Selling company shares to the general public, institutional investors, or financial institutions is a method of raising new capital known as equity finance. Since they have acquired an ownership stake in the company, the individuals who purchase shares are referred to as shareholders of the company. In many ways, debt financing is similar to equity financing. The borrower agrees to accept funds from a third party and makes a repayment commitment for the principal amount and interest.
Small business owners who are attempting to determine whether debt or equity financing is best for them should read this article.
Equity Finance
You can consider defining equity finance as selling a company’s stock in exchange for cash is a way for an organization to raise money to meet its liquidity needs. The stake percentage will vary according to how much of the business the promoter owns. A company must prepare a prospectus with information on its financials before seeking equity financing to satisfy its liquidity needs, diversify its business, or expand. The business must also outline its plans for using the funds raised.
When a business borrows money to meet its liquidity needs, this is known as debt financing. Equity financing is a little bit different. The ideal situation would be for an organization to be able to finance itself through both equity and debt financing. Any sale of equity instruments, such as common stock, preferred stock, share warrants, etc., is referred to as equity financing.
How Equity Financing Works
To raise money through equity financing, common stock as well as other equity or quasi-equity instruments like preferred stock, convertible preferred stock, and equity units that come with warrants and common shares must be sold. A startup that develops into a profitable business will go through several rounds of equity financing. Since startups frequently draw different types of investors at various stages of their development, they might use various equity instruments to meet their financing needs.
When a business is big enough to think about going public, it might think about selling common stock to both institutional and retail investors. In the future, if the business requires more funding, it may decide on secondary equity financing options like a rights offering or an offering of equity units with warrants as a bonus.
Major Sources of Equity Financing
#1. Angel Investors
Rich people known as “angel investors” invest in companies they feel have the potential to grow their profits in the future. The individuals typically contribute their connections, business knowledge, and experience, all of which benefit the business in the long run.
#2. Crowdfunding Platforms
A large number of members of the public can make small investments in the business through crowdfunding platforms. The general public chooses to invest in businesses because they support their concepts and anticipate receiving returns in the future. To reach the desired amount, public contributions are added together.
#3. Venture Capital Firms
Investing in companies that they believe will grow quickly and list on stock exchanges in the future is what venture capital firms do. In comparison to angel investors, they make larger financial commitments to businesses and acquire a larger ownership stake. The approach is additionally known as private equity financing.
#4. Corporate investors
Large corporations that invest in private businesses to give them the funding they need are known as corporate investors. Usually, the investment is made to forge a strategic alliance between the two companies.
#5. Initial Public Offerings (IPOs)
An initial public offering (IPO) is a method of financing for more established businesses. By making their shares available to the general public for trading on the capital markets, an IPO enables businesses to raise money.
#6. Government funds and schemes
Businesses can obtain equity financing from several different government funds. Typically, these funds aid in the launch of new small businesses.
Advantages of Equity Financing
#1. Alternative Funding Source
The main benefit of equity financing is that it gives businesses a different funding option from debt. Startups that might not be able to get large bank loans can get funding from angel investors, venture capitalists, or crowdfunding platforms to pay their bills. Because the business is not required to repay its shareholders, equity financing is seen as less risky than debt financing in this situation.
#2. Freedom from Debt
Businesses that choose equity financing can concentrate on growth rather than worrying about making regular payments or paying high-interest rates.
#3. Possibility of Greater Capital Raising
As a rule, companies can raise more money through equity financing than through debt.
#4. Access to Business Contacts, Management Expertise, and Other Sources of Capital
Additionally, equity financing offers the management of the company some benefits. Some investors are personally driven to support a company’s expansion because they want to be involved in business operations.
Their track records of success enable them to offer priceless support in the form of business connections, management know-how, and access to additional sources of funding. This is how a lot of venture capitalists or angel investors will help businesses.
Disadvantages of Equity Financing
#1. Dilution of Ownership and Operational Control
The main drawback of equity financing is that it requires business owners to forfeit some of their ownership and control. A certain portion of future company profits, if the business is profitable and successful, must also be distributed to shareholders as dividends.
#2. Time-Consuming Process
In comparison to applying for a loan, raising the necessary funds through equity finance may require several rounds of investment and take a lot of time for businesses.
#3. Lack of Tax Shields
Equity finance does not provide a tax break compared to debt. Dividends paid to shareholders are not tax-deductible expenses; however, tax advantages may apply to interest payments. As a result, equity financing becomes more expensive.
Long-term costs are thought to make equity financing more expensive than debt financing. The reason for this is that investors demand a higher rate of return than lenders. When funding a business, investors take a big risk, so they expect a bigger return.
What Types of Companies Use Equity Financing?
#1. Early-Stage Companies
Startup companies may find it more difficult to get bank loans than more established companies due to their lack of a proven track record in the financial world. Investments can help startups get off the ground and pay for costs like R&D at the pre-revenue stage.
#2. Established Companies With Plans for Growth
Companies that intend to grow significantly may need to raise a sizable amount of money to accomplish their objectives. This may occasionally require more funding than they could get from a loan. Equity financing would enable them to obtain the funds they require in this situation without having to make loan payments, which might impede their potential for rapid growth.
#3. Businesses Wanting to Buy Another Company
When one business buys another, it’s common for them to raise the necessary money from several different sources. This also holds when a company’s management completes a management buy-out, or MBO, in which the management retains control of the company after purchasing the owner. In both of these situations, equity financing could assist a business or management team in achieving its objectives.
Equity Finance Examples
Consider starting a small tech business with $1 million in your own money. You currently have complete ownership and control. Your business attracts the interest of different investors, including angel investors and venture capitalists, because of the sector you’re in and the novel social media concept.
Because you know you’ll need more money to maintain your business’s rapid growth, you decide to look for an outside investor. You choose to accept the $400,000 offered by an angel investor whose expertise you feel is sufficient in addition to the funding after meeting with a few and discussing your company’s plans, goals, and financial requirements with each. The sum is sufficient for this round of funding. Additionally, by accepting a larger sum, you wouldn’t want to forfeit a larger portion of your company’s ownership.
As a result, $1.4 million has been invested in your business overall ($1 million + $400,000). You hold a 72% ownership interest while the angel investor owns a 28% interest ($ 400,000/$1.4 million).
Equity Finance vs Debt Finance
When a company wants to raise money for operational expenses, equity financing, and debt financing are typically the two options available to them. Borrowing is a component of debt financing. Selling some of the company’s equity entails equity financing. Although both debt and equity financing have their advantages, the majority of businesses combine the two.
A loan is the most typical type of debt financing. When a company uses debt financing, it must repay the money it borrows plus interest, in contrast to equity financing, which carries no such obligation. A benefit of a loan, however, is that it spares a business from having to cede a portion of its ownership to shareholders.
Lenders do not have any influence over a business’ operations when using debt financing. Your contractual obligation to the lender expires once you have repaid the loan. Companies that choose to raise capital by issuing stock to investors must distribute their profits to these investors and involve them in decision-making that affects the entire company.
Debt financing may also impose limitations on a business’s operations, making it more difficult for it to seize chances outside of its primary industry. Companies generally prefer to have a low debt-to-equity ratio. Such a metric is more appealing to creditors, and if there is a future need for additional debt financing, they might agree.
What Does Equity Mean in Finance?
Equity is the sum of money that a business’s founder has invested owns. The amount of equity a company has is represented on its balance sheet by the difference between its liabilities and assets.
What Are the Four Types of Equity Financing?
- Angel Investors
- Crowdfunding
- IPO
- Venture Capitalist
What Is Equity in Simple Words?
Simple definitions of equity include justice and fairness.
What Are the Sources of Equity Financing?
- Enterprise Investment Scheme (EIS)
- Corporate Investors
- Angel Investors
- IPO
- Crowdfunding
- Venture Capitalists
What Are the Three Types of Equity?
- Common Stock
- Preferred Shares
- Warrants
Conclusion
Companies can raise money by selling shares of their company through equity financing. It is a typical method of financing when businesses require capital quickly. In essence, when a company sells shares for cash, it is selling ownership in the business. For newer or smaller businesses, equity financing is a reliable source of funding.
In exchange for their investment in the business, investors will receive equity. Nevertheless, any business owner seeking to raise money through equity financing should be aware of the risks involved in ceding control of your company. A lot of businesses mix equity financing and debt financing. So make research and decide on the best possible option.
Equity Financing FAQs
What are the Advantages of Equity Financing?
- It provides an alternative source of funds
- There is freedom from debt
- It increases the chance of getting a larger amount of capital
What Are the Four Types of Equity Financing?
- Angel investors
- Crowdfunding
- IPO
- Venture capitalist
What Are the Three Types of Equity?
- Common Stock
- Preferred Shares
- Warrants
Related Articles
- Angel Investment Network: 2023 Company Reviews
- How To Find Angel Investors For Your Small Business
- SMALL BUSINESS INVESTORS: How To Find One
- EQUITY FINANCING: Types, Sources, Advantages & Disadvantages
- WHAT IS AN EQUITY: Meaning, & All You Should Know
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