Equity Financing: Definition, Overview & Example
There are a number of reasons why a business may have short-term financing needs.
They could be looking to finance new growth opportunities. There could be an investment opportunity that they want to take advantage of but don’t have the cash flow. They could simply want to invest the money back into the long-term future growth potential and stability of the company.
But when a company doesn’t have enough capital to cover any of the above, one of the options they have is to turn to equity financing.
But what exactly is equity financing?
Read on as we take a closer look at everything to do with this form of financing.
Table of Contents
- Equity financing is a way for companies to raise capital through selling shares of the company.
- It is a common form of financing when companies have a short-term need for capital.
- There are two different types of equity financing. Public stock offerings, and the private placement of stock with investors.
- Equity financing is a separate form of financing from debt financing. Debt financing is borrowing money whereas equity financing is selling a portion of equity.
What Is Equity Financing?
Equity financing is the process of raising capital via selling shares of a company. Companies can raise money due to the fact that they may have a short-term need to pay off debt or have a long-term financial goal. They would therefore use the funds gained from selling shares to invest in their growth in whichever way they see fit.
By selling shares, a company is essentially selling ownership in their company in return for capital.
Equity financing can come from a number of different sources. For example, through family and friends, investors, or via an initial public offering (IPO). An initial public offering is a process where private companies offer shares of their business to the public in a stock issuance. The public share issuance means that a company can raise capital from public investors.
This is a common tactic in the business world. Huge, multinational companies such as Google have raised billions of dollars worth of capital by undergoing an IPO.
The term equity financing refers to the financing of public companies that are listed on an exchange. However, the term can also apply to private company financing.
How Does Equity Financing Work?
Equity financing involves the sale of equity. This can include:
- Common equity
Quasi-equity is instruments such as:
- Common stock
- Preferred stock
- Convertible preferred stock
- Equity units including warrants and common shares
A startup company that grows into a bustling business will have a number of rounds of equity financing as it grows and evolves. A startup commonly will attract different types of investors at the various stages of its evolution. Therefore it may use different equity instruments for its various financial needs.
Types of Equity Financing
Companies will commonly use two main methods to obtain equity financing:
- The private placement of stock with venture capital firms or investors
- Public stock offerings
It’s a more common occurrence for younger companies and startups to opt for private placement. This is mainly because it is a far more straightforward type of equity financing.
Major Sources of Equity Financing
Venture capitalists and angel investors are commonly among the first set of investors for a startup. They would typically opt for convertible preferred shares. This would be instead of going for common equity in exchange for funding new companies. This is because the former has some downside protection and more upside potential.
Once the company has evolved to a point where it may consider going public, it may decide to sell common equity. This would be to retail and institutional investors.
If the company has any need for additional capital at a later point, it may choose secondary equity financing options. These are things such as a rights offering or an offering of equity units including warrants.
Advantages of Equity Financing
There are many advantages of equity financing, but these two are the main upsides:
- There is no need to repay the money that is raised from an equity investment
- There is no additional financial burden on the company
Disadvantages of Equity Financing
There are some downsides to raising capital through equity financing. Here are some of the disadvantages to equity financing:
- You lose a percentage of your company to the investor
- You have to share any future profit with the investors
- You have to consult with investors whenever you want to make decisions that impact the company in any way
- You have a lack of tax shields
Equity Financing vs. Debt Financing
While equity financing and debt financing are both financing methods, they do differ. The main difference between equity financing and debt financing is the method used to raise capital. In equity financing, a company sells off partial ownership of the company in return for funds. Whereas debt financing is taking on a loan with the promise of paying the capital back over a period of time with added interest.
So to put it simply, debt financing is borrowing money, and equity financing is selling ownership to raise money.
The most common form of debt financing is a loan. This will commonly be from a lender such as a bank or other financial institution. Equity financing requires no repayment obligation. This differs from debt financing which requires a business to pay back the money it receives plus interest. However, one of the advantages of taking out a loan is that it doesn’t require the company to give up any ownership to shareholders.
Another difference when it comes to debt financing is that there is no control over the operations of the business for the lender. Once the company pays the lender back, their relationship ends. Whereas with equity financing, any profits must be shared with the shareholders. And the investors must be consulted when they make large decisions that may impact the company as a whole.
Debt financing can also place a number of restrictions on the operations of a company. This can make it so that they may not have as much leverage when it comes to taking advantage of opportunities outside of the core of the business.
When it comes to taking on debt, companies will generally want to have a relatively low debt-to-equity ratio. This would mean that any potential creditors will look more favorably on them. And allow them to access additional debt financing in the future.
The interest paid on loans is also tax-deductible for a company. And the loan payments make future expense forecasting a much simpler task as the amounts do not fluctuate and stay steady.
Equity financing is a good source of income for smaller or younger companies. Investors will put money into the company and get equity in return. Though any business owner that is looking to raise capital through equity financing should be aware of the dangers of selling off ownership of your business.
Debt financing is also a good option when it comes to raising capital. You don’t give away ownership but you do have to pay the money back with added interest. Running a business with debt can be risky. Especially if you’re already running risky businesses that are prone to sharp changes in funding.
FAQS on Equity Financing
What Are Examples of Equity Financing?
Say Company X decides to sell 300 equity shares of its company stock at a price of $15 per share. If these shares are bought, then they will have raised $4,500. This would also mean that the investor now has an equity stake in the company and a percentage of ownership.
Is Equity Financing a Good Idea?
Equity financing is a good business idea and an effective option to raise capital for a business without the burden of having to repay the money. It is a basic funding option for many companies.
What Is the Risk of Equity Financing?
Equity financing comes at the risk of potential ownership loss. If a business raises too much equity capital, the owner could run the risk of losing majority ownership rights. And eventually they could end up losing complete control of the entire company.
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