Definition of equity financing

What is equity financing?

Equity financing is the process of raising capital through the sale of stocks. Businesses raise funds because they may have a short-term need to pay their bills, or they may have a long-term goal and need funds to invest in their growth. By selling stocks, a company is effectively selling ownership of their company in exchange for cash.

Equity funding comes from many sources: for example, friends and family of an entrepreneur, investors or a initial public offering (IPO). An IPO is a process that private companies go through in order to offer shares of their company to the public as part of a new share issue. Public issuance of shares allows a company to raise capital from public investors. Industry giants, such as Google and Facebook, have raised billions in capital through IPOs.

While the term equity financing refers to the financing of public companies listed on a stock exchange, the term also applies to the financing of private companies.

Key points to remember

  • Equity financing is used when companies, often start-ups, have a short-term need for cash.
  • It is common for companies to use equity financing multiple times during the maturity process.
  • There are two methods of equity financing: private placement of shares to investors and public offerings of shares.
  • Equity financing differs from debt financing: the first involves borrowing money while the second involves selling a portion of the company’s equity.
  • National and local governments keep a close watch on equity financing to make sure that everything that is done complies with regulations.

How Equity Financing Works

Equity financing involves the sale of common stocks, but also the sale of other equity or quasi-equity instruments such as preferred stock, convertible preferred stock, and equity units that include common stock and warrants.

A startup that grows into a successful business will benefit from multiple rounds of equity funding as it matures. Since a Start Usually attracts different types of investors at different stages of its development, it can use different equity instruments for its financing needs.

Equity financing is distinct from debt financing; in debt financing, a company assumes a loan and repays the loan over time with interest, while in equity financing, a company sells a share of the property in exchange for funds.

For example, angel investors and venture capitalists – who are usually the first investors in a startup – are inclined to favor convertible preferred stocks over common stocks in exchange for financing new companies, because the former have a greater upside potential and some downside protection. Once the company has grown large enough to consider going public, it may consider selling common stocks to institutional and retail investors.

Later, if the business needs additional capital, it can choose secondary equity financing options, such as a rights offer or an equity unit offering that includes warrants as a sweetener.

Equity financing and debt financing

Companies generally have two financing options to consider when they want to raise capital for their needs: equity financing and debt financing. Debt financing is borrowing money; equity financing is the sale of part of the equity of the business. While these two types of financing have distinct advantages, most businesses use a combination of equity and debt financing.

The most common form of debt financing is a loan. Unlike equity financing, which has no repayment obligation, debt financing requires a business to repay the money it receives, plus interest. However, an advantage of a loan (and debt financing in general) is that it does not require a company to give up part of its ownership to shareholders.

With debt financing, the lender has no control over the operations of the business. Once you have paid off the loan, your relationship with the financial institution ends. (When companies choose to raise capital by selling stocks to investors, they should share their profits and consult with those investors whenever they make decisions that impact the entire company.)

Debt financing can also place restrictions on a business’s operations, so it might not have as much leverage to take advantage of opportunities outside of its core business. In general, companies want to have a relatively low debt ratio; creditors will see it more favorably and will allow them in the future to access additional debt financing in case of urgent need. Finally, interest paid on loans is tax deductible for a business, and loan repayments make it easier to predict future expenses because the amount does not fluctuate.

When deciding whether to seek debt or equity financing, companies typically consider these three factors:

  • What source of funding is most easily accessible to the business?
  • What is the company cash flow?
  • How important is it for the primary owners to maintain full control of the business?

If a company has given investors a percentage of their company through the sale of shares, the only way to withdraw them (and their stake in the company) is to buy back their shares, a process called buyback. However, the cost of repurchasing the shares will likely be more than the money they initially gave you.

Special considerations

The equity financing process is governed by rules imposed by a local or national securities authority in most jurisdictions. Such regulation is primarily aimed at protecting the investing public from unscrupulous operators who could raise funds from unsuspecting investors and disappear with the proceeds of the financing.

Equity financing is therefore often accompanied by an offer note or prospectus, which contains detailed information that should help the investor to make an informed decision on the merits of the financing. The memorandum or prospectus will indicate the activities of the company, information about its officers and directors, how the proceeds of the financing will be used, the risk factors and the financial statements.

Investor appetite for equity financing depends to a large extent on the state of financial markets in general and equity markets in particular. While a strong pace of equity funding is a sign of investor confidence, a torrent of funding may indicate excessive optimism and an impending market peak. For example, IPOs of dotcom companies and tech companies hit record highs in the late 1990s, before the “tech shipwreck” that engulfed the Nasdaq from 2000 to 2002. The pace of equity financing generally slows down. strongly after a sustained market correction due to investor risk. -aversion during these times.

Equity Financing FAQs

How does equity financing work?

Equity financing is the sale of a portion of a company’s equity in exchange for capital. By selling stocks, a company is effectively selling ownership of their company in exchange for cash.

What are the different types of equity financing?

There are two main methods that companies use to obtain equity financing: private placement of shares with investors or venture capital firms, and public offerings of shares. It is more common for young companies and startups to choose private placement because it is easier.

Is Equity Financing Better Than Debt?

The most important advantage of equity financing is that the money does not need to be paid back. However, equity financing has some drawbacks.

When investors buy shares, it is understood that they will own a small stake in the company in the future. A company must generate consistent profits in order to be able to maintain a healthy valuation of its shares and pay dividends to its shareholders. Since equity financing is a greater risk for the investor than debt financing for the lender, the cost of equity is often higher than the cost of debt.

What are the advantages and disadvantages of equity financing?

Disadvantages of equity financing
  • You must give investors a percentage of your business

  • You must share your profits with investors

  • You should consult with investors whenever you make decisions that impact the business

The bottom line

Companies often need outside investment to maintain their operations and invest in future growth. Any smart business strategy will include a consideration of which balance of debt and equity financing is most profitable. Equity funding can come from many different sources. Regardless of the source, the biggest advantage of equity financing is that it has no repayment obligations and provides additional capital that a business can use to grow its business.

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