If you can’t self-fund your firm or wish to grow faster, you’ll need to seek outside capital. Equity financing is a frequent method for firms to obtain the funds they require.
Continue reading to discover more about equity financing how it works, the sources and types, and whether it is a viable funding choice for your company as compared to debt financing.
What is Equity Financing?
Equity financing is the sale of company shares in order to raise capital. When investors buy shares, they are also buying ownership rights in the company. Equity financing can refer to the sale of an equity instrument, including common stock, preferred stock, share warrants, and so on.
To finance plant assets and initial operational expenses, equity financing is especially critical during a company’s launch stage. Investors profit when their shares increase in value or when they receive dividends.
Types and Major Sources of Equity Financing
When a company is still private, angel investors, crowdfunding platforms, venture capital firms, or corporate investors can be the sources of equity financing. Also, a firm may sell shares to the general public in the form of an initial public offering (IPO).
Here are seven different types or sources of equity financing for new or developing businesses.
#1. Initial Public Offering (IPO)
An initial public offering (IPO) occurs when a firm decides to “go public” and sells its first shares on a publicly-traded market such as the New York Stock Exchange. The move from a privately held corporation to a publicly-traded company is referred to as “going public.”
This sort of funding necessitates constructing the offering in accordance with the Securities and Exchange Commission’s criteria (SEC).
The IPO must be registered and approved by the SEC. If they grant the application, the SEC assigns a listing date to the company. The listing date is the day on which the shares will be accessible for trading on the market.
Once this is completed (or even before), the firm must begin trying to ensure that investors are aware of, and interested in, the shares. They perform this by releasing a prospectus and launching an investor-attraction campaign.
Going public is often reserved for small, regional, or national firms.
#2. Small Business Investment Companies
Small Business Investment Companies (SBIC) is a program licensed and regulated by the Small Business Administration (SBA). It provides venture capital financing to small enterprises. Venture capital firms pool the funds of investors in order to invest in start-up, potentially high-risk businesses. Wealthy individuals, private pension funds, investment firms, and others may be among these investors.
Because a venture capital firm may have any number of firms and projects competing for money at any given time, venture capital equity financing is one of the competitive types of funding.
The underwriting standards are less strict than those for an initial public offering (IPO). This makes it an appealing possibility for smaller businesses that do not require a lengthy IPO procedure.
#3. Equity Financing from Angel Investors
Angel investors are wealthy individuals who invest large sums of money in enterprises. They are wealthy individuals or groups who seek a high return on their investments. They are picky about the firms in which they invest.
Some angel investor clubs actively seek out early-stage companies to invest in, as well as providing technical and operational expertise to fledgling ventures. Following the original start-up capital, these angel investors may contribute the second round of funding for expanding enterprises.
Angel investors become owners of a tiny business. They get a piece of the action in exchange for not only their money but also their skills in assisting a small firm to get off the ground or thrive.
#4. Mezzanine Funding
Mezzanine financing is a type of financing that combines loans and equity. It’s so named because it is typically sought after by medium-sized firms. The funding is intermediate in risk, falling between lower-risk loans and higher-risk equity financing. The lender issues a loan, and if all goes well, the company repays the loan on agreed-upon conditions.
The lender might impose terms for supporting the company, such as financial performance requirements, with mezzanine capital. A high operating cash flow ratio (capacity to pay off existing debts) or a high shareholder equity ratio are two examples of phrases (value for shareholders after debts are paid).
One advantage for borrowers is that mezzanine financing can provide greater value than a regular lender would be willing to offer. Another advantage is that because mezzanine financing is a combination of equity and debt, accountants consider it to be equity on the balance sheet. It can bridge the gap between when a company no longer qualifies for start-up debt financing and when venture capitalists want to fund a firm.
This results in debtors having a reduced debt-to-equity ratio. So, this might attract investors because a low debt-to-equity ratio normally indicates less risk.
#5. Venture Capital
Venture capital firms provide funding in exchange for a stake in your company, or shares. When venture capitalists invest in a start-up small business, they expect a high rate of return. They typically have a large number of rival enterprises from which to pick.
Unlike angel investors, venture capital firms do not invest in enterprises with their own money. These firms are made up of a collection of professional investors that pool their funds to invest in start-ups or expanding businesses. Venture capital firms may potentially be interested in joining your board of directors.
Some venture investors consider a board member to be a kind of investment management. Many venture capital organizations have shifted to a mentorship model to help with investment growth.
When looking for venture capitalists, search for companies that are interested in your company’s line of industry and want to see it succeed.
#6. Financing Through Royalties
Royalty finance, often known as revenue-based financing, is one of the types of equity investment in a product’s future sales. Royalty financing differs from angel and ventures capitalist funding in that you must be making sales before approval.
As a result of the agreements reached with the lender, investors can expect to begin receiving payments immediately. Royalty financiers provide upfront funding for business expenses in exchange for a share of the product’s earnings.
#7. Equity Crowdfunding
In contrast to using a platform to pre-sell your product to the crowd, equity crowdfunding involves selling shares of your firm to the crowd. The proprietors of a privately owned business raise funds by selling a portion of their ownership interest, or equity, to crowd investors.
There are fewer than half as many publicly traded corporations as there were in the 1990s. Companies can remain private while raising capital from the public through equity crowdfunding.
Advantages of Equity Financing
#1. A different source of funding
The primary benefit of equity financing is that it provides organizations with an alternate funding option to debt. Startups that can not qualify for substantial bank loans can obtain funds to pay their costs from angel investors, venture capitalists, or crowdsourcing platforms. Because the company does not have to repay its shareholders, equity financing is considered less risky than debt financing in this scenario.
Investors often look to the long term and do not expect a quick return on their investment. It enables the company to reinvest the cash flow generated by its activities in order to grow the business rather than focusing on debt repayment and interest payments.
#2. Gaining access to business contacts, managerial knowledge, and other capital sources
Company management benefits from equity funding as well. Some investors want to be involved in business operations and are personally driven to help a firm thrive.
Their successful experiences enable them to offer essential support in the form of business contacts, management skills, and access to alternative financing sources. Many angel investors and venture capitalists will help businesses in this way. It is critical throughout a company’s initial era.
Disadvantages of Equity Financing
#1. Ownership and operational control dilution
The biggest downside of equity financing is that business owners must give up some of their ownership and control. If the company becomes profitable and successful in the future, a portion of its profits must be distributed to shareholders in the form of dividends.
Many venture funders demand a 30 percent to 50 percent equity stake in a firm. This is especially if the startup lacks a strong financial basis. Many business owners and founders are loath to give up such a large portion of their corporate control. So, this limits their possibilities for equity funding.
#2. Absence of tax shelters
In comparison to debt, equity investments provide no tax shelter. Dividends paid to shareholders are not deductible expenses, although interest payments are. It increases the cost of equity borrowing.
Long term, equity financing is thought to be a more expensive source of financing than debt. This is due to the fact that investors want a larger rate of return than lenders. When investors fund a company, they take a significant risk and so expect a higher return.
What Is the Difference Between Equity and Debt Financing?
Because they are the two most prevalent ways to generate capital for a firm, equity, and debt financing are frequently compared. While equity financing involves the exchange of shares in exchange for upfront capital, debt financing involves the agreement to pay future interest on the initial capital (aka debt). At their core, these two financing alternatives achieve the same result. So, the lender or investor assumes the upfront risk by providing you with capital that you do not have, and you repay that risk when your firm profits. The repayment, on the other hand, is where equity financing and debt financing diverge dramatically.
With debt financing, regardless matter how well your firm does, you must repay the lender’s money plus interest. Lenders frequently want collateral, such as real estate or a vehicle, to ensure that if you default on the loan, they may still retrieve their money. In other words, there is no way to avoid repaying a loan. This might negatively impact your cash flow for years.
Equity financing does not necessitate incurring debt or making monthly loan payments to repay a lender, which is a significant selling feature for most new small business owners. However, if your business succeeds, you would owe an investor a lot more money if you wish to buy them out and reclaim ownership of your company.
Examples of Equity Financing
Consider this: you need $50,000 to place a large buy order and begin ramping up production. If you took out a company loan with a 10% interest rate and paid it off over three years, you could expect to spend around $8,000 in interest. Consider the following scenario: your company is worth $1 million, and an investor offers you $50,000 in exchange for a 5% interest. If your company grew to be worth $5 million three years later, you would owe that investor $250,000 to buy out their shares. Debt financing is a far better offer from a purely financial standpoint.
However, there is one more distinct advantage to equity financing: your investor becomes a stakeholder in your firm and can frequently add additional value in the form of counsel. So, this can help your business grow far quicker than it could have without the assistance of an experienced investor.
While both equity and debt financing have advantages, your choice may be influenced by the available possibilities. Debt financing is frequently unavailable to small enterprises because they lack a good credit score and a track record of fulfilling expenses. At the end of the day, both equity and debt financing may assist in taking your business to the next level- as long as you make selections that are mindful of your future business, you can be confident that you made the proper choice.
FAQs on Equity Financing
How Does Equity Financing Work?
Equity finance is selling a piece of a company’s equity in exchange for funds. A company that sells shares basically sells ownership in their company in exchange for cash.
What Are the Various Types of Equity Financing?
Companies receive different types of equity financing in two sources: through private placements of stock with investors or venture capital firms, and through public stock offerings. Because it is easier, private placement is more popular among young enterprises and startups.
Is Equity Financing Preferable to Debt financing?
The most significant advantage of equity financing is that the money does not have to be repaid. However, there are several disadvantages to using equity funding.
When investors buy stock, it is assumed that they will possess a minor interest in the company in the future. A company’s profits must be consistent in order for it to maintain a healthy stock valuation and pay dividends to its shareholders. Because stock financing entails more risk for the investor than debt financing entails for the lender, the cost of equity is frequently higher than the cost of debt.
Conclusion
Companies often require financing from outside sources in form of equity to keep their operations running and to invest in future growth. Any wise business strategy would take into account the most cost-effective mix of debt and equity funding. Equity funding can come from a variety of sources and are of different types. The main advantage of equity financing, regardless of the sources, is that it has no payback obligation and provides extra capital that a company can utilize to grow its activities.
