Equity Financing Definition
Equity financing involves selling a company’s shares to obtain funds. The percentage of the company sold is determined by the amount invested in the business and its valuation at the time of financing.
The financing could be either short-term or long-term. As the business expands, the investor’s ownership stake in the company will also increase in value.
We’ll examine why most companies prefer equity finance, types of equity finance, and sources. In addition, we explore the advantages and disadvantages of using equity finance.
Keep reading to learn more!
How does Equity Financing Function?
Equity financing is raising capital for businesses through the sale of common stock or quasi-equity instruments such as preferred stock and convertible preferred stock. Startup companies turn to equity finance to attract investors, such as angel investors and venture capitalists.
These investors purchase stock in exchange for ownership of the company. Equity units, which encompass various types of equity shares, are issued to investors. Convertible preferred shares, for instance, provide investors with the option to convert their shares into common stock.
This approach allows startups to secure funding while giving investors the potential for higher returns through the sale of their equity holdings. In addition, equity finance provides valuable guidance and industry connections. Furthermore, this collaboration can be instrumental in propelling a fledgling company to success.
Why Do Most Companies Prefer Equity Financing?
When starting or growing a business, many things must be considered. One important decision you’ll need to make is how to finance your company.
The reason why most companies prefer equity finance is that it doesn’t have to repay the funds. In case it fails, the investors will retain the shares.
A firm may generate less equity, lower its share price, and increase its dividend payments to attract investors. In addition, the firm must agree with the investor on whom to sell the shares, pricing, and terms for paying the dividend.
It is essential when a firm is starting. Unlike small companies, big companies process their claims through IPOs, which are informal, including contractual agreements.
How To Get Equity Financing
Two ways to get equity funding are to sell company shares to the public or seek private financing. Companies prefer private funding as a public offering does not need many processes.
Public offering processes require a company to comply with legal procedures, unlike private funding, where the company deals directly with the investor. In addition, the company must have a business plan to show investors that its managers have the potential to grow and keep the company.
Types of Equity Financing?
Venture Capitalists
It’s an entity that funds or invests money in high-risk start-up companies. It includes seasons and professional investors who analyze the firm to buy it. Thus, invest only in performing firms with significant competitive advantages, not less than one million dollars.
Angel Investors
Angel investors are members of the family or close friends. They invest an amount of up to $0.5 million. Unlike venture capitalists, Angel Investors do not involve themselves in the company’s day-to-day running.
Crowdfunding
It involves selling part of company shares to several investors through crowdfunding sites. The minimum amount to buy shares is $1000. Contrary to equity funding, crowdfunding is legalized only in some countries under a strict judiciary.
Royalty Financing
Royalty financing is when an investor gives out money to cater to firms’ expenses in return for a product’s sale percentage. In this type of financing, an investor expects payments immediately. Thus, the firm must prove its capability through the balance sheet or profit and loss statement.
Initial Public Offerings (IPOs)
IPOs are a process where a company sells its shares to the public to raise funds. IPO funding is time-consuming and expensive; the firm only does so after raising funds from different equity financing.
Entities that buy these shares get funds from various investors to contribute colossal amounts of money, which managers then invest in several assets.
Mezzanine Financing
This type of funding combines equity and debt financing. It provides a low debt-to-equity ratio, and it’s less risky. Most investors rely on it as it proves firms don’t operate more on debt. Small businesses prefer mezzanine financing, which counts as equity on their balance sheet, thus attracting more investors.
Read also: How to automate your finances
Special Considerations
Equity financing is subject to regulations imposed by securities authorities, aiming to protect investors from fraud. It involves offering documents, such as prospectuses, providing essential details about the company, its management, financing usage, risks, and financial statements.
Investor interest in equity financing depends on the overall financial and equity market conditions. A steady flow of equity financing reflects confidence, but excessive activity may indicate over-optimism and a potential market peak. For instance, the dot-com and tech IPO frenzy of the late 1990s preceded the Nasdaq crash in the early 2000s.
Equity Financing Example
Here’s an equity finance example.
Assume an investor offers $50,000 for a 5% stake in Company XZ. It means the present value of Company XZ would be $0.5 million ($50,000 * 5 = $0.5 million, or 50% of the firm’s capital).
Company XZ’s value will be at $1 million. The investor’s share would be worth $100,000, twice the original funding amount.
Sources of Equity Funding?
There are various sources of equity funding. These include:
- Crowdfunding
- Private investors
- Friends or family
- Stock market
- Self-funding
- Government
- Venture capitalists
Equity Financing vs. Debt Financing
Both equity and debt funds have benefits and drawbacks. Equity funding is better as the firm does not have to repay the debt, but the investors will have a share in the firm’s assets and earnings. The best part is that the firm may ensure the company costs more to get enough returns with equity funds.
With debt financing, the firm will repay debt with interest and have control over everyday operations. So lenders are not involved in business operations. In addition, the relationship ends once the firm repays the debt.
With equity funding, the person lending the money is the investor; with debt funding, the person financing is the lender.
Factors to Consider when Choosing Between Equity And Debt Financing
When choosing between equity and debt financing, there are some factors to consider, including:
Repayment Terms
Investors’ terms vary; most prefer a mix of equity and debt funding for new companies. Some repayment loan terms are complicated, though they may seem simple with a fixed rate.
For example, it may require you to pay the difference at different periods.
Here, you’ll need to compute the average interest rate and the value of the money.
Business Structure
Some businesses are partnerships, which may hinder the process of selling shares. In this case, it’ll involve long processes to declare your company as a public corporation. Understanding this in advance will ease the work.
Interest Rate Availability
Choosing between debt and equity funding will depend on the amount to pay to borrow. You’ll need to do thorough research between various investors to get a good competitive quote. With low-interest rate availability, the average cost of borrowing will be low.
Access To Equity Markets
When choosing equity funding, you must consider the probability of selling the equity to the public. Are investors ready for the equity and to compromise? It will vary depending on whether by equity or debt financing. It would be best to have a good strategy before making final decisions.
Businesses Need To Control
Unlike debt financing, where you have control of your business, with equity financing, you surrender partial ownership to the investor. In this case, it is wise before deciding which percentage to give out control. Mostly, business owners retain sixty to fifty per cent, while investors take forty to forty-nine per cent.
Borrowing Requirements
Another factor to consider is the borrowing requirements. Lenders require a balance sheet, income statement, debt-to-equity ratio, and business plan.
Pros and Cons of Equity Financing
While there are advantages of equity financing, it has its disadvantages. These include:
Pros of Equity Financing
- Equity financing provides a substantial influx of funds to fuel business growth and expansion.
- Investors shoulder a portion of the business risk, reducing the financial burden on the company.
- Equity investors often bring valuable industry knowledge and connections, aiding in strategic development.
- Unlike loans, equity financing doesn’t require regular repayments, easing cash flow constraints.
- Equity investors share in the company’s success, aligning their interests with the long-term goals of the business.
Cons of Equity Financing
- Issuing equity means relinquishing a portion of ownership and control over the business.
- Equity investors are entitled to a share of profits, reducing the earnings available to the founders.
- Publicly disclosing financial information is often necessary, compromising the company’s confidentiality.
- Differences in vision and strategy between founders and investors can lead to conflicts and disagreements.
Equity Financing FAQs
How Do You Calculate Equity Financing?
To calculate equity financing, you subtract the company’s total liabilities from total assets. The company has assets to cater to liabilities if equity is more optimistic.
If negative, the company does not have enough assets to cater for liabilities or exceed investments.
Is Equity Financing A Good Idea?
Yes, and No. Yes, if you use the funds to improve your business or consolidate debt with a low interest rate. No, if it is going to burden your business finances or if it is serving to shift debts around.
Which Is Better, Debt Or Equity Financing?
Debt financing is better than equity financing. With debt financing, nobody follow you once you clear your debt. Unlike equity financing, you involve the investor in all company activities, i.e., decision-making, profits, selling of shares, etc.
What Is The Difference Between Equity and Debt Financing?
The difference between equity and debt financing is that equity financing raises money by selling part of ownership to investors, retaining earnings, or selling stock.
Debt financing raises capital by borrowing and repaying with interest at a certain period.
The Bottom Line
So, what is equity financing? Equity financing is a method for businesses to raise money by offering ownership in the company in exchange for cash. This funding is from various sources, including angel investors, venture capitalists, friends, and family.
The advantage of equity financing is that it provides funding without incurring debt or interest payments, and investors can bring valuable expertise and networks to the business. The disadvantage is that it involves sharing ownership and decision-making power, which may lead to conflicts and loss of control over the company.
If you’re looking for equity financing for your business, it’s essential to research and finds the right source that fits your needs.