The Stock Exchange - How do Firms Raise Finance?

The London Stock Exchange (LSE) tends to deal with firms that are relatively large in size. A sole trader for example is likely to have little or nothing to do with the LSE so this example is based on a firm that is relatively large in size.

The work of the LSE involves dealing with firms who are already very big in some cases and who already have many thousands of shares being traded everyday but who want to raise funds to expand further to other firms that may have outgrown their existing scale and are looking to take that leap to being a public limited company (plc).

Imagine you have a business idea, you think it will be a winner but are at a loss of what to do to get set up. The idea might be the easiest part, getting the practicalities of a business organised is much more daunting. You are likely to need premises, equipment, you have to hire staff, buy raw materials and stock and so on. In many cases all these things have to be done many months before you are able to start selling your product or service and receiving any money.

One way of raising this finance is to go to a bank - for larger firms this will not be the likes of NatWest or Barclays but will be a large investment bank that specialises in raising large sums of money for businesses. Examples of investment banks are Goldman Sachs, Morgan Stanley, Schroders, Merril Lynch, JP Morgan Chase and Lehman.

You may go to the bank with plans for raising £30 million. The bank will look at your plans and make a decision about the level of risk involved and then put together a deal to loan you the money. The £30 million they lend you will attract interest. The bank is looking to make money out of the deal and the price of lending money is the interest rate you have to pay.

In economics, capital is one of the factors of production. Capital is not just money - it is better to think of it in terms of what that money represents. Capital is anything that is not bought for its own sake but which is bought for its contribution to production. A machine for example is bought for helping to produce something rather than for looking attractive; a photocopier is bought to reproduce documents that the firm might use as part of its activities.

All factors of production have a price - the 'price' of land is called Rent (not like the rent you pay on a flat) the price of hiring labour is called Wages and the return on enterprise is called Profit.

For the investment bank, therefore, they will lend you money for your business, which you have to pay back over an agreed period of time. Whilst you have that money, the investment bank cannot use it for any other purpose and so the price you pay for that privilege is interest. If your business proposal is deemed as being quite risky, the bank might charge quite a high rate of interest. The diagram below helps to explain how the investment bank provides this service to businesses and how they in turn make a profit on their activities.

A business decides to expand and wishes to raise funds to finance the purchase of new machinery, equipment, plant and buildings. The total cost is going to be £15 million.

The bank (Merrill Lynch is one such investment bank) agrees to loan the funds over a period of ten years at a flexible interest rate of 5.5%.

There are advantages and disadvantages to raising funds through an investment bank in this way. The firm could be susceptible to changes in interest rates, they have only limited control over the process and there may be limits to the amount they are able to raise through this method.

This is where the Stock Exchange comes in. The basic idea behind a plc is something called 'joint stock' companies. A joint stock company is an association of people who agree to put capital into a business with a view to gaining some return. The first joint stock company was formed in 1553 and has evolved over the years as business and industry has developed and changed. The principle however has remained the same.

This principle is based on the idea that there are people out there who have money they want to save or invest. They may want to save the money to get some form of regular return - a payment every year for example - or they might want to find a way of making their money grow in other ways. Equally there are plenty of firms out there who are wanting funds to be able to expand and grow. Joint stock companies allow those with money to invest to be put in touch with those wanting money. The investor may know very little if anything about the company, they might certainly not want to get involved in its day to day running and so a group of people are appointed to run the company on behalf of those investors.

These people are the Board of Directors of a company. Their role is to run the company on behalf of those people who have invested their money into it - the shareholders. There might therefore be 10,000 people each investing a relatively small amount of money into a company - some might have £1,000 to invest, others £250,000. Each investor however owns a fraction of the company. Let's use a simple example to illustrate this:

Company X wants to raise £30 million. 1,000 people around the world are looking to invest £30,000 each. They each buy £30,000 worth of shares in Company X. Company X now has 1,000 shareholders each of whom own 1% of the company.

Post By Premire Group
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