If you need money to start a new business, you have several possibilities. You can finance the project yourself, borrow money from friends or family, or use equity financing from private investors all around the world.
However, when none of the other choices are available, equity financing can be a wonderful place to start. We’ve covered all you need to know about equity financing in this tutorial. Let’s get started without further ado!
What is Equity Financing?
The practise of obtaining funds through the sale of shares is known as equity financing. Companies raise funds because they may have a short-term requirement to pay bills or a long-term initiative that will enhance growth. A company that sells shares effectively sells ownership of its company in exchange for cash.
Equity financing can be obtained through a variety of sources. Friends and family of an entrepreneur, professional investors, or an initial public offering (IPO) may all provide essential funds.
An IPO is a process that private corporations go through to offer shares of their company to the public in the form of a new stock issuance. A firm can raise funds from public investors by issuing public shares.Industry titans like Google and Meta (previously Facebook) raised billions of dollars through initial public offerings.
While the phrase equity financing refers to the financing of publicly traded corporations, it also applies to private company financing.
How Equity Financing Works
The sale of common stock and other equity or quasi-equity instruments such as preferred stock, convertible preferred stock, and equity units that include common shares and warrants constitutes equity financing.
As a startup matures into a successful firm, it will go through numerous rounds of equity financing. Because a company often attracts different sorts of investors at different stages of its development, it may use additional equity instruments to meet its financing needs.
For example, angel investors and venture capitalists—who are typically the initial investors in a startup—prefer convertible preferred shares to common stock in exchange for funding new companies since the former have greater upside potential and some downside protection.
When a firm has grown large enough to consider going public, it may offer common stock to institutional and retail investors. If the company later needs more capital, it may pick secondary equity financing methods such as a rights offering or an equity unit offering with warrants as a sweetener.
With the proper investment, you’ll not only gain money but also knowledge and contacts to help your firm grow. Would you rather have 100% ownership of a £100,000 firm or 70% ownership of a £1 million company?
Types of Equity Financing
When a company is still private, angel investors, crowdfunding platforms, venture capital firms, or corporate investors can provide equity financing. Finally, shares can be sold to the general public via an IPO. The following are examples of common methods of equity financing:
#1. Angel investors
Angel investors are rich individuals who buy investments in businesses they feel will create bigger returns in the future. Individuals typically bring their business talents, expertise, and connections to the table, which benefits the organisation over time.
#2. Crowdfunding platforms
Crowdfunding systems enable the general public to invest in the company in small quantities. Members of the public opt to invest in companies because they trust in their ideas and want to recoup their investment with future rewards. The public contributions are added together to attain a desired total.
#3. Venture capital firms
Venture capital firms are a collection of investors who make investments in companies they believe will grow rapidly and eventually be listed on stock exchanges. When compared to angel investors, they invest more money and earn a larger ownership in the company. This strategy is also known as private equity financing.
#4. Corporate investors
Corporate investors are major corporations that invest in private enterprises to provide them with capital. Typically, the investment is made to build a strategic relationship between the two companies.
#5. Initial public offerings (IPOs)
Companies with a longer track record can raise funds through an initial public offering (IPO). The IPO allows businesses to raise funds by selling shares to the general public for trading on the capital markets.
When Should You Use Equity Financing?
Equity financing is not appropriate for every business, and it is always a good idea to examine all available funding choices. Here are a few circumstances where it could be useful:
#1. You’re a Startup
This is frequently the case with technology start-ups, which may have significant intellectual assets but limited tangible assets. Often, during the pre-revenue period, they must fund expenses like research and development. If you require a substantial sum of money only to get started, an equity investment may be your best or only alternative.
#2. The Established company you run needs more money to grow
Perhaps you want to grow your business, enter new markets, or diversify your product offerings. Making loan payments may limit your ability to flourish as quickly as you would desire.
#3. Established Lending Sources Ignore You
When traditional financing techniques are unavailable owing to the nature of the business, equity financing is a viable option. Traditional lenders, such as banks, will often refuse to lend to businesses that they deem excessively risky due to an owner’s lack of business experience or an unproven business plan.
#4. You Don’t Want to Incur Debt
You don’t add to your existing debt load with equity financing, and you don’t have a payment obligation. Investors accept the risk of loss on their investments.
#5. You Get Guidance From Experts
Equity financing provides more than just money. You may also receive and benefit from the important resources, knowledge, talents, and experience of investors who want you to succeed, depending on the source of the cash.
#6. You want to sell your business
When you put your company up for sale, it should be at a point of expansion. Raising equity capital could help you speed your company’s growth and make it as appealing to prospective purchasers as feasible.
Advantages of Equity Financing
When done correctly, equity financing can help your firm thrive in a variety of ways. Here are a few examples of how it might help your business grow:
#1. Alternative funding source
The primary benefit of equity financing is that it provides organisations with an alternative funding option to debt. Startups that cannot qualify for substantial bank loans can obtain funds to pay their costs from angel investors, venture capitalists, or crowdsourcing platforms. Because the company does not have to repay its shareholders, equity financing is considered less risky than debt financing in this situation.
Investors often look to the long term and do not expect a quick return on their investment. It enables the corporation to reinvest cash flow from operations rather than concentrate on debt repayment and interest.
#2. Access to business contacts, managerial expertise, and other financial sources
Company management benefits from equity financing as well. Some investors want to be involved in business operations and are personally driven to help a firm thrive.
Their successful experiences enable them to offer essential support in the form of business contacts, management skills, and access to alternative financing sources. Many angel investors and venture capitalists will help businesses in this way. It is critical throughout a company’s initial period.
Disadvantages of Equity Financing
It offers several benefits when used correctly, but it also has some drawbacks that must be addressed. They are as follows:
#1. Dilution of ownership and operational control
The biggest downside of equity financing is that business owners must give up some of their ownership and control. If the company becomes profitable and successful in the future, a portion of its profits must be distributed to shareholders in the form of dividends.
Many venture capitalists demand an equity stake of 30%-50%, especially for firms with limited financial resources. Many business owners and founders are loath to give up such a large portion of their corporate control, which limits their possibilities for equity financing.
#2. Lack of tax shields
In comparison to debt, equity investments provide no tax shelter. Dividends paid to shareholders are not deductible expenses, although interest payments are. It increases the cost of equity financing.
Long-term, equity financing is thought to be more expensive than debt financing. This is due to the fact that investors want a higher rate of return than lenders. When investors fund a company, they take a significant risk and so expect a higher return.
Example of Equity Financing
Assume you’ve created a tiny IT company with £1.5 million in your own money. You have complete ownership and control at this point. Your company attracts the interest of many investors, including angel investors and venture capitalists, due to the industry in which you operate and a novel social media concept.
You recognise that you will need additional capital to maintain your current rate of growth, so you decide to seek outside investment. You decide to take the £500,000 provided by an angel investor who you believe brings enough knowledge to the table in addition to the financing after meeting with a handful and discussing your company’s objectives, goals, and financial needs with each. This amount is sufficient for this round of fundraising. Furthermore, you do not want to give up a larger part of your company’s ownership by accepting a larger sum.
As a result, your total investment in your company has increased to £2 million (£1.5 million + £500,000). The angel investor owns 25% of the company (£500,000/£2 million), while you possess 75%.
How Does an Investor Make Money From an Equity Investment?
Equity investors profit from “capital gains” when they sell shares at a greater price than they paid for them, as well as dividends. Dividends are a portion of a company’s earnings that are given to its shareholders on a quarterly basis.
Dividends are not paid by every company. Some businesses, particularly fledgling ones, prefer to reinvest revenues in the expansion of their operations. Dividend-paying corporations are often larger, more established businesses.
There are various ways an investor can “exit” a business (sell their shares), including:
- Management buyout: investors sell shares to the investee company’s existing management team
- Trade sale: the investee company is sold to a trade buyer, typically another company operating in the same industry
- Secondary sale: investors sell shares to a third-party buyer, such as a venture capitalist or private equity firm
- Initial public offering (IPO): when a privately owned company lists its shares on the stock exchange
What Are the Different Types of Equity Financing?
Companies receive equity financing through two basic channels: private placements of stock with investors or venture capital firms and public stock offerings. Because it is more straightforward, private placement is more popular among young enterprises and startups.
Is Equity Financing Better Than Debt?
The most significant advantage of equity financing is that the money does not have to be repaid. The cost of equity, on the other hand, is frequently higher than the cost of debt.
Is a Bank Loan Equity Financing?
Debt financing is the process of obtaining a conventional loan from a traditional lender, such as a bank.Equity financing is obtaining capital in exchange for a percentage of the company’s ownership.
Is Equity Financing Better than Debt?
Because there is no loan to repay or collateral at stake, equity financing may be less risky than debt financing. Debt also necessitates monthly repayments, which can have a negative impact on your company’s cash flow and ability to grow.
Why Equity Financing is More Expensive?
In the long run, equity financing is regarded to be more expensive than debt financing. This is due to the fact that investors desire a higher rate of return than lenders. Investors take on a lot of risk when they back a business, therefore they want a larger return.
What is Another Name for Equity Financing?
Private equity finance is another name for venture capital. Venture capitalists (VCs) seek to invest larger sums of money in exchange for equity than BAs. Venture money is typically utilised for high-growth enterprises that want to sell or list on the stock market. See also: venture capital.
In conclusion
Companies frequently require outside funding to keep operations running and to invest in future growth.Any wise business strategy will take into account the most cost-effective debt and equity financing mix.
Equity financing can be obtained through a variety of sources. The primary advantage of equity financing, regardless of its source, is that it has no payback obligation and provides extra capital that a company can use to grow its operations.
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- What Is Capital In Business? All You Need To Know
- Internal Sources Of Finance
- Alternative Business Funding
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