What is equity financing?
The equity financing method involves selling shares in order to raise capital. Companies may raise funds to cover short-term bills or for long-term projects that will promote growth. A business can effectively sell its ownership in exchange for cash by selling shares.
Equity funding comes in many forms. For example, friends and family of an entrepreneur, professional investors, or an Initial Public Offering (IPO) can provide the needed capital.
A new stock issue is a procedure that private companies use to offer their shares to the public. A public share issue allows a business to raise capital by attracting investors. IPOs have raised billions for companies like Google and Meta (formerly Facebook).
The term equity financing describes the financing of private and public companies listed on a stock exchange.
Equity Financing: How it Works
Equity financing is the sale of equity instruments, such as common stock or other quasi-equity securities, like convertible preferred stock and equity units, which include common shares, warrants, and preferred stock.
How it works:
Imagine you are the only owner of a company. You own all the equity in your company. You own the entire equity.
You need money to expand your business (or to do something else that will drive it first).
You decide to sell 10% of your ownership to an investor in exchange for money (or to a group of potential investors, but more about that later).
You own 90% of a company and have the money in your bank account to achieve your business goals.
When you talk about equity, things become more complex.
The most common types of equity used for equity financing are:
Common shares are what you imagine when you buy stock on the stock exchange. Common stockholders can influence the operation of the business and certain rights if it goes out of business.
Preferred stock is similar to common stock but does not have voting rights. It also has more claims on assets and earnings.
Convertible preferred shares
Shares with the option of being converted into common shares at the option of holders.
Equity financing: Pros
Equity financing has many benefits for companies that want to raise capital.
Freedom from debt. Businesses can focus on their growth by choosing equity financing over a loan without worrying about monthly repayments and expensive interest charges.
Possibility to raise more capital
Equity financing is a better way to raise capital for companies than debt.
Experience, contacts, and business skills
Some investors add value to their investments by bringing in their expertise in business, skills, and contacts that they have built over a career.
Follow-up funding is possible.
Investors often prepare to provide more funding as the business grows.
Equity financing: Cons
Equity financing has disadvantages compared to other methods for raising money.
As an example:
Loss of control is a potential risk
Some business leaders are concerned that they will lose control of their company because investors now own a part.
Dividends must be split
Investors may split profits with companies, but this can be good if they add value to the company in terms of financial value or expertise.
The process is time-consuming
Raising funds can require several rounds of investments and be a lengthy process compared to borrowing money.
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Equity financing: Common sources
Equity funding can come in many forms, which may affect your deal’s structure.
Equity financing is most commonly sourced from:
Angel investors:
They are wealthy individuals who desire to invest in companies at an early stage—one company rather than investing on the stock exchange.
Venture capitalists (VCs):
They are companies that invest specifically in startups.
Initial Public Offering (IPO):
This is reserved for companies in a later stage of development who have already received several rounds of funding. An IPO takes your company to the public and releases several shares for public investment.
Friends and family:
This is a great option for founders with family and friends interested in investing. It’s similar to angel investment.
Equity Financing: Types
- Individual Investors
It is often the owner’s family, friends, and business partners. Investors need more money and contribute more to achieve their financing goals. They may need to gain the relevant business knowledge, industry experience, or guidance needed to help a company.
- Angel Investors
These are often wealthy individuals or groups who want to fund businesses that they think will offer attractive returns. Due to their experience, angel investors can invest large amounts of money and offer valuable insight, connections, and advice. Angel investors invest at the beginning of a company’s growth.
- Venture Capitalists
Venture capitalists can be individuals or companies capable of investing substantial amounts in businesses they believe have a high growth potential, competitive advantage, and solid prospects for success. They usually ask to own a significant portion of a company in exchange for their resources and connections.
To protect their investment, they might insist on significant involvement in a business’s planning, daily operations, and management. Venture capitalists usually get involved early in the process and exit when a company reaches its IPO, a stage where they can make huge profits.
- Initial Public Offerings
IPOs are a way for a more established business to raise money by selling company shares. This type of equity funding is only used at a later stage in the development of a company after it has grown. Investors who invest in IPOs are less likely to expect control from the company than angel and venture capitalists.
- Crowdfunding
Individual investors invest small amounts through online platforms (such as Kickstarter, Indiegogo, and Crowdfund) to help companies reach financial goals. A belief often unites these investors in the company’s mission and goals.
Bottom Line
Companies require external investment to invest in their future growth and maintain operations. Smart business strategies will consider the best balance between debt and equity finance.
It is possible to obtain equity financing from several sources. Equity financing, regardless of the source, has the advantage of carrying no repayment obligations and providing extra capital that can be used to expand.
