Equity means a stake, ownership, or ownership rights in a business. Commonly, it is used synonymously as shares. Not all businesses can afford the listing of the company on stock markets. Yet, there are several options that small businesses can utilize to secure equity financing.
Any source of finance that comes with ownership rights can be termed as an equity financing source.
Shares – Initial Public Offerings
Initial public offering (IPO) is the most popular option for raising financing for growth companies. A business offers its shares on the stock market to raise finance. The IPO requires certain registration and compliance requirements from the company. The Securities and Exchange Commission provides the scrutiny on approval of an IPO.
IPO is a popular but expensive option for many businesses. A listed company has to publically share financial statements, governance policies, and other important business policies. The company’s valuation embeds public perception along with performance, hence the term “going public”.
A listed company has the option of raising equity financing by issuing more shares to the stock markets. These secondary rounds of issuing shares can be common or preferred stocks.
Crowdfunding is a cheap alternative for small or new businesses instead of an IPO. The business owners can issue shares to the public directly. The advantage of this option is that the business remains private and receives the funding. The owners can purchase back the sold shares to investors later unlike an IPO where the buyback is often difficult.
Venture capitalists are usually interested in investing in new startups. Venture capitalists are a group of investment funds that seek returns on their investments. The investments can be in the form of debt or equity. Either way, these investors seek some control over company operations. Their interest is to ensure high returns on the investment. The borrowing business can buy back the shares issued to the venture capitalists later. Some companies use the option for project financing as well.
Investor or business angels are individuals rather than companies seeking investments in growing businesses. They work similarly as venture capitalists apart from that investors here are individuals and they seek an ownership stake as well.
Investor angels are a popular financing source for tech startups. They provide alternative options to the IPO and crowdfunding as well. The cost of equity with investor angels is significantly higher though.
Investment companies are regulated entities that seek investment returns from businesses. These companies pool funds from wealthy individuals or other businesses. Investment companies may also have funds from large banks, insurance companies, pension funds, Not-for-profit organizations.
Investment companies work similarly to venture capitalists. These are pooled funds that seek high returns in investments in startups or growing businesses.
Convertible Debt into Equity
These are hybrid funds that can be classified as either debt or equity. Convertible debt can be later converted into company shares. The borrowing company sets the conversion date and share prices before issuing such debts. The benefit of this option is to attract investors with large investors interested in debt financing. The lender keeps the option of selling the debt or converting it into equity in the form of shares.
Other Equity Sources
Some other forms of financing can be termed as equity financing. Some common examples of such equity financing are franchising, royalty-based investments, and sales-based financing. Each of these types of equity financing relates to company performance and sales. The investors do not directly own the company but a limited ownership right. The business framework or product trademarks are often the investment attractions in such financing options.
Advantages of Equity Financing
Technically equity financing means using other investors’ money in the business. Small businesses or entrepreneurship aside, other common forms of equity financing are using others’ money into the business.
It has certain advantages over debt financing:
- It provides access to funds without collateral or assets.
- It saves costs on interest payments.
- Once issued through shares, it does not require repayment, unlike debt.
- The company can choose between private investments or public shares.
- It provides a valuation of the company to investors.
- It adds credibility to the company profile with the listing.
Disadvantages of Equity Financing
- Equity financing is difficult to secure for startups and small businesses.
- The cost of equity is higher than the cost of debt.
- The company loses control through the loss of ownership rights.
- Investors and competitive authorities require strict compliance with the regulations.
- The company needs to publically issue all business financial and governance statements to the shareholders.