Equity Financing: What It Is, How It Works, Pros and Cons

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 need funds for a long-term project that promotes growth. By selling shares, a business effectively sells ownership in its company in return for cash.

Equity financing comes from a variety of sources. For example, an entrepreneur's friends and family, professional investors, or an initial public offering (IPO) may provide needed capital.

An IPO is a process that private companies undergo to offer shares of their business to the public in a new stock issuance. Public share issuance allows a company to raise capital from public investors. Industry giants, such as Google and Meta (formerly 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.

How Equity Financing Works

Equity financing involves the sale of common stock and 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—generally the first investors in a startup—favor convertible preferred shares rather than common stock in exchange for funding new companies because the former have more significant upside potential and some downside protection.

Once a company has grown large enough to consider going public, it may consider selling common stock to institutional and retail investors.

Later, if the company needs additional capital, it may choose secondary equity financing options, such as a rights offering or an offering of equity units that includes warrants as a sweetener.

Types of Equity Financing

Individual Investors

These are often friends, family members, and colleagues of business owners. Individual investors usually have less money to invest, so more of them are needed to reach financing goals. Such individual investors may have no relevant industry experience, business skills, or guidance to contribute to a business.

Angel Investors

Often, these are wealthy individuals or groups interested in providing funding to businesses that they believe will provide attractive returns. Angel investors can invest substantial amounts and provide needed insight, connections, and advice due to their industry experience. Normally, angels invest in the early stage of a business's development.

Venture Capitalists

Venture capitalists are individuals or firms capable of making substantial investments in businesses that they view as having very high and rapid growth potential, competitive advantages, and solid prospects for success. They usually demand a noteworthy share of ownership in a business for their financial investment, resources, and connections. In fact, they may insist on significant involvement in the management of a company's planning, operations, and daily activities to protect their investment. Venture capitalists typically get involved at an early stage and exit at the IPO stage, where they can reap enormous profits.

Initial Public Offerings

The more well-established business can raise funds through IPOs, whereby it sells shares of company stock to the public. Due to the expense, time, and effort that IPOs require, this type of equity financing occurs in a later stage of development, after the company has grown. Investors in IPOs expect less control than venture capitalists and angel investors.

Crowdfunding

Crowdfunding involves individual investors investing small amounts via an online platform (such as Kickstarted, Indigogo, and Crowdfunder) to help a company reach particular financial goals. Such investors often share a common belief in the mission and goals of the company.

Equity Financing vs. Debt Financing

Businesses typically have two options for financing when they want to raise capital for business needs: equity financing and debt financing. Debt financing involves borrowing money. Equity financing involves selling a portion of equity in the company. While there are distinct advantages to both types of financing, most companies use a combination of equity and debt financing.

The most common form of debt financing is a loan. Unlike equity financing, which carries no repayment obligation, debt financing requires a company to pay back the money it receives, plus interest. However, an advantage of a loan (and debt financing, in general) is that it does not require a company to give up a portion of its ownership to shareholders.

With debt financing, the lender has no control over the business's operations. Once you pay back the loan, your relationship with the lender ends. Companies that elect to raise capital by selling stock to investors must share their profits and consult with these investors when they make decisions that impact the entire company.

Debt financing can also place restrictions on a company's operations that can limit its ability to take advantage of opportunities outside of its core business. In general, companies want a relatively low debt-to-equity ratio. Creditors look more favorably on such a metric and may allow additional debt financing in the future if a pressing need arises.

Finally, interest paid on loans is tax deductible as a business expense. Loan payments make forecasting for future expenses easy because the amount does not fluctuate.

Factors to Consider

When deciding whether to seek debt or equity financing, companies usually consider these three factors:

• What source of funding is most easily accessible for the company?
• What is the company's cash flow?
• How important is it for principal owners to maintain complete control of the company?
  

If a company has given investors a percentage of their company through the sale of equity, the only way to remove them (and their stake in the business) is to repurchase their shares, which is a process called a buy-out. However, the cost to repurchase the shares will likely be more expensive than the money the investors initially gave you.

Reasons to Choose Equity Financing

You're a Startup

Businesses in their early stages can be of particular interest to angel investors and venture capitalists. That's because of the high return potential they may see, due to their experience and skills.

Established Lending Sources Ignore You

Equity financing is a solution when established methods of financing aren't available due to the nature of the business. For example, traditional lenders such as banks often won't extend loans to businesses that they consider too great a risk because of an owner's lack of business experience or an unproven business concept.

You Don't Want to Incur Debt

With equity financing, you don't add to your existing debt load and don't have a payment obligation. Investors assume the risk of investment loss.

You Get Guidance From Experts

Equity financing delivers more than money. Depending on the source of the funds, you may also receive and benefit from the valuable resources, guidance, skills, and experience of investors who want you to succeed.

Your Goal Is the Sale of Your Company

Equity financing can raise the substantial capital you may need to promote rapid and greater growth that can make your company attractive to buyers and a sale possible.

Pros and Cons of Equity Financing

Pros

Alternative to Debt

Equity financing results in no debt that must be repaid. It's also an option if your business can't obtain a loan. It's seen as a lower risk financing option because investors seek a return on their investment rather than the repayment of a loan. Plus, investors typically are more interested in helping you succeed than lenders are because the rewards can be substantial.

Expertise of Business and Investment Professionals

Equity financing offered by angel investors and venture capitalists can offer access to outstanding business expertise, insight, and advice. It can also provide you with new and important business contacts and networks that may lead to additional funding.

Cons

Profits Must Be Shared

The stakes taken by investors providing equity financing can be significant and thus, profits going to the business owners are reduced. Even small common stock investors get a share of profits. What's more, investors must be consulted any time you plan to make decisions that will impact the company.

Ownership Is Diluted

In exchange for the large amounts that angel investors and venture capitalists may invest, business owners must give over some percentage of ownership. That can translate to having less control over your own company.

More Costly Than Debt

The typically higher rate of return demanded by large investors can easily exceed that charged by lenders. Also, shareholder dividends aren't tax deductible. Interest payments on loans are, with some exceptions (see IRS Publication 535).

Example of Equity Financing

Say that you've started a small tech company with your own capital of $1.5 million. At this stage, you have 100% ownership and control. Due to the industry that you're in and a fresh social media concept, your company attracts the interest of various investors, including angel investors and venture capitalists.

You're aware that you'll need additional funds to keep up a rapid pace of growth, so you decide to consider an outside investor. After meeting with a few and discussing your company's plans, goals, and financial needs with each, you decide to accept the $500,000 offered by an angel investor who you feel brings enough expertise to the table in addition to the funding. The amount is enough for this round of funding. Plus, you don't wish to give up a greater percentage of your company ownership by taking a larger amount.

Thus, the total invested in your company is now $2 million ($1.5 million + $500,000). The angel investor owns a 25% stake ($500,000/$2 million) and you maintain a 75% stake.

Special Considerations

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.

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 dot-coms 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.

The Bottom Line

Companies often require outside investment to maintain their operations and invest in future growth. Any smart business strategy will include a consideration of the balance of debt and equity financing that is the most cost-effective.

Equity financing can come from various sources. Regardless of the source, the greatest advantage of equity financing is that it carries no repayment obligation and it provides extra capital that a company can use to expand its operations.