Equity Financing: What It is, How does it work, Advantage and Disadvantage

What is Equity Financing

Companies raise funds because they can have an immediate need to pay bills or a long-term need to expand their operations. The practice of raising capital through the selling of shares is known as equity financing. A corporation that sells shares essentially transfers the ownership of its business in exchange for money. There are different sources of equity fundraising. Some common equity fundraising sources include raising funds from an entrepreneur’s friends and family, professional investors, or an initial public offering (IPO).

Any private business can raise funds from the general public by issuing public shares. Private companies that want to issue their shares to the public must first go through an IPO (Initial Public Offering) procedure. Industry behemoths like Meta (formerly Facebook) and Google raised billions in capital via IPOs. Common stock and other equity or quasi-equity instruments like preferred stock, convertible preferred stock, and equity units with common shares and warrants are sold as part of equity financing.

A startup that develops into a profitable business will go through numerous equity fundraising rounds. A startup may employ numerous equity instruments to meet its funding needs since it frequently draws diverse sorts of investors at different phases of its development.

In this blog, we will understand the types and the major advantages and disadvantages of equity financing. But, before that, let us first understand how equity financing works:

How Equity Financing works?

As we mentioned above, equity financing effectively gives away a portion of your company’s ownership in return for money.

This is how it goes:

Say you are the only owner of the business. 100% of the company’s ownership is with you. This also means you are the sole owner of your company’s equity. However, you need money to pay for the growth and expansion of your business.

You choose to sell a 10% stake in your company to an investor (or a group of investors) in return for funding. Now, you hold 90% of the company’s shares, but you have enough money in the bank to accomplish your business objectives. This simple example explains how owners can dilute their equity to raise capital for their businesses. But when discussing the various forms of equity, things become a little more difficult.

Common Categories of Equity

Here are some categories of equity that businesses use when opting for equity financing:

Common Shares: 

When the shares are traded on the stock market, they are called common shares. Common investors have little control over how the firm is run, and they enjoy the following rights: 

• Voting power, 
• Ownership, 
• Right to transfer of ownership, 
• Right to receive dividends, 
• Right to inspect corporate documents, and 
• Right to sue the company for any wrongful acts.

Preferred stock: 

A type of stock similar to common stock but has some extra rights associated with it. Here are some rights enjoyed by the holders of preferred shares:

• Preferential right to repayment of capital at the time of liquidation
• No Voting Rights
• May have the option to convert preferred shares into common shares

Convertible Preferred Stock: 

This type of preferred stock may be converted into common shares, but not vice versa.

Types of Equity Financing

Listed below are the different types and sources of equity financing.

Individual Investors

These are frequently the friends, relatives, and acquaintances of company owners. These individual investors might not have any significant business knowledge, industry expertise, or direction to provide a company. Since individual investors often invest smaller sums so the company can meet its financing targets.

Angel Investors

Angel investors typically make investments in startup companies. These are frequently affluent people or organisations looking to invest in companies they think will offer lucrative returns. Due to their extensive business knowledge, angel investors can make large investments and offer the necessary contacts, advice, and insight.

Venture Capitalists

Those with the financial means to invest significantly in companies they believe have strong growth potential, a competitive edge, and a bright future are known as venture capitalists. They often demand a large ownership stake in a company in exchange for their resources, contacts, and financial commitment. 

To safeguard their investment, they may even demand substantial participation in administrating a company’s strategy, operations, and everyday operations. Venture capitalists often enter the picture at an early stage and leave when the company goes public, when they may make huge gains.

Initial Public Offerings

More established corporations can choose IPOs for raising capital. IPOs basically involve getting the company listed on the stock exchange and selling its shares to the general public. This kind of equity financing takes place later in the company’s development because an IPO issue is expensive, time-consuming, and labour-intensive. Less control is expected from IPO investors than from venture capitalists and angel investors.

Crowdfunding

Crowdfunding entails small investments from individual investors made through an online platform (such as Kickstarted, Indigogo, and Crowdfunder) to assist businesses in fundraising. These investors can frequently relate to the company’s aims and objectives.

Let us now talk about the advantages and disadvantages of equity financing:

Pros and Cons Of Equity Financing

Like all other types of financing, Equity Financing also has its fair share of pros and cons. To help you make a better choice, we have listed below the pros and cons of equity financing.

Pros of Equity Financing

• No hassle of repayment

Financing through equity creates no debt to be repaid in future. Equity financing is also the most viable choice if your company cannot secure a loan. Because investors are looking for a return on their investment rather than loan repayment, it is viewed as a lower-risk financing alternative. Furthermore, investors are often more motivated to support your success than lenders since the benefits may be quite high.

• The expertise of Investment Professionals

One can access exceptional business insight, knowledge, and counsel in equity financing provided by venture capitalists and angel investors. Additionally, it may introduce you to new, crucial business contacts and networks that might lead to more funding.

Cons of Equity Financing

• Splitting of Profit

The risks assumed by equity investors are quite high, for which they demand a share in the company’s profit, which lowers the returns that flow to the firm owners. Even modest common stockholders receive a profit share. Additionally, investors must be consulted if the founders intend to make decisions that will influence the firm.

• Dilution of Ownership

Business owners must cede some ownership in exchange for the significant sums that angel investors and venture capitalists may invest. That can mean you have less power over your own business.

• Costlier than Debt

Large investors frequently expect greater rates of return, which can easily surpass those imposed by lenders. Dividends paid to shareholders are also not tax deductible like loan interest payments.

Conclusion

For businesses to sustain and expand, they frequently need outside capital. The most cost-effective form of fundraising is to balance equity and debt financing according to industry norms and business expectations. 

Financing for equity might come from sources like angel investors, crowdfunding or IPOs. But, the biggest benefit of equity financing, regardless of the source, is that there is no requirement to return the invested funds if the company cannot grow its operations.