10 2 Funding: Introduction
For example, securities issued by the firm may belong to different tranches. One tranche
will be regarded as more senior and repaid before securities that belong to other tranches
can be repaid. Another tranche will be regarded as less senior and repaid only provided that
securities belonging to other tranches have been repaid.
Terminology. In corporate finance law, the meaning of the terms “equity”, “debt”
and “mezzanine” can depend on the context and the perspective.
From a legal perspective, different forms of capital will be treated differently
depending on the applicable legal rules. For example, capital that, according to
traditional national accounting rules, is regarded as “equity” may be regarded as
“debt” under IFRS. According to the provisions of company law, a company can
have different forms of capital. Moreover, the tax treatment of different forms of
capital can vary.
Even the subjective perspective can play a role. A certain “debt” instrument
may thus be regarded as an “equity” investment by an investor buying an instru-
ment with a better ranking or, if the capital amount of that instrument does not
have to be repaid soon, by the company issuing the instrument.
In this book, “equity” and “mezzanine” are regarded as techniques rather than
distinct categories of funding. “Equity” is understood as the result of the use of the
“equity technique” (section 5.1), and “mezzanine” as the result of the use of the
“mezzanine technique” (section 6.1). A distinction is made between shareholders’
capital and other forms of equity.
The Basel II Accord has its own terminology. For supervisory purposes, capital is defined
in two tiers, core capital (Tier 1) and supplementary capital (Tier 2). At least 50% of a
bank’s capital base must consist of a core element comprised of equity capital and pub-
lished reserves from post-tax retained earnings (Tier 1) as defined in the Basel II Accord.
Elements of supplementary capital will be admitted into Tier 2 limited to 100% of Tier 1.^18
Tier 1 capital means equity capital and disclosed reserves. Equity capital means “issued and
fully paid ordinary shares/common stock and non-cumulative perpetual preferred stock (but
excluding cumulative preferred stock)”.^19 Tier 2 capital or supplementary consists of undis-
closed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid
debt capital instruments, and certain subordinated term debt.^20
Reduction of external funding needs, retentions. Whereas equity, debt and mezza-
nine capital are regarded as the three main forms of external funding, internal fi-
nancing constitutes the dominant source of finance.^21 Typical ways to reduce the
firm’s external funding needs include: retained earnings, reducing the amount of
invested capital, as well as chain structures and pyramids.
Most firms retain a substantial portion of the earnings left over after the firm’s
contractual obligations have been met rather than pay them out in the form of
dividends to shareholders or bonuses to employees.
(^18) Paragraph 49(iii) of the Basel II Accord.
(^19) Paragraph 49(i) and footnote 13 of the Basel II Accord.
(^20) Paragraphs 49(iv), 49(v), 49(vii), 49(xi), and 49(xii) of the Basel II Accord.
(^21) See Tirole J, op cit, p 96.