It seems strange to ignore the terms agreed to when raising money. A company that raises money via loans typically has more obligations than one that raises money via equity. Doesn't the option value for repayment count for anything?
> It seems strange to ignore the terms agreed to when raising money.
I'm not sure what you mean by this - can you clarify?
> A company that raises money via loans typically has more obligations than one that raises money via equity. Doesn't the option value for repayment count for anything?
Certainly the equity of a highly indebted company will behave differently than the equity of a debt-free company. But "different" isn't necessarily "better". To go back to my company A & B example, if both companies double in enterprise value, the equity holders of company A will get a return of 100% ($1,000,000 profit on capital of $1,000,000), but the equity holders of company B will get a return of 200% ($1,000,000 profit on capital of $500,000). Conversely in a scenario where each company loses half of its value, the equity holders of company A will still be left with half of their money, while the equity holders of company B will be wiped out (to first order - reality is more complicated than this usually).
So in some scenarios the company A equity looks better and in some scenarios the company B equity looks better. Which you prefer overall depends on your individual risk preferences - some people want a higher potential return at the cost of higher risk, some people want less risk at the cost of a lower potential return. There's no objectively "best" structure.
Even for companies with no debt at all you'll see investors who artificially create financial leverage by buying options on the company's equity. Different strokes for different folks, or as my dad likes to say, there's an a$$ for every seat. :)
Interesting. Yes, tolerance for risk varies with each investor, but isn't there supposed to be a consensus way that the market prices risk, on average? I'm just throwing out terminology here, but what about "risk-adjusted return"? Other things being equal (which they never are), prices should be lower for higher-risk investments, to compensate for the risk taken.
So I'm wondering how enterprise value prices risk compared to market value.
> isn't there supposed to be a consensus way that the market prices risk, on average?
Consensus on the price of risk, yes. Consensus on risk preferences, no. :) I.e. two people can agree that a one year US Treasury Bill paying 0.50% interest is worth exactly par, and yet come to completely different conclusions about whether they want to own it at that price.
I.e. you're absolutely right about achieving a consensus on how to value an asset, but people's differing risk preferences are a major reason we have markets in the first place - it's not just zero-sum wagering on what will go up and what will go down.
> So I'm wondering how enterprise value prices risk compared to market value.
To the extent a company has debt, the risk (and expected return) of its equity will always be higher than the risk (and expected return) of an identical company without debt: the equity holders have levered up by borrowing and magnified their risk and potential return. I don't know if that answers your question or not, though.
