What Is Equity Financing, and How Does It Function in Practise?
Equity Financing – What Is It?
When a company uses equity financing to raise money, it sells stock in the company. For short-term financial needs or long-term goals, companies may need money to invest in growth and so raise capital. The sale of stock represents a company’s exchange of equity for cash.
An entrepreneur’s friends and family, private investors, or an initial public offering (IPO) can all provide equity capital (IPO). An initial public offering (IPO) is a procedure that private firms go through in order to sell stock to the general public. To raise money from the general public, a firm might issue public shares. Through initial public offerings (IPOs), industry heavyweights like Google and Meta (previously Facebook) raised billions of dollars.
Phrase “equity finance” relates to both public and private corporate funding, however the term is more commonly used for public corporations that are traded on an exchange.
An Explanation of How Equity Funding Works
It is possible to obtain equity financing through the sale of common stock, but it is more typical to obtain it through the sale of other equity or quasi-equity instruments such preferred stock, convertible preferred stock, equity units that incorporate common stock and warrants.
A startup that matures into a successful firm will go through numerous rounds of equity funding as it progresses through its stages of development. Due to the fact that a startup often draws different sorts of investors at different phases of its development, it may employ a variety of equity instruments to meet its funding requirements.
When it comes to investing new firms, angel investors and venture capitalists prefer convertible preferred shares rather than ordinary equity since the former offers greater upside potential as well as some downside protection, while the latter offers less protection from the former. The firm may contemplate selling common ownership to institutional and retail investors after it has expanded to the point where it can consider going public.
The firm may choose secondary equity financing methods, such as a rights issue or an offering of stock units that includes warrants as a sweetener, if it need extra funds in the later stages of its development.
Equity Financing vs. Debt Financing
When raising funds for commercial purposes, businesses normally have two financing alternatives to consider: equity financing and debt financing. Equity financing is the most common type of financing available to businesses. Stock financing is different from debt financing in that it entails selling a piece of the company’s equity to raise funds. Despite the fact that both equity and debt financing have different advantages, the majority of businesses employ a combination of the two methods of financing.
Among the several types of debt finance, the most prevalent is the loan. In contrast to equity financing, which imposes no payback requirement on the firm, debt financing compels the corporation to repay the money it has received, plus interest, over time. However, one advantage of a loan (and of debt financing in general) is that it does not require a firm to give up a piece of its ownership to shareholders, as is the case with equity financing.
With debt financing, the lender has no influence on the operations of the firm. You will no longer have any dealings with the financial institution once you have paid back the loan in full. (When businesses choose to raise money by selling equity shares to investors, they are required to share their earnings with these investors and consult with them whenever they make decisions that affect the entire business.)
As a result, debt financing can set constraints on a company’s activities, reducing its ability to utilise its resources to take advantage of possibilities that are outside of its primary business. A low debt-to-equity ratio is preferable for most businesses since creditors will view it positively and will allow them to acquire further debt funding if the need arises in the future. Lastly, the interest paid on loans may be deducted from a company’s taxable income, and loan payments make estimating future costs simple because the amount is consistent.
Considerations to Keep in Mind
When deciding whether to seek debt or equity financing, companies usually consider these three factors:
- What source of funding is most easily accessible for the company?
- What is the company’s cash flow?
- How important is it for principal owners to maintain complete control of the company?
Unless a corporation has handed away a part of its company to investors through the sale of equity, the only way to get rid of them (and their position in the business) is to buy them back, which is a procedure known as a buy-out. However, the cost of repurchasing the shares will almost certainly be more than the amount of money they first provided you.
What Are the Pros and Cons of Equity Financing?
Equity financing imposes no additional financial strain on a firm, and the owners are not obligated to repay the money borrowed through the financing. However, you are required to share your earnings with investors in the form of a percentage of your firm, and you are also required to consult investors whenever you make choices that will have an influence on your business.
Considerations That Should Be Taken Into Account
A local or national securities authority regulates the process of obtaining equity financing in the majority of jurisdictions across the world. A primary goal of this type of regulation is to safeguard the investing public from unscrupulous operators who may gather cash from unwary investors just to vanish with the monies raised.
Because of this, equity financing is frequently accompanied with an offering memorandum or prospectus that offers substantial information that should assist the investor in making an educated judgement about the benefits of the financing. Among the material contained in the memorandum or prospectus will be information about the company’s activities, information about its officers and directors, information about how the fundraising funds will be utilised, risk considerations, and financial statements.
The level of investor interest in equity financing is highly dependent on the status of the financial markets in general and the state of the stock markets in particular. While a consistent pace of equity financing is a positive indicator of investor confidence, a torrent of financing may signify undue optimism and the impending peak of the market.
Examples include the record-breaking number of initial public offerings (IPOs) by dot-coms and technology businesses in the late 1990s, prior to the “tech disaster” that consumed the Nasdaq from 2000 to 2002.
The rate of equity financing generally slows dramatically following a prolonged market downturn, owing to investor risk aversion during such moments of market turmoil.