What is Equity Financing? Definition, Sources, Advantages, and Disadvantages

Definition:

Equity finance is a type of finance that is acquired by a company through the sale of its shares or other equity instruments.

This finance can be used to finance different types of activities, ranging from working capital requirements to purchase of fixed assets.

By raising equity finance, the company shares a part of its own with the entity buying the shares.

When a company is incorporated, the main source of equity finance comes from the owners investing in the company in lieu of shares or the owners’ friends and family buying shares.

In the case of bigger companies or public companies, this finance may come from the general public who can buy the shares in the stock market. Companies such as Facebook have gone through many rounds of equity financing to reach the position they are at now.

The rounds are different stages of a company’s growth during each of which, the company may attract different types of investors.

At the initial stages of a company’s lifecycle, the company may offer convertible equity finance instruments to attract potential investors or angel investors.

These types of equity instruments have better downside protection for the investors and a great upside potential.

While later, once the company has established itself in the industry, the company may offer secondary equity instruments such as rights offerings.

Equity instruments such as ordinary shares may be subject to different rules and regulations. For example, public listed companies are dictated by the stock market rules.

These rules exist not only to help the companies but also to safeguard the investors against any possible threats of fraud or scam.

Sources of Equity Financing

Startups may find it particularly difficult to raise any equity finance. Most of the equity finance that a startup receives is through the injection of capital by its owners.

Furthermore, the owners may receive finance from friends or family members. However, there are some other sources of equity finance that companies may avail. These are:

  • Crowdfunding. With the emergence of new channels for crowdfunding such as Kickstarter or GoFundMe, crowdfunding has really become popular among entrepreneurs. Investors from across the globe can invest in companies and become a part of their shareholding. Companies can run campaigns on these websites to attract potential investors.
  • Angel Investors. As the name suggests, angel investors are the initial supporters of a business. They may come in the form of a wealthy friend or family member. Many celebrities are also known to invest in startups as angel investors. Angel investors offer favorable terms to the company and inject a considerable amount of funds into the business. Angel investors do not take part in the management or decision-making of a business, which makes them much more favorable for startups.
  • Venture Capitalists. Venture capitalists are veteran investors or companies who select the businesses they invest in very precisely. They might invest in companies that are well managed or companies that might be facing a management problem but which the venture capitalists deem to have potential growth in the future. Unlike angel investors, venture capitalists take an active role in the management and decision-making process of a company.
  • Placing or public offers. Companies may use placing to place smaller issues of shares. A company can contact an issuing house such as an investment bank, which selects institutional investors to whom the shares are sold or ‘placed’. Companies can also use public offers, which is an invitation to the public by the company to apply for shares. Generally, the company provides the public with information often contained in a prospectus.
  • Internal generation. Equity can also be generated internally by a company. This is also known as retained earnings. These are profits that a company makes but are not paid to equity holders are dividends but are rather retained for further use in business. Profits are retained and generated once a business has an established and steady source of income and as a result of increased efficiency in the management of working capital.
  • Dividends: The main source of income for investors, who invest in the equity instruments of a company, is the dividends paid by the company. These dividends are paid to the investors by the companies when a profit is made. However, different companies have different dividend policies. Some companies choose not to pay their equity holders any dividends. Companies such as Amazon and Microsoft are known to not pay their equity holders any dividends. Any profit made is retained by the companies.
See also  Mezzanine Finance / Fund: Why do companies need Mezzanine Finance?

The investors benefit from this as these retained earnings are invested back into the business which results in the appreciation of the value of the investors’ stocks.

Some companies may also pay dividends to their equity holders in the form of shares issued. These are called scrip dividends. Bonus issues are a type of scrip dividends.

Investors may choose to keep these shares and have a greater holding of the company or sell them in the market.

Advantages and Disadvantages of Equity Financing

Equity financing has its own advantages and disadvantages as compared to other types of financing, specifically debt financing:

Advantages

  • To obtain equity financing, a company does not need to have a good credit rating. This is a great advantage for startups with no credit past. Companies do, however, need a great business plan to convince potential investors.
  • Equity finance is the easiest form of finance to obtain. There are no interest charges associated with equity finance. If the revenues and profits of the company decline or the company face cash flow problems, the company is not obligated to pay any interest or dividend to the equity holders. Whereas, if the company fails to pay debt finance obligations, it may face legal actions.
  • Equity finance does not need to be paid back. Unlike debt finance, equity finance is not paid back to the original investors. An investor who wants to receive their investment amount back can simply sell their shares in the market without affecting the company’s cashflows.

Disadvantages

  • One particular disadvantage that equity finance has over other forms of finance is the dilution of control. As the company raises more capital through equity finance, the control of the company is diluted. The new equity holders may interfere with the management and decision-making process of the company. However, rights issues can be used to tackle this problem.
  • Any payments made to equity holders are not tax-deductible and are considered a decrease in retained earnings. The same is not true for debt finance, where interest payments may be tax-deductible and can help with the tax planning of an organization.
  • The process of raising equity finance is time-consuming and may be costly. This is true especially for startups where if a startup company wants to raise equity finance, it must produce a thorough business plan and forecasts to attract any potential investors.
  • As mentioned above, companies have to go through some rules and regulations of the market in which they are offering their equity instruments. While the rules and regulations exist to give both the company and the investors some guidelines and safeguards, it may be considered as an extra administrative overhead by companies. The company may also have to pay a fee to the regulatory body and may also have to pay fines in case of any deficiencies.
See also  What is idle time? (Calculate and Controls)

Conclusion

Equity finance is the main source of finance for companies especially startups. Ultimately, it is up to the companies to decide whether they want to opt for equity finance or other sources of finance.

A company must consider factors such as the accessibility of finance, the amount of finance, the costs of issue procedures and regulatory bodies, the dilution of its control, and the dividend policies before opting for equity finance.

Scroll to Top