What is equity financing?
Equity financing is normally used as seed money for business startups or as additional capital for established businesses that want to expand.
Equity financing is a way by which companies raise funds to expand their business ventures, add new product lines, and in general grow their business. Large corporations use this tactic to gain investments so that they can expand their empire. On the other hand, new startups with high potential also implement equity financing to start their company operations.
Equity financing is a simple way for a business to raise capital by selling shares. It is very different from debt financing, where the company would get a loan from a financial institution and repay them back later, with interest. Equity financing is normally used as seed money for business startups or as additional capital for established businesses that want to expand.
A business usually gets this kind of financing by selling the company’s common stock. And each share represents a single unit of ownership in the company. For instance, if the company has issued 10,000 shares of common stock and the owner has 6,000 shares, they would own 60% of the company. The ownership in the company usually becomes diluted when additional shares are issued. But issuing shares becomes important when you want to obtain funding and is usually the best way out.
Why Does Equity Financing Matter?
During the early stages of growth in a company, usually when the company does not have enough revenue, equity financing can attract capital from early stage investors who are willing to take risks in new investments.
The same is true for a company that has been established and has assets, but does not have enough to expand. In this case, the company can raise capital through an equity financing such as a public offering or having a large investment firm invest in the company. And based on the share price in the company, a part of the company gets sold to a new investor.
Although equity financing is a great thing for entrepreneurs, it’s also bad as it dilutes their ownership and may reduce their control in the company. For investors, equity financing is a way for them to acquire ownership interest in someone’s company. And once an investor gets a part of a company, they are wary that the subsequent rounds of equity financing would dilute their ownership even more. But if the company is growing fast, then they usually do not mind the dilution as the company’s value grows.
How does equity financing work?
Equity financing involves the sale of company shares in exchange for cash. With this, the person who invests in the company gets a part of the ownership based on the amount of cash they put into the company.
For instance, a founder who invests $5,600,000 in the startup will at first own all the shares of the company. But as the company grows and needs more capital, the owner might seek an outside investor. In this case, let us say that the investor is ready to pay $4,400,000 and the price of the share is $10 at that time. Then the total capital in the company would be raised to $10,000,000 (since the original $5,600,000 invested would still be worth $5,600,000). Now, the founder would control 56% of the company and 44% by the new investor (assuming the share price stays constant).
Advantages and Disadvantages of Equity Financing
Equity financing is usually more appropriate than getting a loan from the bank. Why? Let us look at the advantages of equity financing to understand this more as well as discuss the disadvantages to this.
Advantages of equity financing
- Investors are usually prepared to offer follow-up funding as the business grows.
- Just like you, the investors have a vested interest in the success of the business and its growth.
- Angel investors and VCs bring their experience, contacts, and valuable skills to your business that helps it grow. They can also guide you with key decisions and strategy making.
- Investors expect the company to deliver value, so they always help in exploring and executing growth ideas.
- You would not have to keep cash to pay back loans or debt in this case.
- All the money that comes into the company can be retained or used to grow the business.
- Even though you are sharing a part of the company, as the value of the company increases, the part you own would become worth more.
Disadvantages of equity financing
- There can be regulatory and legal issues that have to be complied with when raising equity financing.
- You will have to give a lot of time to the business and offer regular updates to the investors as they monitor the company growth.
- Based on the kind of investor joining your company, you might lose a certain amount of control.
- Investors do look into the background information about you and your company. They will want to see good results in your past and will also interview your management team if needed. Even though this is a disadvantage, a lot of companies find this part a positive aspect of getting equity financing.
- Raising equity finance is demanding, costly and time consuming, and may take management focus away from the core business activities.
Equity Financing vs Debt Financing
As mentioned initially, there are two ways by which a company can raise funds, debt financing and equity financing. You already know what equity financing is all about, so let us understand what debt financing is to know about their difference.
Debt financing involves the borrowing of money and paying it back with interest. Companies take money in form of loans from financing institutions, like banks. There are a lot of benefits to this. For instance, the lender has no control over your company. As soon as you give the loan back, the relationship with the financer ends. Additionally, the interest that you pay can be deducted in your tax return. It’s also easier to forecast expenses as there are no fluctuations in the loan repayments.
But what happens if your company goes through a bad time, or a bankruptcy, what happens then? And what if the company does not grow as you expected it to? Well, in that case, you still have debt to pay, which may cause a lot of cash flow issues. This is why many growing startups choose to go with equity financing.
Equity financing involves selling a portion of your company’s equity for capital. Here, you do not have to worry about giving anything back and if the company fails, you don’t need to return the funds to the investors. So, there is no financial burden on the company or on you for this. But the investors get to control your company as they get a part of it and its profits. And the only way out of this is by buying the investor out.
Equity Financing vs Debt Financing Example
Let us now take an example to understand this better. Assuming there is a company, Best Services, that wants to expand their business by buying a new factory and buying some new equipment. The company needs about $40 million capital for these. To get this amount now, the company decides to get a combination of both debt and equity financing.
For equity financing, the company sells about 20% of its stake to a venture capitalist for $30 million capital in exchange. And the rest of the amount is obtained via debt financing. For this, the company goes to a bank and requests $10 million with an annual interest rate of 4% with a maturity date of five years.
Now, this is just a simple example. There can be any number of combinations of this scenario. And each example would have a different outcome. For instance, if the company decided to raise capital just with equity financing, the amount of ownership that the owners would have to give up would be more. This would reduce their decision-making power and share of future profits. On the other hand, if they decide to use only debt financing, their monthly expenses would be very high and this would leave less cash in hand to help the company. Things can get tough for them. It would also add a huge debt burden on them.
Manage Company Equity on Eqvista
So if you are about to give out equity to obtain equity financing for your business, just ensure that you keep track of all the shares you give out. For this, you need a cap table application like Eqvista.
Eqvista is a FREE application that operates with advanced technology, allowing you to keep track and manage all your company shares. It is easy to create a cap table and analyze all your company’s ownership in one place so you can start making smart financial decisions for your company.