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Theme 2Tier 1 capital

Main article: Tier 1 capital

Tier 1 capital, the more important of the two, consists largely of shareholders' equity and disclosedreserves. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not theamount those shares are currently trading for on the stock exchange), retained profits subtracting

accumulated losses, and other qualifiable Tier 1 capital securities (see below). In simple terms, if theoriginal stockholders contributed $100 to buy their stock and the Bank has made $10 in retained

earnings each year since, paid out no dividends, had no other forms of capital and made no losses,after 10 years the Bank's tier one capital would be $200.

Tier 2 (supplementary) capital

Main article: Tier 2 capital

Tier 2 capital, or supplementary capital, comprises undisclosed reserves, revaluation reserves,general provisions, hybrid instruments and subordinated term debt.

Undisclosed Reserves

Undisclosed reserves are not common, but are accepted by some regulators where a Bank has madea profit but this has not appeared in normal retained profits or in general reserves. Most of the

regulators do not allow this type of reserve because it does not reflect a true and fair picture of theresults.

Revaluation reserves

A revaluation reserve is a reserve created when a company has an asset revalued and an increase invalue is brought to account. A simple example may be where a bank owns the land and building of

its headquarters and bought them for $100 a century ago. A current revaluation is very likely toshow a large increase in value. The increase would be added to a revaluation reserve.

[edit]General provisions

A general provision is created when a company is aware that a loss may have occurred but is notsure of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions werecommonly created to provide for losses that were expected in the future. As these did not represent

incurred losses, regulators tended to allow them to be counted as capital.

[edit]Hybrid debt capital instruments

They consist of instruments which combine certain characteristics of equity as well as debt. They canbe included in supplementary capital if they are able to support losses on an on-going basis without

triggering liquidation.

[edit]Subordinated-term debt

Subordinated debt is classed as Lower Tier 2 debt, usually has a maturity of a minimum of 10 yearsand ranks senior to Tier 1 debt, but subordinate to senior debt.

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Subordinated Debt & Equity

Equity (or sub-debt) investment in a private company is the most risky type of financing and therefore can be difficult to obtain. With this kind offinancing, the primary security of a company is often pledged to other lenders therefore the greater risk. Consequently, the rate of return that aninvestor negotiates for an investment of this type is usually higher than for other investment types.

SUBORDINATED DEBT

Sub-debt is often referred to as mezzanine financing. This type of financing occupies a location on the balance sheet of a company between seniordebt and equity. It can be viewed as a hybrid form of capital, combining elements of both debt and equity. It most commonly takes the form ofsubordinated debt coupled with warrants that enable the investor to purchase shares in a company at a predetermined price. It is not a controlinvestment and is normally not used to take an ownership position in a company. The subordinated debt, or "sub debt", has all the characteristics ofother debt instruments, but is structurally junior in priority of payment and its claim on collateral to senior debt. Because of this subordinateposition, sub debt presents a greater risk profile to the lender and, thus, warrants a higher rate of return. The warrant position that accompanies thesubordinated debt is known as the "equity kicker" and is structured to provide an additional return to the investor. Unlike the debt component, thisportion of the total return to investors does not come in the form of periodic payments of interest, but through the projected increase in the equityvalue of a company.

EQUITY

Equity financing, the capital source that most often comes to mind first for many business owners, is a good option for those who have a compellingenough business to attract investors. The catch with equity financing is that it can dilute the ownership of the company for the shareholders,potentially resulting in a loss of control.

Equity investment includes the acquiring of common or preferred shares or a contractual right to acquire shares of one type or another. Thecontractual rights often are provided in the form of warrants, options or debentures and most often used either to increase the return of aninvestment or reduce risk.

Equity financing is generally recommended for a business that's experiencing very high growth with high investment risk. For example, an early-stage, high-growth company with limited revenues and prospects for negative operating income for the next few years would find this to be a goodoption.

In Order to Bullets:

Equity

There's a distinct loss of ownership.

It's the most expensive financing option with the highest cost of capital.

The capital stays in the business for the long term; dividends are taxable.

The valuation of the company is a huge issue in landing the capital.

Investors will want a say in how the business is run and may elect to take seat(s) on the board of directors.

Sub-Debt

There's relatively less loss of ownership through warrants.

It's a less-expensive financing option: it costs more than senior bank debt but less than equity.

The loan must be repaid and includes interest charges, but the interest is tax deductible.

The company needs to provide security on the loan, perhaps even personal guarantees.

It's unlikely there'll be management advisors, but financial disciplines and controls may be imposed by the lender.