What Is Equity Financing?
Equity financing is a way for businesses to raise capital by selling a portion of their ownership. This process involves attracting investors who contribute cash in exchange for a share of the company. This approach is commonly used by companies to fulfill both short-term and long-term financial needs.
Equity refers to the amount of capital invested by the owner of a company. Hence it also includes the value of shareholders’ stake in the company, as shareholders are owners of a company.
If a business owner is unable to fund the company independently or needs a substantial amount of capital to expedite growth, seeking external funding through equity financing becomes a practical and efficient solution that also allows quick access to capital.
Along with a significant cash investment, equity financing provides the owner the expertise to take their company to the next level.
The success of equity financing is closely tied to the company's financial performance. If the business achieves its financial goals, shareholders receive a favorable return on their investment. Return on investment, a widely used metric, serves as a measure of the profitability of an investment, reflecting the gains made by shareholders through dividends or selling their shares at a higher price.
Equity financing involves selling ownership stakes in a business to raise capital, commonly used by companies for short and long-term financial needs.
Equity encompasses the capital invested by the owner and the value of shareholders' stakes, making it a crucial element in financing decisions.
Equity financing is advantageous for businesses needing substantial capital quickly, offering both funding and expertise to propel company growth.
Unlike debt financing, equity financing doesn't impose a repayment obligation, and shareholders benefit from returns based on the company's success.
Various sources, including crowdfunding, angel investors, venture capital, IPOs, and family/friends, contribute to equity financing, with investors seeking unique ideas, solid financials, and a well-prepared business plan.
How Equity Financing Works
Financing through equity can be done at various stages of the company’s growth, whether an esteemed and established company or a start-up. Likewise, capital can be raised at various stages through multiple rounds.
When you raise funds through equity, the investor gets a part of the company's ownership. So choosing the right investors will give the business an excellent boost to grow to its full potential.
Patience is of utmost importance, as raising funds through this process can be a tedious and complicated pathway. It requires a significant investment of time and money.
The founder has to negotiate the terms of the deal and compile all the required legal documents to facilitate the process. Sourcing and evaluating interested parties, pitching ideas, and onboarding investors make it a lengthy process.
To find the right investors for your business, asking yourself these questions might help:
- Do their goals and vision for the business align with yours?
- Do they represent the core values and brand image of your business well?
- Can they provide access to a bigger and more valuable network?
- Finally, how much do you want them to participate in the affairs of the business?
Types of Equity Financing
A few of the sources are:
1. Crowdfunding
Crowdfunding is the process of raising money from many people to fund a business with the help of the internet and social media. Individuals who firmly believe in the company's vision contribute to the fund.
Crowdfunding provides access to a diverse group of investors. Equity-based crowdfunding is gaining wide popularity as it allows companies to raise capital without giving any stake.
2. Angel investors
An angel investor usually assists start-ups in their initial stages when they cannot onboard other investors. They are individuals with high net worth who offer capital to small ventures in exchange for angel investor equity or convertible debt.
The network, finance, connections, and other perks that angel investors provide to these businesses help the company to accelerate its growth to newfound heights in the long term.
3. Venture capital
Venture capital is an attractive opportunity for new companies with a limited operating scale and hasn’t reached the stage where they can secure a bank loan. Venture capital is a form of private equity financing.
Venture capitalists get a significant amount of ownership of the companies in exchange for the high risk of investing in early-stage companies. As a result, venture capitalists get a bulkier stake in the company compared to angel investors.
4. Initial Public Offerings (IPOs)
In an IPO, shares of a company are sold to institutional investors and individuals to raise new equity capital. Investment banks underwrite these IPOs and also make arrangements for these shares to be listed on various stock exchanges.
Through this process, a privately held company is converted into a public company, enabling the funding of new capital and trading of existing shares with ease.
5. Family and friends
Offering a share in your business in exchange for finance to friends and family is a convenient way to raise funds as long as it does not strain your relationships with them.
Reasons to prefer Equity financing
Some of the reasons are:
1. Expertise and networking
Raising funds through equity finance gives access to networks with high-net-worth individuals. Their contacts, expertise, and other resources provide invaluable support to the company.
The assistance these angel investors or venture capitalists provide is crucial to the company's growth in its early stages.
2. Alternative funding source
Equity financing is a great way to raise funds in cases where companies do not qualify for a bank loan or raise funds through debt financing. Crowdfunding, IPOs, venture capitalists and angel investors become measures to raise funds.
3. Reduced burden
Unlike debt financing, it does not require the companies to pay timely interest. This is especially helpful to start-ups that do not make positive cash flows. The burden of making enough profits to pay interests is mitigated.
No loan is required in this process. Investors make plans for the long term; hence they do not expect returns on their investments immediately.
4. Creditworthiness issues
Start-ups not eligible for a bank loan due to their credit rating and history can raise funds through equity financing instead of debt. Creditworthiness is not an obstacle in equity financing.
5. Long-term vision
The investors who contribute their money to the business do not expect the start-up to give returns on their investments immediately. They believe in the vision of the company and plan for the long term.
The company is not burdened in its initial stages to make profits and provide a return on investment.
When to consider Equity finance?
Choosing the right way to raise funds for the business is crucial. The pros and cons are weighed and analyzed to determine which process works well for the business. Following are some factors one must consider while opting for equity finance:
a) How important is it for the owners to control the company with complete authority and ownership?
It requires the owners to sell a portion of the company's stake in exchange for funds. If complete ownership is not essential to the owners, they may opt for equity funds.
b) Cost of finance
The overall aim of any business is to minimize the cost of finance and maximize owners’ wealth as much as possible. However, the cost of finance has a significant impact on net income.
Hence it is important to understand the repercussions while choosing the source of funds. Each type of financing has its own set of pros and cons. It is vital to understand each of them and decide upon the source.
c) What is the most suitable source of funding for the company?
If you intend to fund your business through equity finance, you must understand that you need access to investors interested in buying the shares.
Contradictory to what most business owners believe, a pool of venture capitalists is not readily available to provide funds to businesses.
Networking with a wide range of individuals, presenting the business plan with finesse, and negotiating many terms and conditions; are just some tasks to be carried out to fund the business using equity.
Equity finance is feasible only for those business owners who can justify the lack of debt. For the rest, debt finance would be a more suitable option to finance.
d) Business capital structure
Thegearing ratiois a metric used to measure financial risk. It expresses a company’s debt in terms of its equity. A high gearing ratio indicates the company may be unable to meet its obligations.
Debt seems attractive due to its low financing cost, but it still has a disadvantage of the interest to be paid. If excessive capital is borrowed and the company cannot pay principal and interest, it may have to liquidate.
The company's capital structure must be reviewed thoroughly before opting for a type of finance.
What do investors look for before investing in a business?
Once you’ve decided equity finance is the right decision for the business, you’ve to start pitching the business plan to potential investors. Then, consult a business attorney who will assist you with writing contracts for the investors.
It is essential to clearly define the rules that apply and the role of every party involved in the company’s growth. But what is it that investors look for before investing in a business?
Venture capitalists are in the business of putting money into promising businesses where they can make money. They want a return on their investment in the long run. You're almost there if you can demonstrate your business can make money!
1. An extraordinary idea
With the market saturated with thousands of identical products, investors look for innovative and lucrative ideas. Does your company solve a unique problem? How does it stand out?
Conveying how your product is unique will convince them to invest in your business.
2. Crunch the numbers
The investors want to see the hard data! You need to show your business has been putting out great numbers. The data from balance sheets, profit, and loss statements, and cash flow statements should be at your fingertips.
If your business is in the pre-revenue or net loss stage, you need to explain to them your vision for the business, what you plan to achieve a few years down the line, your business model, etc.
3. Concrete business plan
A solid business plan should represent a successful business. A business plan mainly contains the vision and mission of the company, methods of achieving them, and the time required to do so.
Other than these items, a good business plan should include the sales channels, the target market, marketing strategies, financial projections, and potential hurdles and action plans to deal with them.
Being well prepared to make a successful pitch is of utmost importance. The business plan must be carefully designed, and the pitch must be made in a compelling narrative. Showing your investors that you’re future-oriented will assure them, as it is their biggest concern.
Disadvantages of Equity Financing
As much as equity financing seems like the most feasible method to raise funds for a business, it still has some disadvantages that should be considered before deciding to finance through equity.
1. Loss of control
The major disadvantage of raising funds through equity is a dilution of ownership and loss of operational control. But on the other hand, the investors and shareholders get a share of the profit they deserve.
2. Absence of tax shields
The interest paid on debt is tax-deductible, whereas the dividends distributed to shareholders are not tax-deductible expenses. Thus there is notax shieldwith equity financing.
The lack of any tax shield makes equity financing more costly than debt financing in the long term.
3. Differences of opinion
Equity brings in multiple partners or owners involved in decision-making. As a result, there will likely be differences in opinion, and conflicts may arise between the partners due to differences in perspectives, administration, and management.
Equity financing Vs. debt financing
Equity and debt are ways in which businesses raise funds. Deciding which method is the most suitable for your business depends mainly on the need for ownership control, risk appetite, and the business capital structure.
Some sources of debt financing include:
- Bank loans
- Mortgages
- Overdrafts
- Instalment purchases
- Lenders.
On the contrary, equity financing sources include:
- Institutional investors
- Angel investors
- Venture capital firms
- Corporate investors.
With debt financing, making payments is required almost immediately. If not done at the right time, you may lose your collateral. In addition, the monthly payments may cause cash flow issues when the business does not have enough working capital.
Even with these cons, you get complete ownership and control over the business, unlike in the case of equity. In addition, debt interest payments are also tax-deductible, thereby decreasing the taxable income.
If the business is not at a profitable stage, it can be tricky to adopt debt financing. However, financing through equity could be riskier as the investors expect a huge share of profits in the long term.
Ownership control is sacrificed in equity financing to a huge extent. It may also be possible that the investors own more share control than the owner themselves.
Researched and authored by Sumedha Vasadi | LinkedIn
Reviewed and edited by Justin Prager-Shulga|LinkedIn
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