What Is Equity Financing?
Equity financing is the process of raising capital through the sale of shares. Companies raise money because they might have a short-term need to pay bills or they might have a long-term goal and require funds to invest in their growth. By selling shares, they sell ownership in their company in return for cash. Equity financing comes from many sources; for example, an entrepreneur's friends and family, investors, or an initial public offering (IPO). Industry giants such as Google and Facebook raised billions in capital through IPOs.
While the term equity financing refers to the financing of public companies listed on an exchange, the term also applies to private company financing. Equity financing is distinct from debt financing, which occurs when a business borrows funds.
Types of Equity Financing
Equity financing involves 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.
[Important: Equity financing is distinct from debt financing; in debt financing, a company assumes a loan and pays back the loan over time with interest, while in equity financing, a company sells an ownership share in return for funds.]
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 because 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, if the company needs additional capital, it may choose secondary equity financing such as a rights offering or an offering of equity units that includes warrants as a sweetener.
Special Considerations: 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.
Equity financing is thus often accompanied by an offering memorandum or prospectus, which contains extensive information that should help the investor make an informed decision on the merits of the financing. The memorandum or prospectus will state the company's activities, information on its officers and directors, how the financing proceeds will be used, the risk factors, and financial statements.
- Companies seek equity financing because they might have a short-term need for funds or they might need to finance a long-term growth strategy.
- Companies raise capital through equity financing by selling common equity, 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.
- An IPO occurs when a private company decides to issue stock to the public.
- Equity financing is heavily regulated by national and local government.
Investor appetite for equity financing depends significantly on the state of the financial markets in general and equity markets in particular. While a steady pace of equity financing is 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.
[Fast Fact: The biggest IPO to date was that of Alibaba Group Holding Limited (NYSE:BABA), an online e-commerce company based in China; the company went public on September 18, 2014, raising a staggering $21.8 billion, and four days later, underwriters exercised an option to sell more shares, bringing the total IPO to $25 billion.]