Equity financing is a method through which companies raise capital by selling their shares to investors. This set of investors can range from the public to institutional investors to financial institutions. Those investors who end up buying the shares become shareholders.
Companies may choose to opt for equity financing during the initial stages of operation. It allows a company to liquidate its shares and raise money. This sum of capital can be used to expand the business at a time when there is a dearth of funds.
Equity financing is one of the two methods through which companies raise money, the other method being debt financing. The shares are sold to these investors in the form of common stock, which means that the company must first be incorporated. Each share represents a unit of ownership in the company. Thus, when additional shares are issued, previously owned shares are diluted.
Often, new businesses that need capital to expand their business turn to equity financing instead of taking debt. Equity investors can be industrialists, venture capitalists or even family members and friends at times.
The process through which equity financing is done depends highly on the investors engaged in the process. The investors and owner can personalize the deal to fit their requirements better. When a big company opts for equity financing, the process is highly regulated, and the shares are offered on a public exchange. However, for small companies, the process may not be as formal and can be conducted by means of a contractual agreement.
The following methods allow businesses to raise capital through equity financing:
The process of an IPO involves following the necessary guidelines to issue the shares of a company publicly. Once approved, the business is given a listing date, post which the company becomes open to be traded. Before the listing date arrives, the business must contact potential investors and make them aware of the listing.
These firms obtain money through other investors who pool their money together to invest in start-up businesses that appear promising. In return for these funds, venture capitalists receive ownership of shares in the company and may also become a part of the board of directors in the company.
Unlike venture capitalists, angel investors use their personal funds to invest in a company. These investors may also help fresh businesses with the technical know-how of running a company as well as with marketing techniques and better opportunities to sell. In exchange for providing these funds, angel investors often ask for a share in the company.
Mezzanine financing gives borrowers a lower debt-to-equity ratio, and the capital given under this financing can give more value than that given by a traditional lender.
Equity financing is different from a loan as it does not leave the business with a liability on its balance sheets. Offering a part of ownership may seem like a better idea to many businesses than having to repay the amount given by investors.
This is also helpful for those business owners that do not have a credit history or have a poor track record in repaying loans. Equity financing removes the need to have strong creditworthiness to obtain funds.
Additionally, having investors as partners often adds value to a new business. Most investors are experienced with large sums of money at their disposal. This allows them to give business insights to these young professionals who are new to the game.
Sharing ownership means sharing a part of the business’ profit as well. Companies that allow investors to buy their shares also lose out on the profit that the business brings. Business owners must carefully consider what part of their profits they are willing to lose out on to obtain the funding.
Apart from profits, business owners also must compromise on the level of authority they have on the board. Often, investors asked to be included in the board of directors to make important decisions for the company, leading to a conflict of opinion at times.
Thus, businesses must rely on their own judgement apart from the expertise offered by outside investors. It may sometimes be a lengthy process as investors would often ask for detailed information regarding the business. Constant efforts would have to be made to ensure that the board and shareholders are content with the firm’s current situation.