Companies have two sources of financing; equity and debt. Equity financing is the primary source of funds for any business. It refers to investment against ownership stakes in a company.
Private and public companies can use equity financing. However, the methods used to raise funds for both types of companies will vary considerably. The funding received through this source does not need to be repaid, unlike debt. It comes with a higher rate of return as compared to debt financing though.
Deeper Definition
Equity financing refers to a form of financing where the owner(s) sells a portion of ownership to the investor(s) for receiving money.
Private and public companies raise capital through equity financing. The principle behind capital raising remains the same. It is to trade ownership of the company against investment. The sources or methods for both types of companies vary significantly though.
How Does Equity Financing Work?
A company can be incorporated with equity, debt, or a combination of sources. As it grows, it will need further investment for short-term and long-term projects. Investors and creditors invest their money for different objectives. Equity financing remains a preferred method of investment for groups seeking ownership rights and expecting higher rates of return.
When a company raises capital through equity financing, it practically sells a proportion of ownership stakes. The capital through this method can raise through private or public offerings.
Private offering is a direct placement of shares to investors or existing shareholders of the company.
Public Offering is selling shares through public markets such as stock exchanges to raise capital.
Both methods can be used by private and public companies. Listed companies can also issue private offerings to investors such as business angels. For example, a rights issue is a form of direct offering to existing shareholders to raise capital.
Sources of Equity Financing
Equity financing can be sourced either privately or publicly. Both types of sources aim to bring in additional capital for the company. Both sources can be used by private and public companies.
Here are some widely used equity financing sources.
Initial Public Offerings
IPOs are the preferred method for public companies. In this method, shares are offered to investors through stock exchange listings.
Rights Offerings
Rights offerings are also commonly used by listed companies. In this method, additional shares issued by the company are directly offered to the existing shareholders.
Direct Public Offerings
It is a similar method of issuing shares to public investors. However, this method does not include third-party facilitators, and the company issues shares directly.
Venture Capitalists / Business Angels
These are wealthy groups/individuals who invest in startups usually in return for ownership stakes. These groups are often actively involved in the management decisions of the company they invest in.
Crowdfunding
Crowdfunding is done through particular platforms. These platforms pool funds from several investors and the public and then invest in companies against equity stakes.
Corporate Investors
Large companies and corporate entities often invest in emerging startups. They invest money to form a strategic partnership and gain access to particular technology or assets.
Special Considerations with Equity Financing
Equity financing is costly as compared to debt financing. However, it is preferred by many companies for several reasons. Foremost, it keeps the company’s leverage under control. That in turn favors the company to seek more debt financing.
Public companies need to comply with certain regulations before they can go public with an IPO. That’s why going public is an expensive and complex process for private companies.
Private companies raising capital through equity financing also need to follow certain regulations. These regulations protect investors against loss of investment or fraud. However, private companies can directly make contracts with private investors by agreeing on terms such as rate of return or proportion of ownership.
Advantages of Equity Financing
Equity financing comes with several advantages for all types of businesses.
- Equity financing is a perpetual source of capital, meaning companies do not need to repay the capital raised through equity.
- This financing is less risky than debt financing as investors get compensated immediately with ownership rights.
- It often comes with investor’s active participation that can benefit the business.
- It comes with fewer complications and covenants as compared to debt financing.
Disadvantages of Equity Financing
Equity financing comes with some disadvantages as well.
- The cost of equity is higher than the cost of debt, as shareholders expect higher returns with greater risk exposure.
- Companies have to sacrifice ownership stakes to investors.
- Profit-sharing can be tough for private companies with new investors.
- Some investors seek active participation in management roles that can create difficulties for the management.
Conclusion
Equity financing is the method of raising capital against ownership rights in a business. Private and public companies can use different methods to raise capital through equity financing. However, the cost of equity is always higher than the cost of debt.
