The sale of company shares to raise capital
What is Equity Financing?
Equity financing refers to the sale of company shares in order to raise capital. Investors who purchase the shares are also purchasing ownership rights to the company. Equity financing can refer to the sale of all equity instruments, such as common stock, preferred shares, share warrants, etc.
Equity financing is especially important during a company’s startup stage to finance plant assets and initial operating expenses. Investors make gains by receiving dividends or when their shares increase in price.
Major Sources of Equity Financing
When a company is still private, equity financing can be raised from angel investors, crowdfunding platforms, venture capital firms, or corporate investors. Ultimately, shares can be sold to the public in the form of an IPO.
1. Angel investors
Angel investors are wealthy individuals who purchase stakes in businesses that they believe possess the potential to generate higher returns in the future. The individuals usually bring their business skills, experience, and connections to the table, which helps the company in the long term.
2. Crowdfunding platforms
Crowdfunding platforms allow for a number of people in the public to invest in the company in small amounts. Members of the public decide to invest in the companies because they believe in their ideas and hope to earn their money back with returns in the future. The contributions from the public are summed up to reach a target total.
3. Venture capital firms
Venture capital firms are a group of investors who invest in businesses they think will grow at a rapid pace and will appear on stock exchanges in the future. They invest a larger sum of money into businesses and receive a larger stake in the company compared to angel investors. The method is also referred to as private equity financing.
4. Corporate investors
Corporate investors are large companies that invest in private companies to provide them with the necessary funding. The investment is usually created to establish a strategic partnership between the two businesses.
5. Initial public offerings (IPOs)
Companies that are more well-established can raise funding with an initial public offering (IPO). The IPO allows companies to raise funds by offering its shares to the public for trading in the capital markets.
Advantages of Equity Financing
1. Alternative funding source
The main advantage of equity financing is that it offers companies an alternative funding source to debt. Startups that may not qualify for large bank loans can acquire funding from angel investors, venture capitalists, or crowdfunding platforms to cover their costs. In this case, equity financing is viewed as less risky than debt financing because the company does not have to pay back its shareholders.
Investors typically focus on the long term without expecting an immediate return on their investment. It allows the company to reinvest the cash flow from its operations to grow the business rather than focusing on debt repayment and interest.
2. Access to business contacts, management expertise, and other sources of capital
Equity financing also provides certain advantages to company management. Some investors wish to be involved in company operations and are personally motivated to contribute to a company’s growth.
Their successful backgrounds allow them to provide invaluable assistance in the form of business contacts, management expertise, and access to other sources of capital. Many angel investors or venture capitalists will assist companies in this manner. It is crucial in the startup period of a company.
Disadvantages of Equity Financing
1. Dilution of ownership and operational control
The main disadvantage to equity financing is that company owners must give up a portion of their ownership and dilute their control. If the company becomes profitable and successful in the future, a certain percentage of company profits must also be given to shareholders in the form of dividends.
Many venture capitalists request an equity stake of 30%-50%, especially for startups that lack a strong financial background. Many company founders and owners are unwilling to dilute such an amount of their corporate power, which limits their options for equity financing.
2. Lack of tax shields
Compared to debt, equity investments offer no tax shield. Dividends distributed to shareholders are not a tax-deductible expense, whereas interest payments are eligible for tax benefits. It adds to the cost of equity financing.
In the long term, equity financing is considered to be a more costly form of financing than debt. It is because investors require a higher rate of return than lenders. Investors incur a high risk when funding a company, and therefore expect a higher return.
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FAQs
Equity financing is the process of raising capital through the sale of shares. Companies raise money because they might have a short-term need to pay bills or need funds for a long-term project that promotes growth.
What is the meaning of equity funding? ›
Equity finance is generally the issue of new shares in exchange for a cash investment. Your business receives the money it needs and the investor will own a share in your company. This means the investor will benefit from the success of your business.
What is equity in finance example? ›
Equity can be defined as the amount of money the owner of an asset would be paid after selling it and any debts associated with the asset were paid off. For example, if you own a home that's worth $200,000 and you have a mortgage of $50,000, the equity in the home would be worth $150,000.
Is equity financing better than debt? ›
Equity financing may be less risky than debt financing because you don't have a loan to repay or collateral at stake. Debt also requires regular repayments, which can hurt your company's cash flow and its ability to grow.
What is a disadvantage of equity financing? ›
Equity Financing also has some disadvantages as compared to other methods of raising capital, including: The company gives up a portion of ownership. Leaders may be forced to consult with investors when making a decision. Equity typically costs more than debt financing due to higher risk.
Is equity funding risky? ›
Risk: Debt and equity financing both involve risk. With debt financing, you risk defaulting on the loan and damaging your credit score. With equity financing, you risk giving up ownership and control of your business. Cost: Both debt and equity financing can be expensive.
How does an equity loan work? ›
A home equity loan, also known as a second mortgage, enables you as a homeowner to borrow money by leveraging the equity in your home. The loan amount is dispersed in one lump sum and paid back in monthly installments.
What are the pros and cons of equity financing? ›
Pros & Cons of Equity Financing
- Pro: You Don't Have to Pay Back the Money. ...
- Con: You're Giving up Part of Your Company. ...
- Pro: You're Not Adding Any Financial Burden to the Business. ...
- Con: You Going to Lose Some of Your Profits. ...
- Pro: You Might Be Able to Expand Your Network. ...
- Con: Your Tax Shields Are Down.
Equity is the value and ownership an organization or individual has in a business or personal asset after subtracting its liabilities. Equity may include goods, stocks and property in equity, so this amount can vary significantly.
How are equity investors paid back? ›
Unlike debt financing, where there is an obligation to repay the loan, equity investments are permanent and do not require repayment in the traditional sense. Investors expect to see a return on their investment through profit sharing, but there is no set timeline for repayment.
The main advantage of equity financing is that there is no obligation to repay the money acquired through it. Equity financing places no additional financial burden on the company, however, the downside can be quite large.
Why equity financing is more expensive? ›
Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins.
Is equity financing cheaper? ›
Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders).
What is 100% equity financing? ›
100% equity means that there will be no bonds or other asset classes. Furthermore, it implies that the portfolio would not make use of related products like equity derivatives, or employ riskier strategies such as short selling or buying on margin.
Why is too much equity financing bad? ›
Additional equity financing increases the number of outstanding shares for a company. The result can dilute the value of the stock for existing shareholders. Issuing new shares can lead to a stock selloff, particularly if the company is struggling financially.
When to use equity financing? ›
In addition to venture scale, you can also use equity funding when you: Are a new business. During seed and angel rounds, equity is your best option because you won't have enough creditworthiness, cash flow or collateral to finance with debt. Angel investors won't care how many assets you have on your balance sheet.
What is the benefit of equity funding? ›
Less burden.
With equity financing, there is no loan to repay. The business doesn't have to make a monthly loan payment which can be particularly important if the business doesn't initially generate a profit. This in turn, gives you the freedom to channel more money into your growing business.
What does 100% equity fund mean? ›
What Is a 100% Equities Strategy? A 100% equities strategy is a strategy commonly adopted by pooled funds, such as a mutual fund, that allocates all investable cash solely to stocks. Only equity securities are considered for investment, whether they be listed stocks, over-the-counter stocks, or private equity shares.
How do equity funds make money? ›
Private equity firms buy companies and overhaul them to earn a profit when the business is sold again. Capital for the acquisitions comes from outside investors in the private equity funds the firms establish and manage, usually supplemented by debt.
What does 80% equity fund mean? ›
The Fund's investment objective is to hold investments that will pay out money and increase in value through exposure to a diversified portfolio comprised of approximately: 80% by value of shares; and 20% by value of bonds and other similar fixed income investments.
