Equity financing definition, examples, pros and cons

Equity finance definition

Equity financing can be defined as a type of financial transaction in which a business raises money by selling shares in the company to investors, rather than borrowing money through debt financing or inviting investment from other companies (mergers/acquisitions). Equity financing is frequently referred to as ‘going public‘ or equity funding.

When companies cannot find another way to finance their business or project they might consider using equity financing as a way to raise money by asking shareholders for help.  In this kind of financing, the owners of the company often sell shares and receive money, and become shareholders. The risk is low because they can always revert back if things don’t go well and there is little chance they will lose control over the business but they do leave more open to risk than with debt financing.

3 Examples of Equity Financing

This is a very basic look at some examples of equity financing and the most common forms it takes. Equity financing whether in its earliest form or one of its latest forms is utilized by public and private companies alike in order to get the money they need for whatever their venture may be no matter how big or small. Here are some examples of equity financing:

1. Example of Initial Public Offering (IPO)

An example of equity financing is an initial public offering, known more commonly as IPO. An IPO occurs when a company offers shares of the company to the general public for sale on the stock market. The shareholders get their money back and also get their desired percentage share in proportion to how many shares they own. For example, if you owned 1% of all the 100,000 shares issued by a company that did an $88 million dollar IPO then you would be part owner of that company and entitled to 1% of its profits or losses. You would also receive $880 dollars if you decided to sell your shares immediately following the IPO because this is what one percent of eighty-eight million would make.

2. Example of Venture Capital Financing

Another form of equity financing is venture capital financing. Venture capital funds are groups of investors who pool their money together in order to take on very risky investment opportunities with the hope that one or two out of all the companies they fund will become extremely profitable and pay back all the initial investments plus a lot more. Thus, venture capitalists want to invest in high-risk/high gain startups because there are far fewer loss expectations than if they were investing in already established businesses. For example, when Google was just starting out, it got its early money from the VC firms – Sequoia Capital and Kleiner Perkins Caufield & Byers. Today these firms own over ten percent of Google’s outstanding stock.

3. Example of Venture Debt or Mezzanine Financing

Another form of equity financing is venture debt or mezzanine financing. Mezzanine financings are riskier than initial public offerings and venture capital because they offer a higher return on investment to the investor but also come with more risk as well. Venture debt and mezzanine financing happen when a private company takes on debt before an IPO (or sale) as a way to finance their growth as they prepare for that larger offering. For example, if Company A had $100 million in revenue, it might take on some project-specific mezzanine debt from investors before going public so its existing shareholders could maintain control.

How equity finance works

An equity financing can be used when the company has made significant milestones and needs further capital for continued growth. Raising money through equity financing means that only previously existing shareholders are diluted, while new shareholders buy newly issued stock. The amount raised through an equity offering is often less than what could be obtained through bank finance; however, the use of bank loans often leads to significant additional administrative costs. An equity financing may either be done by seasoned issuers (issuing securities) or by selling securities in an offering made to a wider range of investors. With seasoned issuers, the underwriters are often subject-matter experts with significant financial expertise and relationships with larger institutions; this is especially important when the issuer is unable to offer significant discounts on its securities because its stock valuation has already been significantly reduced by existing shareholders.

The biggest disadvantage of equity financing: If the business goes bankrupt or makes less profit than expected, all shareholders will lose money (shareholders’ value decreases). If the business performs very well and needs more capital for future growth, it can finance its expansion plans through equity markets.

2 major types of equity financing

1. Private placement
2. Public stock offering

Private placement

A private placement is the sale of securities directly to a small number of sophisticated investors, usually high net worth individuals or institutional investors.  These investors are often subject to less stringent regulations than publicly traded companies.

Public stock offering

Public stock offering: this is the sale of company shares that are offered for purchase to the public at large, either through a traditional initial public offering (IPO) on an exchange such as NASDAQ or NYSE or in the form of an at-the-market offering. Stockholders receive their shares after the IPO while buyers acquire their shares immediately in the at-the-market offering.

Sources of equity financing

1. Venture capital
2. Angel investors
3. Bootstrapping
4. Shareholder loans
5. Sale of securities by crowdfunding participants
6. Sale of securities by a company to its employees
7. Sale of securities by other equity participants
8. Initial Public Offerings (IPOs)
9. Crowdfunding
10. Software licensing

Venture capital source of equity finance

Venture capital is a type of private equity capital that is provided by investors in exchange for securities such as preferred stock or common stock. The preeminent form of venture capital is that provided by institutional investors known as venture capitalists, who are often professionals with significant expertise in the venture finance industry. During their search for new ventures, they investigate the prospects of young companies and decide whether to risk capital on them. Venture capitalists are more likely to invest in risky start-up projects rather than established companies with proven revenue growth records. However, they will only provide financing when they see potential payoff if an investment succeeds. Not all investments turn out to be successful.

Angel investors

Angel investors are high net worth individuals who invest in small, private companies that do not have access to equity markets by using professional venture capital or bank financing. Angel investors usually provide seed funding to startups rather than late-stage financing because they are most likely accustomed to playing the role of being hands-on managers and mentors instead of passive financial backers. The main reason why startup companies approach angel investors for early-stage financing is that it is easier for them to obtain compared to other forms of venture capital and only angel investors will consider putting money into new or young businesses with high-risk potential but potentially high rewards. It has been shown that very few angel-backed startups fail; however, there is no guarantee an investor will see a return on his investments.

Bootstrapping

Bootstrapping is the practice of funding a business by relying on internal cash flow generated either from sales of finished goods or services or through financing activities such as credit sales and bank loans. Bootstrapping allows startups to maintain control over all aspects of company policy and decision making without having to register securities with the Securities Exchange Commission which requires disclosure of financial conditions. This form of equity financing is probably the most difficult to execute because of the limited access to capital markets available for smaller companies with no track record. If capital markets are accessible it is better to use them instead of bootstrapping because, after registration, they are subject to more regulation about their operations which will impose higher costs and lower returns. Even though there will be lower risks than other forms of equity financing, it is still not risk-free because business owners often spend their personal assets to keep the company afloat until profits are generated or capital markets are secured.

Shareholder loans

Shareholder loans are used to avoid liabilities of issuing out new debt securities by having shareholders lend money to their own companies instead of borrowing through outside lenders. Shareholder loans are usually paid back on an amortized basis using either cash or noncash methods which include additional shares or concessions granted by the company to the shareholder who made the loan. This form of financing comes with high costs since interest charges will be assessed against it but at least companies do not have to issue out new securities and incur costly legal and accounting expenses. Shareholder loans are restrictive because they limit the way new equity can be raised by preventing any new securities from being issued without shareholder approval.

Sale of securities by crowdfunding participants

In recent years, crowdfunded projects have been gaining popularity because they offer investors an early opportunity to purchase new products or services before they are commercially available in order to obtain rewards such as additional features, exclusive access, discounts on future purchases, etc. In cases where a significant portion of equity financing is required to start a new company, the sale of securities by crowdfunding participants model can be used. In this form of equity financing, an individual or group that needs funding for their project will offer securities in the form of equity shares, convertible debt, or other related financial rights through a crowdfunding platform to potential investors who finance the company’s operations in exchange for consideration such as products from the company or discounts on future purchases.

Sale of securities by a company to its employees

Many startup companies rely on equity financing from corporate employees who have been early adopters and have high levels of trust in management because they see value in what the business is trying to achieve. This often happens when a worker takes compensation paid in cash and uses it to buy company shares they believe will be more valuable in the future. It is reported that equity financing of this type can be an efficient way for companies to sidestep demanding angel investors or venture capital firms so long as they are willing to share ownership with their employees which makes it a very attractive option when raising money because the people who work for you want your business to succeed so they won’t ask hard questions about how their investment is being used.

Sale of securities by other equity participants

Equity financing participants include early-stage investors, accredited individuals, and government agencies that provide seed funding specifically designed for startup businesses through various financial instruments such as convertible debt, preferred stock options, etc. Like any other form of equity financing, this method is attractive because it lowers capital requirements and offers a level of transparency not found with traditional forms of financing. On the other hand, crowdfunding platforms often have their own rules about who can contribute or how much money individuals can invest so being aware of these restrictions will help companies avoid any potential problems once they have acquired their new capital.

Initial Public Offerings

Initial Public Offering (IPO) is another form of equity financing in which the company’s shares are traded publicly. The IPO is either the first sale of stock by the company to investors or is done concurrently with other financing methods to generate cash for the company.

The IPO is used when a private company has matured and needs capital for further growth. It offers opportunities to both companies and the public as companies raise equity finance, which can be used to sustain its business development while offering liquidity options to existing shareholders by selling part of their stake in exchange for cash through an issue of fresh shares.

Crowdfunding

Equity crowdfunding allows small businesses to raise investments from many people with a minimum amount of administrative work. An online portal brings together potential investors with companies looking for funding; it simplifies communication between the two parties and reduces costs for both sides by offering efficient access into previously illiquid markets (such as angel investing). Many countries around the world are starting to develop their own equity crowdfunding regulations and portals.

Crowdfunding is the way of the future. With more and more businesses losing their investments or being denied loans, entrepreneurs are turning to their customers for help in getting their products started. This involves offering part of the business to potential investors, who can often receive a return on their investment if the business succeeds.

This trend has become increasingly popular over recent years with more businesses trying to gain investments through crowdfunding sites such as Kickstarter or Indiegogo. However, these websites are not suitable for every type of business looking for funding. To ensure your company gets off on the right foot it’s important that you choose an equity financing platform carefully.

Software Licensing

For software developers, one of the most popular forms of equity financing is to license their products to corporate users. This form of financing has been growing more popular since technologies such as broadband have made rich media-based content very accessible to consumers everywhere. Licensing provides an easy way for companies to distribute their assets in exchange for upfront payment but it is important to remember that licensing does not require any initial capital investment on the part of an individual or company who wants access to a particular technology or service so there are no real long term rewards. Also, companies who have been successful in using licensing as a source of equity financing must constantly be mindful about how their intellectual property is being used and compensate themselves accordingly to avoid any potential conflicts or controversy that could negatively affect the company’s relationship with consumers and partners in the future.

Pros and cons of equity financing

Advantages of equity financing

• One of the advantages of equity financing is that it allows for capital growth within the organization by allowing it to invest in itself.
• Since investors are involved in the business, they can provide advice and expertise to help it grow.
• Another benefit of equity financing is that it has a lower cost than debt financing because it does not require interest payments, and there is no requirement for collateral. This means that equity funding can provide funds without restricting the cash flow of the company.
• Additionally, since it does not have fixed repayment dates or rates, it provides flexibility within the company’s financial structure.
• One of the pros of equity financing is that it can increase the company’s value by allowing it to raise funds without incurring debt, which results in lower financial risk for investors . This is especially true if the company can grow its profits over time, sustaining any additional costs associated with the investment.

Disadvantages of equity financing

• One of the disadvantages of equity financing is that the the firm’s share quantity may not be sufficient to meet investor demand.
• Another con of equity financing is that investors need to be compensated for their investments, and this could result in lower profits for the business.
• Investment in equity funding will affect employees’ trust in management and employees’ ownership in general.
• It is not risk-free. If the businesses fails, the shareholders have nothing, they all lose their money.
• Ownership in the business is diluted when other investors are involved.

Equity financing vs Debt financing

Though equity financing and debt financing are two common types of financing in business; as with all business decisions, using debt or equity financing involves balancing the risks and potential rewards of each option. It pays to carefully consider all available options before making the decision that is best for your business. Below are the differences between debt and equity financing.

Debt vs equity financing differences

1. While equity is like a stock market in which both investors and entrepreneurs make investments in exchange for money and ownership in the company, debt is like paying back loans with interest in order to get access to borrowed money.
2. Debt financing requires less money up front than equity financing, but it also has the highest associated interest costs. For example, if you borrow $1 million at 10% interest, you’ll need to pay $100,000 in annual interest on top of the $1 million of principal (the original loan amount).
3. On the other hand, because equity investors are investing their own money in exchange for ownership they have an incentive to help your company succeed so that the value of their investment will increase over time.
4. Equity investors are willing to accept a lower return on their investment when compared with debt lenders because they know that there is more risk involved–their money is being put into something where they don’t have any rights to control how it is spent.

FAQs on Equity Financing