What is Equity Financing?
Equity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. One of the advantages of this type of financing is that the money that has been raised from the market does not have to be repaid, unlike debt financing, which has a definite repayment schedule.
The scale and scope of equity financing cover a wide spectrum of activities, from raising a few hundred dollars from friends and relatives to Initial Public Offerings (IPOs), which run into billions of dollars raised by giant corporations and subscribed by a large number of investors.
Table of contents
- Equity financing refers to the sale of an ownership interest process to various investors for raising funds for business goals. It saves a lot on interest expenses than debt financing.
- The advantage is that the money raised from the market does not have to be repaid, unlike debt financing, which has a definite repayment schedule.
- The equity financing sources include Angel Investors, Venture Capitalists, Crowdfunding, and Initial Public Offerings.
- The scale and scope of this type of financing cover a broad spectrum of activities, from raising a few hundred dollars from friends and relatives to Initial Public Offerings (IPOs). It runs into billions of dollars raised by giant corporations and subscribed by many investors.
How Does Equity Financing Work?
Equity financing can come from any source, be it a friend or an entity. There are investors who are ready to spend on budding firms in the form of investments. However, to qualify for this financing, one must ensure meeting the expectations of the interested investors. If a business unit proves its worth, it is likely to receive positive responses from investors.
In the process, the companies make available their shares to people who are interested in investing in the companies. The IPOs become the best way to invite investments from individuals and entities. They buy shares of the companies that appear fruitful to them. As the company grows and progresses, and performs well, making profits, the investors are open to receiving returns in proportion to the investment they made in the company.
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The types of equity financing are derived from the sources these financings are obtained from. Exploring these sources makes the equity financing meaning even clearer:
#1 – Angel Investors
This type of equity financing includes investors, usually family members or close friends of the business owners. Even wealthy individuals or groups who extend financial funding for businesses are also known as angel investors Angel InvestorsAngel investors refer to wealthy investors who supply capital to budding businesses in return for a portion of their equity. .
- The amount invested by such investors is usually less than $0.5 million.
- An angel investor will not get involved in the day-to-day management of the business.
#2 – Venture Capitalists
This type of financing includes professional and seasoned investors and extends funding to handpicked businesses. Such investors analyze the concerned industry based on strict benchmarks. Consequently, they are very selective about investing only in well-managed companies with a strong competitive advantageCompetitive AdvantageCompetitive advantage refers to an advantage availed by a company that has remained successful in outdoing its competitors belonging to the same industry by designing and implementing effective strategies that allow the same in offering quality goods or services, quoting reasonable prices to its customers, maximizing the wealth of its stakeholders and so on and as a result of which the company can make more profits, build a positive brand reputation, make more sales, maximize return on assets, etc. in their particular industry.
- Venture capitalists believe in actively managing the companies they stay invested in. It helps them maintain a strong watch on the business’s day-to-day activities and implement measures to maximize the return on their investment.
- A venture capitalist typically invests an amount above $1 million.
- Venture capitalists usually invest in a business at its nascent stage and eventually exit the investment by converting the firm into a public company by placing the shares on sale at a securities exchange through Initial Public Offering (IPO). As a result, a venture capitalist can yield huge profits from IPOs.
#3 – Crowdfunding
It comprises large angel investors who extend funding to smaller businesses. A crowdfunding investment can be as small as $1,000 for each investor. One can initiate this type of fundraising by starting an online crowdfunding “campaign” through one of the crowdfundingThe CrowdfundingCrowdfunding refers to how the business can raise capital from many individuals beyond friends, family, relatives, and customers by posting the project details on websites and other social media platforms. sites.
- Crowdfunder and AngelList in the U.S. and Kickstarter and Indiegogo in Canada are a few examples of such crowdfunding websites.
- However, it is to be noted that equity funding through crowdfunding is legal only in some jurisdictions and under certain circumstances.
#4 – Initial Public Offering
A well-matured company can raise funds through an IPO. In this type of fundraising, a company can source funds by selling the company shares to the public.
- Usually, institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples. with huge corpus funds invest in such fundraising activities.
- Typically, a company uses this equity financing only after having already raised funds through other equity financings. That is because an IPO process can be a very expensive and time-consuming source of this financing.
Let us consider one of the equity financing examples of an entrepreneur, Mr. X, an example of an entrepreneur who invested seed capital of $1,000,000 in starting his company. Since the entire investment is his own, he initially owns all the shares in the business.
The owner may seek additional funding from interested angel investors or venture capitalists as the business grows. Let us assume that the outside investor bids to pay $500,000, while the original investment is $1,000,000, then the company’s total capital will add up to $1,500,000 (= $1,000,000 + $500,000).
Finally, when the outside investor has purchased the company’s shares, the entrepreneur does not own 100% of the business now but 66.67% (investment of $1,000,000 in a total investment of $1,500,000). On the other hand, the investor owns 33.33%, i.e., the company’s remaining shares.
Relevance & Uses
One of the company’s most popular funding methods is the fund raised through global equity financing. The business, however, can generate the fund internally or be raised externally through IPO, venture capitalists, angel investors, etc.
- A few advantages of such financing are that it saves a lot on interest expensesInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense. compared to debt financing. In addition, the fund raised through equity financing does not have to be repaid if the company fails, unlike debt.
- Consequently, if this financing is planned carefully, an entrepreneur can guarantee the growth of their business without diluting much of their stake. The organizations with higher growth potential are likely to continue to obtain equity finance more easily, given the value seen by interested equity source financers.
- A small company does not have good turnover, cash flow, or physical assets to provide collateral during its early stages. In such a scenario, the company can attract equity financing from early-stage investors willing to take risks.
- A small company that matures into a large successful company will likely have several rounds of equity financing during growth. Therefore, this option is equally important for small and large companies at different stages of their development.
Frequently Asked Questions (FAQs)
Debt financing means taking a conventional loan from a traditional lender like a bank. Equity financing includes securing capital in exchange for a percentage of business ownership.
In this type of financing, there is no loan repayment. The business need not make a monthly loan payment if the company does not make a profit at the start. As a result, it may provide one the freedom to make more money in the flourishing business.
The disadvantage is that business owners must back down part of ownership and reduce their control. In addition, if the company makes a profit and becomes successful in the long run, it must give the shareholders a specific profit share to the shareholders as dividends.
This financing type provides project financing, combining project-generated cash flow and federal tax benefits. In addition, it includes both tax deductions and tax credits.
It is better than debt financing because it involves less burden as there is an absence of loan repayment. Therefore, a company/firm need not have to make a monthly loan payment, which can be crucial when the business does not profit. In return, it also gives one the freedom to turn more money into flourishing businesses.
This article is a guide to what is Equity Financing. Here, we explain its types or sources along with an example, relevance, and uses. You can learn more about corporate finance from the following articles: –