Equity means a stake, ownership, or ownership rights in a business. Commonly, it is used synonymously as shares.
Not all businesses can afford the company listing on the 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 an equity financing source.
1) Shares – Initial Public Offerings
An 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 scrutiny on the approval of an IPO.
IPO is a popular but expensive option for many businesses. A listed company must publicly share financial statements, governance policies, and other important business policies.
The company’s valuation embeds public perception and performance, hence the term “going public.”
A listed company can raise equity financing by issuing more shares to the stock markets. These secondary rounds of issuing shares can be common or preferred stocks.
2) Crowd Funding
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.
3) Venture Capitalists
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.
4) Investor Angels
Investors or business angels are individuals rather than companies seeking investments in growing businesses.
They work similarly to venture capitalists. Apart from that, investors here are individuals and seek an ownership stake.
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.
5) Investment Companies
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, and not-for-profit organizations.
Investment companies work similarly to venture capitalists. These pooled funds seek high returns in investments in startups or growing businesses.
5) 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.
This option’s benefit is attracting 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.
6) Other Equity Sources
Some other forms of financing can be termed equity financing. 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 have a limited ownership right.
The business framework or product trademarks are often the investment attractions in financing options.
Does equity financing have to be repaid?
Equity financing does not need to be repaid in the traditional sense, as it is not a loan agreement. Companies receive money in exchange for an ownership stake, typically in shares or stock.
The repayment comes when the company liquidates and sells its assets.
In this case, investors will receive a portion of the proceeds based on their proportion of equity held in the company.
Alternatively, suppose a business opts to go public and offer its shares to other investors through an Initial Public Offering (IPO).
In that case, shareholders can benefit from capital gains if they sell their stakes at a higher price than what they originally paid.
In addition, private equity firms may invest in a company with the expectation that the company’s value will rise over time and the invested capital will be returned through dividends or the sale of company stakes, known as the exit strategy.
Therefore, while equity financing does not have to be repaid in conventional terms, investors still expect some form of return on their investments through capital gains or dividend payments based on future performance.
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 in the business.
Equity financing has many advantages for businesses looking for capital. Here are the top 10 advantages of using equity financing:
- No debt: Unlike debt financing, equity financing does not require repayment and eliminates the risk of default.
- Higher valuation: Equity investors often have a more significant potential to increase the value of their investments, as they can provide additional resources and guidance.
- Improved access to capital: With equity finance, businesses can access more significant amounts of capital than their profits would allow them to borrow from banks or other lenders.
- Retention of control and ownership: Equity investors typically take a minority stake in the business and are unlikely to interfere with management decisions or directly influence daily operations. This allows entrepreneurs to retain control and ownership over their business ventures.
- Tax benefits: The tax treatment of equity finance is often favorable compared to debt financing, as dividends paid out on equity could be tax-deductible against certain types of income, such as trading income or profits from partnerships or corporations.
- Flexible terms: Equity investors may agree on more flexible terms than traditional lenders and offer more growth and expansion opportunities.
- Long-term relationships: A successful equity investment can forge a long-term relationship between an investor and a business, opening up potential avenues for further funding if needed down the line, as well as advice and support during times of struggle or uncertainty.
- Reduced restrictions: As there is no requirement to repay any funds borrowed through equity finance like in debt financing, businesses need not worry about meeting predetermined loan payments each month or having limits on cash flow set by creditors.
- Access to expert guidance: Many venture capitalists have years of experience investing in similar companies and industries, able to provide valuable advice throughout an entrepreneurial journey that would otherwise be unavailable.
- Profiling/branding opportunities: Taking on board external investors can be beneficial for public relations purposes; it demonstrates credibility in the eyes of customers, suppliers, and other stakeholders outside your company.
List of 10 Disadvantages of Equity Financing
Equity financing can come with some risks and drawbacks. Here are the top 10 disadvantages of using equity financing:
- Dilution of ownership: Owners of a business taking on equity finance will see their ownership stake diluted, as outside investors will become shareholders in the company too.
- Lack of control: Taking on external investors means giving up some autonomy over decision-making. Investors may want a say in how the money is managed and how decisions are made, meaning that entrepreneurs need to weigh up their own opinion against the investor’s view.
- Costly fees: Generally, equity finance involves paying fees that may include upfront costs, ongoing fees, and exit fees when cashing out on investments. This can be costly for cash-strapped start-ups looking for an injection of capital.
- Management changes: Investors often require changes to management or board composition in exchange for funding; this could mean removing current staff from their positions or hiring new personnel.
- Short-term focus: Private equity investors tend to have shorter time horizons than other sources of capital; this raises the risk of them pushing businesses into taking short-term decisions that may not be beneficial for long-term growth or sustainability.
- Risk of failure: Any investment carries the risk of failure, no matter what type; if an investment fails due to unforeseen circumstances, investors may experience losses and negative returns on their investments.
- Uncertainty over exits: Investing money into a business involves uncertainty over when you’ll be able to cash out your stake; it could take several years before investors get any return on their investment.
- Potential conflicts between founders & investors: Though there’s potential for harmony between founding teams and external investors during the funding process, conflicts often arise once funding has been secured due to competing goals or different opinions over strategy or product development direction.
- Long-term commitments: Equity finance typically involves longer-term commitments from both parties. As with any investment, there’s always a chance it won’t turn out profitable, and further financing may need to be obtained before seeing any returns.
- Losses are more significant than loans: With debt financing, lenders only stand to lose whatever amount they loaned; with equity financing, however, losses can add up much quicker as losses are based on overall performance rather than just what was initially invested.
Top 10 Different Between Equity Finance and Debt Financing
- Equity finance is raising capital by selling an ownership interest in the form of shares or stock. In contrast, debt financing raises funds by securing a loan against future company cash flow returns.
- Equity financing involves giving up a portion of ownership and control to investors, whereas debt financing does not involve any exchange of ownership.
- With equity finance, payment of dividends to shareholders cannot be enforced like the repayment of loans with debt financing.
- The cost of equity finance can be variable depending on the business performance and risk associated. In contrast, the cost of debt finance is fixed based on the lender’s terms and conditions.
- Debt financing requires businesses to pledge collateral for repayment, while no such security is needed with equity financing.
- Equity funding enables companies to leverage existing assets without burdening their balance sheet with additional liabilities, while debt funding increases long-term liabilities on a company’s balance sheet.
- Equities are permanent sources of capital, while most debts are repaid after a certain period for which they were taken out in the first place.
- Most venture capitalists prefer to invest in equity rather than debt because it carries more risk that has the potential for high rewards if successful.
- Interest payments made by borrowers towards their creditors are tax deductible, unlike dividends paid out to shareholders from their profits due to double taxation laws applied in most countries worldwide.
- Equity-financed companies benefit from investor relationships since shareholding implies rights over significant corporate decisions, such as appointing or removing directors. In contrast, debtor relations with creditors may not extend beyond contractual obligations.