What is Equity Financing?
Equity financing is a process of raising capital by selling shares of the Company to the public, institutional investors, or financial institutions.
A Company, when in need of funds, can finance it using either debt and equity. Equity financing is usually a preferred mode as it does not require the Company to paybacks the investors in case the Company fails. The investors, in turn of their finances, get the ownership of the Company and voting rights proportionate to their investments.
Example of Equity Financing
A Company ABC was started by an Entrepreneur with an initial capital of $ 10,000. At the start of the Company, he owns 100% of the equity in the Company. After a few initial years of starting, he is seeking new funds for the growth of the Company. He sells 50% of the equity of the Company at a valuation of $ 100,000. A venture capitalist or an angel investor will receive 50% equity in the Company by investing $ 50,000 in the Company, and the stake of the entrepreneur will be reduced to 50% although he has invested only $ 10,000 in the Company at the beginning.
Thus, Equity financing and the amount of stake owned by each investor depends on the time and valuation of investments in the Company.
Types of Equity Financing
A Company can have different classes of shares; Equity financing does not only involve financing by common equity but through other mediums as well:
Different classes of shares are issued by the Companies, usually large enterprises:
- Class A shares: Investors get ownership, i.e. voting rights and dividend
- Class B shares: Investors get ownership (voting rights) but no dividend
- Preference shares: Investors receive a dividend (in some cases higher dividend or guaranteed dividend) but no ownership
- Differential voting rights shares: Investors get differential voting rights, i.e. 2 shares owned by the investor will get 1 vote, and to compensate for this differential voting right, they receive higher dividend than the common equity investors
Sources of Equity Financing
When a new business is started, the owner invests their own funds either through a sale of his personal assets like land and property or from cash assets. However, as the business grows and the need for financing increases, the funds are taken from external sources. Various investors at different stages of the Company’s growth investments in the Company, and are mentioned below:
Angel investors are typically the first investors apart from the business owner or founder. They are usually wealthy individuals and friends/family of the business owner. They provide financial backing at an early stage of the business at favorable terms and do not usually get involved in the management of the business. Angel investors generally take out their investments at higher returns once the Company seeks funds from venture capitalists.
Venture Capitalists or VCs are investors who invest in the Company after the business has been run successfully for some years and they feel there is a competitive advantage in the market. VCs are selective in their investments and look at various aspects of the business, management, and market before investing. They invest a huge amount and generally take board seats and active management responsibility. Their role is to increase the Company’s business aspects and finally list them on stock exchanges where they can be publicly traded.
Companies offer their shares to the general public through Initial Public Offerings or IPOs. IPOs act as an exit route for some founders and VCs and give a chance to public investors to invest in a growing and well-settled business. Shares are listed on stock exchanges and actively traded between the investors, which could be retail investors or institutional investors.
Crowdfunding is another route by which Companies can raise funds from a group of investors in small amounts. Each investor invests a small amount in the business through a crowdfunding campaign run by the Company. The investors are generally the group of angel investors who believe in the product and the founders of the Company and would like to fund for the initial set up of the business.
Advantages of Equity Financing
Equity financing has various advantages both to the founders and to the investors:
- The Company does not have enough cash, collateral, or resources to raised funds from debt financing; hence equity financing is a good source of funds for the entrepreneur as the investors would take the risk of the business along with the founders.
- Funds can be raised through IPOs once the business is settled and has a regular cash stream. Such funds can be used for future technological advancements. Equity financing helps the entrepreneurs and management of the Company to raise funds for diluted ownership and to take a business to better profitability and a higher scale.
- Investors get ownership of the Company. They get better returns than other investment vehicles either from increased share prices or dividends paid by the Company.
Disadvantages of Equity Financing
- Dilution of shares: Equity financing leads to dilution of the shareholding of the initial investors. As the funds are raised from new investors, the initial shareholders, founders lose a proportionate amount of shareholding in the Company.
- Loss of control: As new investors are added to the Company, the reduced shareholding of the founders may lead to a potential conflict of interest and leading to loss of control of their own Company. As investors may be involved in active management of the Company, that may raise conflict on the way of doing business.
- Time and effort: Potential investors spend a lot of time in due diligence of the Company before investing. They look for a business plan, sales and profit forecasting, market conditions and need to be sure whether their investment will be safe, secure, and profitable. Thus, it is time-consuming for the entrepreneurs who are out seeking the funds and also focussing on their business.
Equity financing is a mode of financing for the Company where it takes funds from the investors through the sale of shares. The Company can issue a different variety of shares to different investors. However, the investors do understand that the returns from such investments are not fixed as in debt financing, where the funds are borrowed for a stipulated time and at predefined interest rates.
This has been a guide to Equity Financing. Here we have discussed different types of Equity Financing and its sources with the help of examples. Also, we discussed the advantages and disadvantages of Equity Financing. You may also take a look at some of the useful articles here: