What is Equity Financing
Equity financing is the process of raising capital through the sale of shares in an enterprise. Equity financing essentially refers to the sale of an ownership interest to raise funds for business purposes. Equity financing spans a wide range of activities in scale and scope, from a few thousand dollars raised by an entrepreneur from friends and family, to giant initial public offerings (IPOs) running into the billions by household names such as Google and Facebook.
While the term is generally associated with financing by public companies listed on an exchange, it includes financing by private companies as well. Equity financing is distinct from debt financing, which refers to funds borrowed by a business.
BREAKING DOWN Equity Financing
Equity financing involves not just the sale of common equity, but also the sale of other equity or quasi-equity instruments such as preferred stock, convertible preferred stock and equity units that include common shares and warrants.
A startup that grows into a successful company will have several rounds of equity financing as it evolves. Since a startup typically attracts different types of investors at various stages of its evolution, it may use different equity instruments for its financing needs.
For example, angel investors and venture capitalists – who are generally the first investors in a startup – are inclined to favor convertible preferred shares rather than common equity in exchange for funding new companies, since the former have greater upside potential and some downside protection. Once the company has grown large enough to consider going public, it may consider selling common equity to institutional and retail investors. Later on, if it needs additional capital, the company may go in for secondary equity financing such as a rights offering or an offering of equity units that includes warrants as a “sweetener.”
How Equity Financing Is Regulated
The equity-financing process is governed by rules imposed by a local or national securities authority in most jurisdictions. Such regulation is primarily designed to protect the investing public from unscrupulous operators who may raise funds from unsuspecting investors and disappear with the financing proceeds. An equity financing is thus generally accompanied by an offering memorandum or prospectus, which contains a great deal of information that should help the investor make an informed decision about the merits of the financing. Such information includes the company's activities, details on its officers and directors, use of financing proceeds, risk factors, financial statements and so on.
Investor appetite for equity financing depends significantly on the state of financial markets in general and equity markets in particular. While a steady pace of equity financing is seen as a sign of investor confidence, a torrent of financing may indicate excessive optimism and a looming market top. For example, IPOs by dotcoms and technology companies reached record levels in the late 1990s, before the “tech wreck” that engulfed the Nasdaq from 2000 to 2002. The pace of equity financing typically drops off sharply after a sustained market correction due to investor risk-aversion during such periods.