What Is Equity Financing?

What Is Equity Financing?

Equity financing is the process of raising capital through the sale of shares. Both private and public companies raise money for short-term needs to pay bills or long-term projects by selling ownership of their company in return for cash. Equity financing can come from friends and family, professional investors, or an initial public offering (IPO).

Selling Shares

Equity financing involves the sale of equity instruments such as preferred stock, convertible preferred stock, and equity units that include common shares and warrants. This action can affect existing shareholders and impact the ability to reach new shareholders.

A startup that grows into a successful company will have several rounds of equity financing as it evolves. Angel investors and venture capitalists are commonly the first to fund a startup and favor convertible preferred shares rather than common stock in exchange for funding new companies.

Once a company has grown large enough to consider going public, it may consider selling common stock to institutional and retail investors. If the company needs additional capital, it may choose secondary equity financing options, such as a rights offering or an offering of equity units that includes warrants.

Types of Investors

• Individual Investors: Friends, family members, and colleagues of business owners with little to no relevant industry experience.
• Angel Investors: Wealthy individuals or groups interested in funding businesses they believe will provide attractive returns. Angel investors can invest substantial amounts and provide insight, connections, and advice. Typically, angels invest in the early stage of a business's development.
• Venture Capitalists: Individuals or firms who make substantial investments in businesses that they view as having very high and rapid growth potential, competitive advantages, and solid prospects for success. They usually demand a noteworthy share of ownership in a business for their financial investment, resources, and connections. Venture capitalists may insist on managing a company's planning, operations, and daily activities to protect their investment.
• Initial Public Offering: A business can raise funds through IPOs, selling company stock shares to the public. Due to the expense, time, and effort that IPOs require, this type of equity financing occurs in a later stage of development after the company has grown. Investors in IPOs expect less control than venture capitalists and angel investors.
• Crowdfunding: Individual investors invest small amounts via an online platform like Kickstarter to help a company reach particular financial goals. Such investors often share a common belief in the company's mission and goals.

Equity Financing vs. Debt Financing

Debt financing involves borrowing money. Equity financing involves selling a portion of equity in the company. Most companies use a combination of equity and debt financing. The most common form of debt financing is a loan. Unlike equity financing, which carries no repayment obligation, debt financing requires a company to pay back the money it receives, plus interest.

With debt financing, the lender cannot control the business's operations. When the loan is repaid, the relationship with the lender ends. Companies that elect to raise capital by selling stock to investors must share their profits and consult with investors when they make decisions that impact the company.

Debt financing can restrict a company's operations. In general, companies want a relatively low debt-to-equity ratio. Creditors look more favorably on such a metric and may allow additional debt financing in the future. Interest paid on loans is tax deductible as a business expense. Loan payments make forecasting future expenses easy because the amount does not fluctuate.

Advantages and Disadvantages of Equity Financing

Equity financing is a solution when established financing methods aren't available due to the nature of the business. Traditional lenders may not extend loans to companies they consider too new or risky. New businesses interest angel investors and venture capitalists especially if the companies provide a growth potential.

With equity financing, companies avoid adding debt and don't have a payment obligation. Companies may also receive valuable resources, guidance, skills, and experience from investors. Equity financing can raise substantial capital to promote rapid and greater growth, making the company attractive to potential buyers.

Investors assume risk when providing equity financing so the profits for business owners are reduced. Moreover, investors may want to be consulted whenever the company makes changes. In exchange for the large amounts that angel investors and venture capitalists invest, business owners forfeit a percentage of ownership and control.

Example

An individual starts a small tech company with a personal capital of $1.5 million, owning 100% of the company. The company attracts the interest of various investors, including angel investors and venture capitalists. After discussing the company's plans, goals, and financial needs, the owner accepts the $500,000 from an angel investor. The total invested in the company is now $2 million ($1.5 million + $500,000). The angel investor owns a 25% stake ($500,000/$2 million), and the owner maintains a 75% stake.

The Bottom Line

Companies often require outside investment to maintain their operations and invest in future growth. Any business strategy will include a consideration of the balance of debt and equity financing that is the most cost-effective. The greatest advantage of equity financing is that it carries no repayment obligation and provides extra capital that a company can use to expand its operations.