Updated July 29, 2023
What is Equity Financing
Equity financing is a process of raising capital by selling shares of the Company to the public, institutional investors, or financial Institutions.
Equity financing could be the perfect solution for you. It allows you to raise capital without debt by selling a portion of your business to investors. Here we provide examples of the types of equity financing available to you.
Example of Equity Financing
An Entrepreneur started the company ABC with an initial capital of $ 10,000. At the start of the Company, he owns 100% of the equity in the Company. After a few initial years of starting, he is seeking new funds for the growth of the Company. He sells 50% of the equity of the Company at a valuation of $ 100,000. A venture capitalist or an angel investor will receive 50% equity in the Company by investing $ 50,000, and the entrepreneur’s stake will be reduced to 50%. However, he invested only $ 10,000 in the Company at the beginning.
Thus, Equity financing and the amount of stake each investor owns depends on the time and valuation of investments in the Company.
Types of Equity Financing
A Company can have different classes of shares; Equity financing does not only involve financing by common equity but through other mediums as well:
The Companies issue different classes of shares, usually large enterprises:
- Class A shares: Investors get ownership, i.e., voting rights and dividend.
- Class B shares: Investors get ownership (voting rights) but no dividend.
- Preference shares: Investors receive a dividend (in some cases higher or guaranteed dividend) but no ownership.
- Differential voting rights shares: Investors get differential voting rights, i.e., 2 shares owned by the investor will get 1 vote, and to compensate for this differential voting right, they receive a higher dividend than the common equity investors.
Sources of Equity Financing
When a new business starts, the owner invests the funds by selling his personal assets like land and property or cash assets. However, as the business grows and the need for financing increases, the funds are taken from external sources.
Various investors at different stages of the Company’s growth investments in the Company, and are mentioned below:
1. Angel Investors
Angel investors are typically the first investors apart from the business owner or founder. They are usually wealthy individuals and friends/family of the business owner. They provide financial backing at an early stage of the business at favorable terms and do not usually get involved in the management of the business. Angel investors generally take out their investments at higher returns once the Company seeks funds from venture capitalists.
2. Venture Capitalists
Venture Capitalists or VCs are investors who invest in the Company after the business has been run successfully for some years and they feel a competitive advantage in the market. VCs are selective in their investments and look at various business, management, and market aspects before investing. They invest a huge amount and take board seats and active management responsibility. Their role is to increase the Company’s business aspects and list them on stock exchanges where they can be publicly traded.
3. Retail Investors/IPOs
Companies offer their shares to the general public through Initial Public Offerings or IPOs. IPOs act as an exit route for some founders and VCs and give a chance to public investors to invest in a growing and well-settled business. Companies list their shares on stock exchanges, and investors (who could be retail or institutional) actively trade them.
4. Crowdfunding
Crowdfunding is another way. Companies can raise funds from a group of investors in small amounts. Each investor invests a small amount in the business through a crowdfunding campaign the Company runs. The investors are generally a group of angel investors who believe in the product and the founders of the Company and would like to fund the initial setup of the business.
How it Works
- Companies seeking will typically create a business plan that outlines their goals and objectives.
- Companies will then identify potential investors and present their plans.
- Investors will evaluate the company’s plan and decide whether to invest.
- If the investors agree to invest, they will provide the company with capital in exchange for equity.
Advantages of Equity Financing
This has various advantages both to the founders and to the investors:
- The company does not have enough cash, collateral, or resources to raise funds from debt financing; hence equity financing is a good source of funds for the entrepreneur as the investors would take the risk of the business along with the founders.
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Companies can raise funds through IPOs once they have settled their business and have a regular cash stream. They can use these funds for future technological advancements. Equity financing helps the entrepreneurs and management of the Company to raise funds for diluted ownership and to take a business to better profitability and a higher scale.
- Investors get ownership of the Company. They get better returns than other investment vehicles, either from increased share prices or dividends paid by the Company.
Disadvantages of Equity Financing
Given below are the disadvantages of equity financing:
- Dilution of shares: Equity financing leads to the dilution of the shareholding of the initial investors. As new investors provide funds, the initial shareholders and founders lose a proportionate shareholding in the company.
- Loss of control: As the Company adds new investors, the founders’ reduced shareholding may lead to a potential conflict of interest and loss of control of their own Company. The active involvement of investors in the management of the Company may also create conflicts in the way of doing business.
- Time and effort: Potential investors spend a lot of time in the Company’s due diligence before investing. They look for a business plan, sales and profit forecasting, and market conditions and must ensure their investment will be safe, secure, and profitable. Thus, it is time-consuming for entrepreneurs who are out seeking funds and also focussing on their business.
Conclusion
Equity financing is a mode of financing for the Company where it takes funds from the investors by selling shares. The Company can issue a different variety of shares to different investors. However, investors understand that such investments do not offer fixed returns like debt financing, where they borrow funds for a stipulated time and at predefined interest rates.
Frequently Asked Questions(FAQ)
Q1. What are the different types?
Answer: The different types of equity financing include venture capital, angel investors, and public offerings.
Q2. What are the benefits of equity financing?
Answer: This can benefit long-term growth, allowing companies to access capital without debt.
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