Corporate Finance Tutorials
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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 equity 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.
Types of Equity Financing
Few of the major and well-known types of equity financing from outside include:
#1 – Angel Investors
This type of equity financing includes investors is usually family members or close friends of the business owners. Even wealthy individuals or groups of such individuals who extend financial funding for the businesses are also known as angel investors.
- 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 equity financing includes investors who are professional and seasoned investors and extends funding to handpicked businesses. Such investors analyze the concerned business based on strict benchmarks and consequently they are very selective with regard to investing only in those businesses that are well managed and have a strong competitive advantage in their particular industry.
- Venture capitalists believe in active participation in the management of the companies in which they stay invested as it helps them to maintain a strong watch on the day-to-day activities of the business and implement measures to maximize the return on their investment.
- A venture capitalist typically invests an amount in excess of $1 million.
- Venture capitalists usually invest in a business at its nascent stage and then eventually exit the investment converting the business into a public company by placing the shares on sale at a securities exchange through the process of Initial Public Offering (IPO). A venture capitalist can yield huge profits from IPOs.
#3 – Crowdfunding
This type of equity financing comprises large groups of angel investors who extend funding to smaller businesses. A crowdfund investment can be as small as $1,000 for each investor. This type of fundraising can be initiated by starting an online crowdfunding “campaign” through one of the crowdfunding sites.
- Few examples of such crowdfunding websites are Crowdfunder and AngelList in the U.S. and Kickstarter and Indiegogo in Canada.
- 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 fund through this type of equity financing in the form of IPO. In this type of fundraising, a company can source funds by selling the company shares to the public.
- Usually, institutional investors with huge corpus fund invest in such fundraising activities.
- Typically, a company uses this form of equity financing only after it has already raised fund through other types of equity financing because an IPO process can be a very expensive and a time-consuming source of this financing.
Example of Equity Financing
Let us take an example of an entrepreneur who has invested seed capital of $1,000,000 in starting up his company. Since the entire investment is his own, he owns all the shares in the business initially.
As the business starts growing, the business owner may seek additional funding from interested angel investors or venture capitalists. 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 shares of the company, 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. remaining shares of the company.
Relevance and Uses
The fund raised through equity financing is one of the most popular methods of financing utilized by a company because the fund can be generated by the business internally or be raised from externally through IPO, venture capitalist, angel investors etc.
- The few of the advantages of equity financing is that it saves a lot on the interest expense in comparison to the cost associated with a debt financing and in case the company fails the fund raised through equity financing does not have to be repaid, unlike debt.
- Consequently, if equity financing is planned carefully, an entrepreneur can guarantee the growth of its business without diluting much of its 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.
- On the other hand, a small company does not have adequate turnover, cash flow or physical assets to provide as collateral during its early stages. In such a scenario, the company can attract equity financing only from early-stage investors who are willing to take risks along with the entrepreneur.
- A small company that matures into a large successful company is likely to have several rounds of equity financing during the process of growth. As such, an equity financing option is equally important for both small and large companies at a different stage of its development.
This has been a guide to what is Equity Financing, its definition, and meaning. Here we also discuss the types of Equity Financing along with practical examples. You can learn more about Corporate Finance from the following articles –