What is Equity Financing?
Equity financing involves firms raising capital by selling shares or an ownership stake in their company. Companies can use this capital to fund their operations and growth through investing in PP&E or to fund an M&A transaction. There are many sources of equity financing, such as the personal capital of the business founders, other private investors, or the public via equity capital markets. The term equity financing applies both to publicly listed companies as well as private companies.
Key Learning Points
- Equity financing involves firms raising capital by selling shares or an ownership stake in their company
- Companies can use this capital to fund their operations and growth, through investment in PP&E and other assets to generate future economic benefits
- Equity financing is more expensive compared to debt financing and is typically more favorable to start ups and companies with growth opportunity
- Advantages of equity financing include; no obligation to repay the money raised from investors as well as no fixed costs (interest expense) related to borrowing
Understanding Equity Financing
Businesses require a sufficient source of financing to fund their operating activities as well as cash commitments for investing and financing activities for their foreseeable future. There are broadly two ways of raising funds: 1) equity financing and 2) debt financing.
In equity financing, the business is not obligated to return the investors’ funds, as would typically be the case for debt financing. Their rewards stem from a potential increase in the value of the shares and from profits distributed in the form of dividends. The risk they bear is a drop in share price or a lack of expected dividend payments. Finally, if a company goes bankrupt, shareholders will be paid out last from any remaining assets within the company and may well lose their entire investment.
A company may use equity financing at several stages during its lifecycle. Very fast-growing or start-up businesses will often have negative operating and investing cash flows. These will typically be financed by equity because such companies may find it hard to obtain debt financing, due to concerns from lenders about the company’s ability to meet interest and principal repayments.
Mature businesses are more likely to be generating consistent positive cash flows from their operations and as such, will have better creditworthiness, due to their greater ease at meeting interest and principal payments. Such companies are more likely to rely on debt financing for any funding needs. However, during an economic downturn, even mature businesses may rely on equity financing if they are unable to borrow through the debt markets. Equity financing is also more expensive when compared to debt financing.
Understanding Debt Financing
Debt financing involves borrowing money on the condition of repaying the amount borrowed (principal) and additional compensation in the form of interest payments. Companies can raise debt financing through private sources (banks and financial institutions) or public sources (issuing bonds through securities markets).
Equity Financing: Key Terminologies Explained
Type of equity financing
Most companies use two types of equity financing: 1) common stock and 2) preferred stock. Companies must have common stockholders, since they are the owners of the business, and they typically form the vast majority of shareholders in an organization. Preferred shareholders enjoy preferential rights compared to common shareholders since they must receive dividends before common holders and in bankruptcy, they have first claims on any remaining assets of the business after all creditors have been paid, however, they are typically only entitled to a fixed dividend or the par value of the shares in a liquidation.
Initial Public Offering
An initial public offering (IPO) is when a company which previously only had privately held shares, sells shares to the public for the first time. This is typically done to allow the company to sell new shares to a wider group of potential invests to raise capital for the company In addition following an IPO, existing private investors will be able to observe the share price continuously and be able to sell their shares on the secondary market.
A rights issue allows existing shareholders to buy additional shares at a discounted price. Unlike normal equity financing, which is raised from the general public, a rights issue is offered only to a company’s existing shareholders, however, those shareholders can typically sell their rights if they do not which to provide more capital to the company through purchasing the shares on offer.
Equity financing places fewer restrictions on a company to debt financing. Unlike debt financing, even firms with no or unstable cash flows can raise equity financing, since there is no obligation to repay the money raised from investors, and there are no ongoing required payments, as would be the case with interest on a loan.
However, raising funds from the public involves substantial regulatory requirements. Countries generally put laws in place to protect the common public from unscrupulous or fraudulent businesses trying to raising equity financing through an IPO.
The main disadvantage of equity financing is a loss of voting power since there will be shares in issuance which have voting rights attached to them, held by new investors. A key deciding factor between choosing debt and equity financing is how important it is for the founders to retain their business control.