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The Two Types of Capital

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The Two Types of Capital

It is important to distinguish between the two types of capital. Two types of investors invest capital into companies: creditors ("loaners") and shareholders ("owners"). Creditors provide a company with debt capital, and shareholders provide a company with equity capital.

Things To Know

  • Lenders require a return commensurate with the risks associated with the company.
  • Shareholders are entitled to profits generated by the company after everyone else gets paid.

Who are creditors?

Creditors are typically banks, bondholders, and suppliers. They lend money to companies in exchange for a fixed return on their debt capital, usually in the form of interest payments. Companies also agree to pay back the principal on their loans.

The interest rate will be higher than the interest rate of government bonds, because companies generally have a higher risk of defaulting on their interest payments and principal. Lenders generally require a return on their loans that is commensurate with the risks associated with the individual company. Therefore, a steady company will borrow money cheaply (lower interest payments), but a risky business will have to pay more (higher interest payments).

Who are shareholders?

Shareholders that supply companies with equity capital are typically banks, mutual or hedge funds, and private investors. They give money to a company in exchange for an ownership interest in that business. Unlike creditors, shareholders do not get a fixed return on their investment because they are part owners of the company. When a company sells shares to the public (in other words, "goes public" to be "publicly traded"), it is actually selling an ownership stake in itself and not a promise to pay a fixed amount each year.

Shareholders are entitled to the profits, if any, generated by the company after everyone else—employees, vendors, lenders—gets paid. The more shares you own, the greater your claim on these profits and potential dividends. Owners have potentially unlimited upside profits, but they could also lose their entire investment if the company fails.

It is also important to keep in mind a company's total number of shares outstanding at any given time. Shareholders can benefit more from owning one share of a billion-dollar company that has only 100 shares (a 1% ownership interest) than by owning 100 shares of a billion-dollar company that has a million shares outstanding (a 0.01% ownership interest).

Once a profit is created …

Companies usually pay out their profits in the form of dividends, or they reinvest the money back into the business. Dividends provide shareholders with a cash payment, and reinvested earnings offer shareholders the chance to receive more profits from the underlying business in the future. Many companies, especially young ones, pay no dividends. Any profits they make are plowed back into their businesses.

To pay out or not to pay out?

One of the most important jobs of any company's management is to decide whether to pay out profits as dividends or to reinvest the money back into the business. Companies that care about shareholders will reinvest the money only if they have promising opportunities to invest in—opportunities that should earn a higher return than shareholders could get on their own.