Every business needs money to sustain and grow its operations. While taking out a bank loan is one option to secure the capital necessary for these purposes, another option is equity financing.
Essentially, equity financing involves issuing fresh shares to new or existing shareholders or investors for a certain amount of money that goes to the entity raising the fund.
Equity financing can come in during any phase of a business from inception to expansion and in many forms such as direct equity investment or through a public offer. The entity raising fund has to make a strong pitch on growth and profit to entice investors. Investors look for two kinds of return from their equity financing – dividend or growth or a combination of both. Let us look at these two in slight details.
Dividend: When a business makes profit it can decide to share a part of it with shareholders. This is done through many ways but mainly dividend. Hence, profit-making ability now or in future and ability to distribute it as dividend are key factors an equity financier takes into account when making investment.
Growth: When trying to attract equity financers, an entity also shows its ability to increase the value of shares, based on various factors such as revenue growth, profit etc. Equity investors look at the chances of their shares rising value in tandem with the growth of the firm. This is especially true for companies listed on exchanges or equity financing by angel investors or venture capital or private equity.
Types or Major Sources of Equity Financing
Equity financing are categorised based on the nature of the investors, the phase at which the firm is raising fund or if the fund is being raised from at public exchange.
Let us look at some of these in detail:
Individual Investors – This works mostly in case of small ticker equity financing. Individual investors can be family, friends or others targeting growth potential of shares. Modern day professions who have made money from their other ventures and are now looking at other avenues to invest have also emerged as big individual investors. Such investors mostly don’t take part in running of the business.
Angel Investors – They mimic individual investors in terms of number, but angel investors also bring their expertise to the business apart from fund. They are mostly skilled individuals with already a proven track record in the field in which the investment is being made or in management etc. Angel investors put equity financing in firms that they expect will generate exponential growth over time and will also gain from their expertise.
Venture Capitalists – They usually bring bigger money and are made of a group of investors. Venture capitalists do equity financing of businesses they think will grow rapidly and lead to manifold rise in value of shares.
Private Equity - They bring even more money than venture capitalists and usually entry a firm at a slightly later stage than venture capitalists.
Initial Public Offerings – A firm may choose to tap stock exchanges to raise money through initial public offer or IPO. In this of initial public offer, a firm will invite public to invest money in its shares and then list the shares on stock exchanges.
Crowdfunding – Many platforms allow a person or firm to list their venture and allow anyone to invest in it. These are usually initial stage firms that have created a product or business which can attract general public to invest in them.
Equity Financing vs. Debt Financing
The most important difference between equity financing and debt financing is the transfer of shares or ownership and another is return of investment.
• Debt financing does not entail transfer of shares or ownership while equity in financing does.
• In debt financing the money is eventually returned with interest. In equity financing there is no guarantee of return of the money.
• Return in debt financing is usually fixed in the beginning. In case of equity financing, the dividend return as well as return in the form of share appreciation depends on the performance of the firm.
Factors to Consider When Choosing Between Equity Financing and Debt Financing
• Which route is likely to get faster funds?
• Will the firm make enough cash to service and repay debt
• How much valuation will the firm command in case of equity financing
• New firms are less likely to get debt financing unless they have good cash flow or assets to secure the debt
• Equity financing dilutes the stock ownership, while debt financing does not affect ownership
• Debt financing carries a responsibility to pay back, while in equity financing there is no such liability.
Advantages and Disadvantages of Equity Financing
Like any other form of funding equity financing too carries its own pros and cons.
• No burden to pay back – In equity financing there is no liability to pay back the funds. The investors get the money through dividend and stock appreciation as the firm grows.
• Shared Expertise – In case of angel investing or investment by PE, VC firms, you can tap into their expertise in running a business.[AH1]
• Valuation discovery – Equity financing also allows discovery of valuation of a firm.
• Dilution of ownership – In equity financing, shares of the company have to be given to investor. This leads to dilution of ownership.
• Makes promoters answerable – Those buying shares in equity financing get a say in running of the company.
• Susceptible to hostile takeover – In case a company is listed on an exchange, it can be taken over by someone else if promoters don’t maintain majority stake
• Sharing of dividend – The profits of the firm, if distributed, will have to be shared with investors under equity financing.
When to Choose Equity Financing?
There are various factors for choosing equity financing, including the basic fact that a firm may need money to run or expand or both.
• Startups – Most startups need seed or angel funding to start the business or if they are already set up then to grow. They mostly tap individual investors, angel funding, venture capitals, private equity or crowdfunding platforms.
• Difficult to get money from established sources – Many times the traditional sources of funding may be difficult to tap in the absence of established cash flow or assets to offer as mortgage. Also, traditional sources of funding may be loathe to invest in new age companies.
• Debt can be costly – In many situations debt financing can be problem, especially if cash flows are yet to be established or there is no certainty when the business will be able to return the principal amount.
• Investor expertise – Some of the equity financiers bring management or field expertise with them. These investors can help run the business better and grow it fast.
Equity financing is a smart way to get money for your business without compromising on your liquidity. It also helps bring outside expertise without having to spend much money, especially for startups. Every business should consider equity financing as its first step towards funding, especially if they can command a good valuation.
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