Market-based financing refers to a system of markets, such as equity and debt markets, in which financial instruments` supply (companies seeking financing) meets demand (the public and institutions, including funds, insurers, etc.) in an organized way.
Accessing market-based financing enables the Company to raise money from a wide investor pool (without borrowing from financial institutions), including by having the ability to engage in secondary stock offers. Additionally, accessing market-based financing has a positive impact on the conditions in which the Company can obtain bank-based financing, as it provides a more solid standing with financial institutions, leading to lower borrowing costs through lesser perceived risk. Presence in capital markets also grants the company increased recognition, credibility and prestige, which in turn improve the company’s ability to increase market share, reach new markets and attract and retain better talent.
Although the decision to access market-based financing should result from a diligent understanding about the steps of the process and best practices in dealing with investors, regulators, the media and public scrutiny, one of the first steps should be a deep reflection on the benefits that such process can unlock. The potential benefits that are achievable by accessing market-based financing are:
***1 – Access to a wider investor pool***
Gain access to a broader community of investors, which tend to be aligned with the company’s long-term strategy and goals. Market-based financing provides greater flexibility and independence for the company’s management, empowering management to pursue a long-term strategy that will maximize long-term value. The investor pool normally includes also private investors (for example investment funds or insurance companies) which often bring more management knowledge and attentive and professional relationship.
***2 – Internationalization***
The process of going public and entering capital markets facilitates companies’ international expansion, by granting the company increased recognition, credibility and prestige, while simultaneously being more visible by foreign investors.
***3 – Access and diversification of funding sources with greater operational flexibility***
Grants the company easy access to funding, not only at initial offer, but also afterwards through secondary offers. The easier access to funding from capital markets after going public generally enables the company to raise money in a less costly and efficient way, with more flexibility than it could through bank-based financing. It also provides access to more flexible financing instruments, giving the company more freedom to tailor the funding strategy to its specific needs of the business at any given time.
Provides alternative forms of finance to firms, through several capital market sources, improving the efficiency of the funding process, by avoiding a high dependence on the banking system and increasing resilience by mitigating financial risk.
Markets are less dependent on financial institutions, are less exposed to systemic risk and are not directly connected to the payment infrastructure, which means that in some cases, during an economic crisis, it is advantageous and easier to obtain funds in the capital markets than by borrowing from financial institutions.
Additionally, Bank-based financing most often implies greater management constraints than market-based financing. Bank debt often hold the company to more restrictive covenants that reduce operating flexibility (covenants are legally binding obligations made by the borrower to always comply with a certain rule or when taking a specific action).
An example would be a leverage covenant such that Debt / EBITDA is no more than 3.0x at the end of each fiscal quarter. In this case, the company would then have to ensure that this financial threshold is maintained. Covenants may also reduce the ability to return capital to shareholders (limiting dividends, share repurchases, opportunistic purchases of subordinated debt). Covenants may also be impediments to being able to pursue attractive acquisitions because of maximum leverage covenants or other constraints.
***4 – Improved liquidity***
As securities are continuously traded in a transparent manner, prices are always defined by the matching of supply and demand. This enhances the liquidity of capital markets, making it easier for market participants (including current shareholders) to rapidly buy or sell securities.
With high liquidity and being easily tradeable, listed securities are an excellent form of currency for mergers and acquisitions and to be used for collateralization of bank-based financing. As the price of stocks is defined by the market, sellers and banks are much more willing to accept liquid publicly tradable stock than illiquid private company stock.
The liquidity of listed securities also allows for share-based employee profit-sharing schemes, including stock options and other equity awards, which attracts and retains key talent, while encouraging commitment and long-term motivation amongst employees, without incurring additional cash expenses. One of the best incentives is allowing employees to share the company’s profits, promoting their loyalty and productivity.
As an example, many companies included stock option plans in their remuneration policy, giving the possibility to their employees to buy the companies’ shares at a discount to promote employee engagement with business performance and share value.
***5 – Greater efficiency and transparency***
Transparency, reporting and corporate governance requirements for the public capital markets encourage greater professionalization across listed companies, including better internal processes and reporting mechanisms. The open communication with investors, analysts and the media provides an opportunity to receive valuable feedback that may support the management team on how to best manage the company and what direction to follow.
***6 – Increased market value***
Valuations of public companies are usually higher than those of comparable private companies. Similarly, private placement bonds tend to have higher yields when compared to publicly traded bonds. This is mainly justified by the increased liquidity, availability of information and easily determinable value of the securities, altogether with lower perceived risk. Accordingly, investors in non-publicly traded securities require additional return relative to comparable publicly traded securities to compensate for perceived risk.
***7 – Higher visibility and improved image***
Economic agents know that the process of going public, demands that the company has a high level of organization and internal controls. This common knowledge enhances the company’s visibility and prestige, nationally and abroad, increasing its credibility with clients, suppliers, business partners, employees, and financial institutions, and is heightened by that fact that by going public the company receives greater media coverage.