.

The Special Features of Growing Companies
The most obvious sign of a rapidly growing company is its large appetite for cash. Even though income rises along with sales, cash flow is generally negative because the investment required to finance the growth in sales typically exceeds the current net operating cash flow. A company, or its division, usually begins to generate substantial free cash flow only after the business matures and sales growth slows. Therefore, the ability to locate potential sources of external funds and to arrange them in an attractive financial package are major factors affecting corporate growth. The absence of free cash flow also reduces the likelihood that this will be a source of conflict between management and shareholders. The second prominent feature of growing companies is less obvious, but critical nonetheless in devising a financial plan. For a company to grow in value, not just in size, it must have access to investment opportunities with positive net present values. These opportunities may be thought of as growth options.14 Such options include the possibility of increasing the profitability of existing product lines as well as expanding into profitable new products or markets. Growth options are typically the primary source of value in rapidly expanding firms. Such firms often have few tangible assets in place; their assets instead consist primarily of specialized knowledge and management skill. For example, Genentech, a gene-splicing company, had a stock market value of over $3 billion in late 1986 even though earnings for the year were only

The idea of growth options was introduced by Stewart C. Myers, “Determinants of Corporate Borrowing,” Journal of Financial Economics November 1977, pp. 138-147. For discussion of new techniques for valuing such options, see Volume 5 Number 1 of the Midland Corporate Finance Journal which is devoted entirely to that subject.

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$11 million, giving it a P/E ratio of over 270 to 1. Clearly, the market was valuing Genentech’s future ability to capitalize on its research in areas such as anti-cancer therapy and blood clot dissolvers for heart attack victims. A third key aspect of growth companies is that the market is likely to have a particularly difficult time in establishing their values. Unlike companies whose value depends primarily on familiar, straightforward projects, the value of a growth company depends on the value of growth options, for which there are no obvious comparables. Instead, such valuations must be based on expectations about future profits from yet-to-be-developed products (as in the case of Genentech) or novel markets niches (as in the case of Federal Express). This difficulty in valuing growth options both exacerbates the credibility problem and increases the potential for conflicts among managers, investors, and non-investor stakeholders. The credibility gap between management and investors is likely to be most pronounced in the case of growth companies because management in such cases will often have far better information about the future profitability of undeveloped products and untapped market niches. This greater possibility for important inside information increases the amount by which investors will discount the price of new corporate securities to compensate for their informational disadvantage. The natural management response to this problem, which is to provide investors with additional information, is often not credible because such statements are likely to be selfserving. Nor is the provision of such information to outsiders a possible alternative in many cases, because going public with the information necessary to evaluate its investments could jeopardize the company’s competitive position. Investors must also cope with the problem of uncertainty about management’s abilities and commitment. The problems of managerial shirking and misrepresentation, which are liable to exist in all firms, are especially critical in growth companies because the value of growth options is especially dependent on the performance of management. The higher the percentage of value accounted for by growth options, the worse these problems are likely to be (unless management has a sizeable equity stake in the company). Bondholders’ fears of being exploited are also magnified in the case of growth companies. Growth options often involve the possibility of future projects whose actual undertaking depends on how events unfold over time. Also, other things being equal, the riskier an investment the more valuable is an option on it. Taken together, these factors increase the risk to bondholders of opportunistic behavior on the part of shareholders of companies with substantial amounts of growth options. Another problem for bondholders is that growth options typically have little value apart from the firm. The absence of a secondary market for such options limits their use as security for debt claims. Stockholders and bondholders are not the only parties for whom the wider information gap besetting growth companies is an important problem. Non-investor stakeholders such as customers and suppliers must make “firm-specific investments” whose returns depend on management’s ability to exploit growth options effectively. If the firm fails to expand and develop new products, those parties that chose to do business with the firm will suffer. To

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reassure these stakeholders, management must do more than simply promise to honor their implicit claims; it must find some means to “bond” those promises. These bonding mechanisms are particularly important for growth companies because, in most instances, management has not had the time to develop its reputation or the reputation for the firm’s products.

Financing Growth Companies
In the first two sections of this article, we presented a checklist of issues to guide the financial manager in his or her attempt to make financial choices that maximize the value of the firm. Some of these issues are more important for growth companies than others. Taxes, for example, are primarily of concern to companies in the highest effective tax bracket. Companies with fairly stable or predictable incomes, and with little other means of shielding their income from taxes, know that they will be in the highest corporate tax bracket each year. Examples include consumer goods firms, utilities, some computer manufacturers, and packaged foods companies. Growth companies, by contrast, are typically unsure of their tax bracket because it is unclear whether they will have net taxable income in any given year. On average, therefore, the effective tax rate for these companies is significantly below the maximum corporate rate. Moreover, since the variability of profit is likely to be higher for a growth company, there is a lower probability that they will be able to make full use of the interest tax shield, particularly at high levels of debt. This means that the tax advantages of debt are less valuable for growth companies than for mature companies.15 Although growth companies are unlikely to be able to benefit from the tax advantages of debt, taxes may still play a role in their financing strategy. Specifically, low tax bracket growth companies may be able to use financing to transfer certain tax benefits to other companies that can more fully utilize them in return for a lower effective cost of funds. For example, we saw earlier that low-tax-bracket companies may be able to raise funds at a lower after-tax cost with preferred stock than with debt. Similarly, leasing (rather than buying) assets allows a growth company that isn’t sufficiently profitable to make current use of all its depreciation deductions to transfer these deductions to investors in higher tax brackets; in return it gets financing with a lower effective interest rate. As discussed earlier, there are two reasons for designing innovative securities: (1) to satisfy unmet market demand for a particular security with a unique risk/return trade-off; and (2) to solve specific incentive problems and resolve potential conflicts. Only the second reason is likely to be a reliable source of value for growth companies. As also noted earlier, unmet demands for new securities are unlikely to persist for long in a competitive financial marketplace. Furthermore, a growth company may be at a disadvantage in introducing innovative securities. Because of the relatively large credibility gap that faces growth companies, investors are likely to be especially wary of new securities from such companies that promise unique risk/return
15

There is another reason why the tax advantage of debt is unlikely to be significant for a growth company. Recall that Merton Miller has argued that debt will be issued in aggregate until the tax advantage at the corporate level of issuing more debt is fully offset by the higher returns demanded by investors who must pay tax on their interest receipts. Even if some tax advantage to debt remains, Miller’s argument implies that only those firms that face the highest effective tax rates are likely to benefit from issuing more debt. Growth companies are unlikely to fall into this category.

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trade-offs. Fearing that these securities may be designed to exploit their ignorance, investors are likely to discount them more heavily, thereby negating the benefits of innovation. Increasing liquidity and reducing transaction costs are potentially useful ways to increase the value of a firm. However, the benefits of these actions are apt to be smaller for growth companies. Growth companies are likely to attract investors who are more interested in long-run capital appreciation. Such investors typically follow a buy-and-hold strategy, so that the benefits of increasing liquidity or reducing transaction costs are likely to be minimal. When weighed against the costs of increasing liquidity or lowering transaction costs, therefore, such measures appear to be less beneficial for growth companies than for more mature companies. The Credibility Gap and the Problem of Financing Growth Companies Growth companies, then, are not likely to have a comparative advantage in creating value by dividing up the cash flow pie. By contrast, measures designed to bridge the credibility gap are likely to be particularly valuable for growth companies. Both investor and non-investor stakeholders will be more uncertain about the future prospects of a growth company than about the prospects of a more mature firm. Measures the firm can take to resolve this uncertainty will both raise the price that investors are willing to pay for its securities and reduce potential conflicts among the various corporate stakeholders. The problem of credibility for growth companies is so pervasive that it affects all aspects of their financing. Perhaps the best way to introduce the problem is to consider a growing firm that needs new funds to exercise a growth option. Assume the firm is making a straightforward choice of debt or equity. To make the example concrete, suppose the option is the chance to invest in the development of a new software package for word processing. If the firm goes to the equity market today to finance development of the product, credibility will be a serious issue. How are investors to know exactly what the product will look like, and whether management will be capable of producing the product on schedule, effectively marketing it, and enhancing and supporting it? Because of this uncertainty, the firm has an incentive to delay exercising its growth option until investors become better informed. Competitive conditions, however, provide an incentive for early exercise. Because these options are often shared with other competitors and cannot generally be traded, a company that waits to exercise a shared growth option — such as the chance to enter a new market or to invest in a new technology — may find that competitors have already seized the opportunity. For instance, a software firm that delays developing its new word processing program may find that, by the time the program ships, customers are committed to a competing product. (The problem is analogous to deciding whether to exercise an option on a dividend-paying stock before maturity; you preserve the option by waiting but forgo the dividend.) The message here is that companies must structure their financing to remain flexible enough to exercise growth options at the opportune moment. In this regard, future flexibility may be as important as current flexibility. Many strategically important investments — such as investments in R&D, factory automation, a brand name, or a distribution network — are often but the first link in a chain of subsequent investment decisions. The company must be prepared to exercise each of these related growth options in order to fully exploit the value of the initial investment. 14

Moreover, stakeholders will condition the price they are willing to pay for the company’s implicit claims today on the company’s financial capacity to exercise these growth options in the future and provide them with the services and products they expect. For example, if our software firm decides it must have the funds today to retain its flexibility, then it must issue equity at a big discount or go to the debt market. As noted earlier, the discount on debt will be much smaller because the cash flows received by creditors are less sensitive to the performance of the firm. However, there is a cost to issuing debt which is likely to be particularly great for growing firms. First, the cost of financial distress is apt to be particularly large for growing firms. As we have seen, much of the value of a growing company comes from growth options which, as also noted, are highly intangible assets. Such intangible assets will rapidly depreciate in value if the firm experiences — or even seems likely to experience — financial trouble. Because the probability of financial distress increases with financial leverage, the expected cost of financial distress increases with the amount of debt issued. Recognizing the costs of financial distress, creditors of growing firms require detailed covenants to protect themselves against potential managerial opportunism and incompetence. These covenants are likely to be especially restrictive for highly-leveraged growth companies because these companies, by their nature, are engaged in high-risk activities. Although restrictive loan covenants avoid many of the potential conflicts associated with debt financing — by limiting management actions that are potentially harmful to bondholders — they also may turn out to be costly to shareholders because the constrain management’s choice of operating, financial, and investment policies and reduce its capacity to respond to changes in the business environment. For example, lenders may veto certain high-risk projects with positive net present values because of the added risk they would have to bear without a corresponding increase in their own expected returns. The opportunity cost associated with the loss of operating and investment flexibility will be especially high for firms with substantial growth options because such firms must be able to respond quickly to continually changing product and factor markets. All else being equal, therefore, the high costs of financial distress, together with the costs associated with resolving the conflicts of interest between shareholders and bondholders, reduce the optimal amount of debt in a growth firm’s capital structure. For example, in explaining why his company shunned debt, the chief financial officer of Tandem Computer commented, “We were a young company competing with the likes of IBM. Not taking on debt was a marketing decision because we might not get customers if we seemed financially shaky.”16 By contrast, established firms operating in stable markets can afford more debt since their competitive stance will be less compromised by the restrictions and delays associated with high financial leverage. Faced with this unsatisfactory trade-off between the steep discount on new equity and the restrictive covenants associated with issuing straight public debt, growth companies are well advised to look elsewhere for funds. One place to start is with a commercial bank.

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This statement appeared in Kate Ballen, “Has the Debt Binge Gone Too Far?” Fortune, April 25, 1988, pp. 87-94.

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The Role of Bank Loans in Financing Growth Companies A banking relationship may solve many of the problems associated with public debt. The potential advantages of a bank credit are twofold: First, the firm can more readily custom-tailor a set of terms and conditions in face-to-face negotiations with its bankers than by trying to deal with a large number of smaller investors. Second, renegotiating certain covenants in response to changing circumstances is less cumbersome with a bank loan. The flexibility, discretion, and durability of these arrangements is what is termed a “banking relationship”. Richard K. Goeltz, Vice President-Finance of Seagram & Sons, Inc., makes this point as follows: There is an important advantage in dealing with individual bankers rather than an amorphous capital market. One can explain a problem or need to account officers at a few institutions. Direct communications with the purchasers of [bonds] are almost impossible. These investors, as is the case for most public issues, have little feeling of commitment to the borrower or sense of continuity … If the borrower can modify the terms and conditions of the former more easily and inexpensively than the latter, then the bank loan will be less costly, even if the effective interest rates are identical.17 The advantages of a banking relationship to a growing company stem from the personal nature of the relationship between borrower and lender. Presumably, bankers, who deal directly with the borrower, have lower costs of monitoring client activities than do bondholders, who are anonymous (in the case of bearer bonds) or are not interested, as are banks, in a long-term relationship with the borrower. Some recent research supports this assumption. The basic argument of this work is that banks play the part of delegated monitors who check on the behavior of the firm’s managers.18 Specifically, it is claimed that banks have a comparative cost advantage in information gathering and monitoring relative not only to investors in public capital markets, but relative to other financial institutions as well. This comparative advantage arises in large part from banks’ ongoing deposit history with the borrower and from the short-term repeat lending activity in which banks specialize.19 When a firm is unable to make interest payments on time or when its financial statements indicate problems, the banker’s first response is to examine the firm’s condition more closely. Such examination is particularly valuable for growth companies because much of their value arises from options that will be lost if the firm cannot get financing on sufficiently flexible terms. If the banker finds that the firm’s prospects are promising, he can reschedule the firm’s payments, waive a covenant, or even increase the amount of the bank’s loan.

Richard Karl Goeltz, “The Corporate Borrower and the International Capital Markets”, manuscript dated March 6, 1984, p.5. 18 The information production and monitoring services of banks are discussed, respectively, by Tim Campbell and William Kracaw, “Information Production, Market Signalling, and the Theory of Financial Intermediation,” Journal of Finance, September 1980, pp. 863-882 and Douglas W. Diamond, “Financial Intermediation and Delegated Monitoring,” Review of Economic Studies, August 1984, pp. 393-414. 19 For a good review of this literature, see Mitchell Berlin, “Bank Loans and Marketable Securities: How Do Financial Contracts Control Borrowing Firms?” Business Review, Federal Reserve Bank of Philadelphia, July/August 1987, pp. 9-18.

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The relationship with a bank can also reduce a growth company’s information problem with other investors. The view that bankers, as insiders, have better information about the firm’s prospects than outsiders and are better able to supervise its behavior implies that the loan approval process should convey two pieces of positive information about the borrowing firm to outside investors: (1) the bank believes the firm is sound, and (2) the bank will supervise corporate management to ensure that it behaves properly. In support of this argument, a recently published study by Christopher James (presented in a later article in this issue) documents a consistently positive stock market response to companies announcing the arrangement of loan commitments from commercial banks.20 Another important aspect of a banking relationship is the provision of continuous access to funds. In the typical commercial banking relationship, the bank can be viewed as writing options for its loan customer. Through such devices as credit lines or lending commitments, the borrower can choose the timing and the amount of the loan; the borrower can often prepay or refinance the loan at a nominal fee. Most important, the bank makes an implicit, and sometimes explicit, commitment to provide funds in times when the borrower finds them difficult to obtain from other sources. This flexibility is critical for growth companies because the timing of their investment program is so difficult to forecast. Despite the advantages of bank debt, banks cannot supply all the financing required by growth companies. The difficulties are three: First, bank debt is still debt, which retains many restrictive features. Second, like any form of debt, bank loans increase the probability of financial distress, with all its adverse consequences for firms trying to sell implicit claims. Third, from the standpoint of the creditor, financing high-risk investments such as growth options is not attractive. The creditor bears all the downside risk without sharing in the upside benefits. Growth options also make poor collateral; their value in liquidation is usually nil. The Role of Venture Capital in Financing Growth Companies In the case of start-ups, whose assets are comprised primarily if not exclusively of growth options, bank loans are virtually unobtainable. Venture capital has evolved as a solution to these problems. In effect, venture capitalists provide private equity. But, in return, they demand a much closer relationship, more control, and a significantly higher expected rate of return. Venture capitalists also typically demand a financial structure that shifts a great deal of risk onto company management. In order to ensure that the founders remain committed to the business, venture capital firms try to structure the deal so that management benefits only if the firm succeeds. This usually involves modest salaries for managers, with most compensation tied to profits and the appreciation in the value of their stock. Moreover, the venture capitalist usually buys preferred stock convertible into common shares when and if the company goes public. Besides giving the venture capitalist a prior claim on the assets of the firm in liquidation, one obvious effect of using preferred stock instead of straight

20

See Christopher James and Peggy Wier, “Are Bank Loans Different?”, Journal of Applied Corporate Finance Vol. 1 No. 2, which is based in turn on Christopher James, “Some Evidence on the Uniqueness of Bank Loans,” Journal of Financial Economics, 19 (1987).

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equity is to transfer risk from the venture capitalist to the entrepreneur. But, this is probably not the primary reason for using convertible preferred because there are no clear net gains to the venture capitalist from simply transferring risk; if the founders have to bear more risk, they will raise the price to the venture capitalist of acquiring a given stake in the firm. As William Sahlan argues (in the article following this one), two more likely reasons for using a financial structure that shifts a major share of the risk to the founders are as follows: (1) to force the founders to signal how strongly they believe in the forecasts contained in their business plan; and (2) to strengthen the founders’ incentive to make the company succeed by ensuring that they benefit greatly only if they meet their projections. By their willingness to accept these terms, the founders increase investors’ confidence in the numbers contained in the business plan. The venture capitalist, therefore, is willing to pay a higher price for his equity stake. The financial structure also motivates management to work harder and thereby increases the probability that a favorable outcome will occur. To further limit their downside risk, venture capitalists also rarely give a start-up company all the money it needs at once. Typically, there are several stages of financing. At each stage, the venture capitalists will give the firm enough money to get it to the next product or market development milestone. By staging the commitment of capital, the venture capitalist gains the option of abandoning the project or renegotiating a lower price for future purchases of equity in line with new information. In return for this option, the venture capitalist is willing to accept a smaller ownership share for a given investment. The founders benefit from this financing structure because it means giving up a smaller share of ownership for the needed funding. If the venture progresses according to plan, the founders will be able to bring in future capital with less dilution of their ownership share. Staged financing thus provides the founders with the option to raise capital in the future at a higher valuation. Both of these venture capital practices, the use of convertible preferred stock and staged capital commitment, can be seen as means of overcoming the “credibility gap” that confronts all growth companies in raising capital. The Role of Private Placements in Financing Growth Companies Although bank loans and venture capital offer the benefit of flexibility that comes with a close relationship, they are both expensive. The interest rates on bank loans are generally higher than the rates on straight debt, and venture capitalists demand a high rate of return for the risks they bear and the time they invest. For this reason, growth companies have an incentive to issue securities despite the problems discussed earlier. The key is to design such securities so as to minimize the credibility gap that leads to a large discount on equity and to restrictive covenants on debt. A growing firm that needs flexible debt financing may be able to secure such funds by way of a private placement. As in the case of bank debt, dealing directly with the ultimate investor opens the possibility for negotiation and renegotiation of the lending terms. In addition, the firm may be able to provide a few creditors with sensitive strategic information that it would not want to make publicly available. 18

Unfortunately, there is one major complication that arises when growing firms attempt private placements. Because privately placed securities are difficult to sell prior to maturity, investors will want to be assured at the outset that payments will be made over the life of the security. It is just such assurances that are difficult for growth companies to provide. This produces an incentive for the creditors to protect themselves with restrictive covenants and thereby leads to the same problem that exists with publicly issued debt. The Role of Convertible Securities in Financing Growth Companies Another alternative to straight debt is to issue bonds or preferred stock that are convertible into common stock at the bondholder’s option. If the conversion features are set properly, convertible securities can overcome some of the problems that cause investors to demand strict covenants on straight debt. Convertibles offer investors participation in the high payoffs to equity when the firm does better than expected while simultaneously offering them the downside protection of a fixed-income security when the firm’s value falls. If a firm with convertibles is expected to undertake high-risk projects, the value of the conversion option will increase (because stock price volatility increases an option’s value), offsetting to some extent a decline in the value of the fixed income portion. As Michael Brennan and Eduardo Schwartz have argued, this offset means that the value of an appropriately designed convertible should be relatively insensitive to the risk of the issuing company.21 This feature of convertibles is particularly valuable when investors and management disagree about the risk of a company, as is likely to be the case with rapidly growing firms. Consider the case of company which investors believe to be very risky, but which management, with privileged information, believes is only moderately risky. Assume further that management is confronted with the choice of paying a coupon rate of 12 percent on straight debt when companies that management deems of comparable risk are paying only 10 percent. In such a case, as Brennan and Schwartz illustrate, management is likely to be able to sell a convertible bond issue with the same conversion premium but only a slightly higher coupon rate (say, 8 percent relative to 7.75 percent) than the moderately risky company. The reason, again, that the effect of the divergence in risk assessment is much less for the convertible than for straight debt is that the value of convertibles is much less sensitive to changes in risk; or, to put it a little differently, the implicit warrant in a convertible protects bondholders from large changes in risk. Thus, if the market overestimates the risk of a small growth company (and thereby undervalues the company’s straight debt), it will overvalue the convertible’s call option feature. In this sense, convertible securities are well suited for coping with differing assessments of a company’s risk.22

Michael Brennan and Eduardo Schwartz, “The Case for Convertibles,” Chase Financial Quarterly, Spring 1982, pp. 27-46: reprinted in this issue. 22 A convertible issue may also provide more advantageous financing terms if management believes the market is undervaluing the company’s stock. Convertible securities can be seen as an alternative to equity which allows the firm to issue common stock at a higher price, albeit on a deferred basis, thereby avoiding current market fears that management has chosen to sell equity because it is overpriced. Even if the call option embedded in the convertible security is underpriced due to the credibility gap, when the true information is ultimately revealed, and the issue is

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The problem with convertibles for growth firms, however, is that the very flexibility they afford investors may actually reduce management’s financing flexibility. Once issued, a convertible bond is a hybrid security which effectively becomes an equity claim when times are good (and the value of the firm appreciates) but a straight debt claim when the value of the firm falls. It is, of course, precisely when times are bad that debt can cause problems for growth companies short of tangible assets. At the same time, however, the coupon reduction on convertibles relative to straight debt may significantly reduce the debt service burden and, with it, the likelihood of financial distress. Also, the less restrictive covenants associated with convertibles provide management with more flexibility in responding to unforeseen events than does straight debt. Corporate Stakeholders and the Financial Policy of Growth Companies Capitalizing on growth options involves more than developing a new product or exploiting a new market niche. The company must develop relationships with customers, suppliers and distributors, all of whom make “firm-specific investments” when they do business with the company. In making these commitments, as we argued before, customers and other stakeholders are in effect purchasing implicit claims for timely delivery, product support, future enhancements, and the like. The prices they pay for these claims depends on how confident they are that the company will be able to honor them. Established firms can use reputation to “bond” their implicit claims. Customers realize that if IBM were to fail to stand behind one of its machines, the resulting damage to IBM’s reputation would be very costly. They understand, therefore, that it is not in IBM’s best interest to default on its implicit claims. Unfortunately, this bonding mechanism is not available to growth companies, which by definition have not had time to develop a reputation. Therefore, growing firms must turn to alternative mechanisms for bonding implicit claims. One possibility is to use financial policy. In a capital market with information freely available to all and without material transaction costs, financial policy would not play an important role in the firm’s effort to convince stakeholders that it will honor its implicit claims. Because a company can always go to the capital markets whenever it needs to finance its growth options, all the company has to do is to convince stakeholders that it has a profitable sequence of growth options. Stakeholders will then take it for granted that the firm will go to the capital market whenever it comes time to exercise a growth option. However, this “perfect markets” view overlooks the credibility gap problem that we have stressed throughout this paper. A growth company always faces a significant problem whenever it goes to the capital market. This problem is exacerbated if the company even appears likely to

converted into common stock, the firm will receive a higher price than it would have received had it sold equity directly. Of course, if management truly believes that the stock market is undervaluing the company’s shares, the least expensive financing option would be to issue straight debt. Thus, convertibles are the best choice in this situation only if straight debt is inappropriate under the circumstances, for example, because of the added restrictive covenants that would come along with it.

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face financial distress. Under these circumstances, financial policy can play an important role in bonding implicit claims. The problem from a stakeholder standpoint is as follows: If a growing firm develops a cash shortage or faces financial distress, it may be in the company’s interest to default on implicit claims rather than go to the capital market. Even if the company intends to honor its implicit claims, the disruption to its operations caused by financial difficulty may not allow the company to provide stakeholders with their expected payoffs. For this reason, the firm must convince stakeholders up-front that it has the financial resources to see projects through to completion; otherwise they will not make commitments to the firm. To reassure stakeholders, growth companies generally should maintain substantial financial resources in the form of unused debt capacity, large quantities of liquid assets, excess lines of credit, and access to a broad range of fund sources. This financial flexibility helps preserve operating flexibility. A firm that has left itself with financial reserves for contingencies can respond to an adverse turn of events by allowing long-term considerations to prevail. By contrast, a firm with a high debt-to-equity ratio, minimal liquidity, and few other financial resources might have to sacrifice its long-term competitive position to generate cash for creditors. The Critical Importance of Financial Flexibility for Growth Companies The ability to marshall substantial financial resources also signals competitors, actual and potential, that the firm will not be an easy target. Consider the alternative, a firm that is highly leveraged, with no excess lines of credit or cash reserves. In such a case, a competitor can move into the firm’s market and gain market share with less fear of retaliation. In order to retaliate – by cutting price, say, or by increasing advertising expenditures – the firm will need more money. Because it has no spare cash and can’t issue additional debt at a reasonable price, it will have to go to the equity market. But we have already seen that firms issuing new equity face a credibility gap. The credibility problem will be particularly acute when the firm is trying to fend off a competitive attack. Thus, a firm that lacks financial reserves faces a Hobson’s choice: Acquiesce in the competitive attack or raise funds on unattractive terms. Similarly, when opportunity knocks, a firm with substantial financial resources will be better positioned to take advantage of it than a firm with few financial resources and bound by tightly drawn debt covenants. Thus, firms with valuable growth options should place a high priority on financial flexibility. In the attempt to preserve financing flexibility, however, management must perform what amounts to a balancing act. Recall that corporate managers historically have demonstrated a strong preference to fund new investment with the least risky sources available: first, retained earnings, next, straight debt, and, last (and only if necessary), common stock. This financial “pecking order,” as Stewart Myers argues, reflects the attempt to avoid the greater information costs (in the form of larger price discounts) of riskier offerings. By adhering to the pecking order and overcoming one problem, however, management may well be creating another. The reason: a firm that issues debt today thereby increases the probability that it “must” raise equity tomorrow – perhaps on very unfavorable terms.

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In short, a firm that needs to raise funds today faces a trade-off. If sources low on the pecking order (internal funds and debt) are used in the current period, then current financing costs appear to be low. But, as a result, the firm faces the hidden opportunity cost of being pushed up the pecking order in the uncertain future and thus being forced to issue more costly equity.23 Conversely, if the firm reverses the pecking order and instead issues equity in the current period (and the funds are held as cash), then current costs may be higher, but the option to move “down” the pecking order in the future may actually provide the firm with a cheaper source of funds overall. For growth companies, then, beginning with a substantial equity endowment and thus preserving the option to move “down” the pecking order is likely to be the favored strategy. A balance sheet heavily weighted toward equity, and perhaps including large cash balances at various times, should provide growth firms with the kind of financing flexibility necessary to exercise their “growth options”. As we saw earlier, however, too much financial flexibility may also create its own problems. For one thing, there is a tax penalty associated with investing corporate funds in marketable securities because the interest on these securities is taxed twice, once at the corporate level and again at the investor level. But potentially more important, companies with excess financial resources are more insulated from the discipline exerted by the financial marketplace. On the other hand, the weakening of management incentives that tends to come with financial “slack” is most likely to be a problem for mature companies where managers have much smaller equity stakes than those typically held by managers of growth companies. Thus, although new equity for growth companies may be expensive to raise, providing the management of such firms with an “equity cushion” is much less likely to introduce some of the incentive problems that come with corporate age and prosperity. With growth options to finance and free cash flow generally negative, the managements of growth companies have a clear incentive to husband their funds wisely. Moreover, the knowledge that such managements typically have major equity stakes in their firms provides comfort to outside equity investors that they often do not have with large established companies.

Financing Growth Companies: Summing Up
Despite all the complexities involved in financing a growth company, our suggestions for policy are relatively simple and straightforward. First, complicated strategies designed to divide the cash flow pie in unusual ways are unlikely to be profitable exercises for growth companies. Younger and rapidly growing firms whose credibility is not yet established are at a comparative disadvantage in this arena relative to mature firms such as General Electric or General Motors. Second, for a rapidly expanding company, the primary role of finance should be to preserve the growth options that are its principal source of value. Growth options, which are opportunities to undertake future investments, are different from on-going projects in that their cash requirements and their future payoffs are generally more uncertain. This uncertainty compounds the credibility

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As mentioned earlier, the financing costs referred to here are added discounts due to the credibility gap. These are costs the company must pay in addition to the normal cost of capital associated with the securities being issued.

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problem that any company faces whenever it issues new securities (Is management selling securities now, investors will ask, because it knows they are overvalued?). In addition, the potential conflicts between managers and investors, between managers and non-investor stakeholders (such as customers and suppliers), and different groups of investors (such as stockholders and bondholders) are aggravated when the company’s future is hazy. These credibility problems and potential conflicts have the effect of increasing the discount at which the company can sell its securities or, alternatively, reducing the flexibility of the terms on which securities can be sold. The task confronting the financing manager is to minimize the discount while still providing the financial flexibility to allow the company to exercise its growth options at the opportune time. One way to improve the terms of this trade-off is to develop a close working relationship with the providers of funds. This means that a banking relationship, or some other source of “private” debt, may be particularly important for those growth companies with enough tangible assets to support moderate amounts of debt. In the case of start-ups, venture capital – probably structured in the form of convertible preferred – most likely will be the principal source. In both of these cases, the credibility problem is partly resolved by the close relationship between management and the provider of funds that allows for the exchange of information on a confidential basis. Moreover, these funding sources can negotiate financing terms which offer management considerable financial and operating flexibility while at the same applying strong pressure for performance. And by their willingness to accept such terms, management can in turn signal its confidence to the providers of capital. If a growth firm is able to tap the public capital markets in an economical manner, the security should be carefully designed to minimize the credibility and conflict problems. For instance, convertible securities, by giving bondholders an option to convert to equity, reduce the incentive for managers to exploit bondholders by undertaking riskier-than-expected projects. They also reduce the valuation consequences of differences of opinion between management and investors about the riskiness of the company. These considerations increase the flexibility of the terms at which debt will be provided and reduce the discount demanded by investors. Finally, a growing company cannot make financial policy without considering its non-investor stakeholders. If customers, suppliers, and distributors feel that the firm is so financially weak that its longevity is in question, they will not make the investment required to develop a relationship with the firm. Without such commitment from non-investor stakeholders, the firm is likely to fail before it can fully develop its growth options. For this reason, a growing firm must demonstrate that it has financial strength and flexibility. Thus, the analysis in this article points to one unavoidable conclusion: A growth company needs a good deal of equity upfront (despite the steep discount at which it might be forced to issue its securities); debt is to be used with care and moderation.

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