When a company sells shares to raise capital, it is known as equity financing. When an investor purchases the shares, they become owners. Some of the equity instruments involved in equity financing include:
- Share warrants
- Common stock
- Preferred shares
This type of financing is used during the startup phase to finance initial operating expenses. Investors make money on these shares through dividends or when the shares increase in price.
Sources of Equity Financing
When a company is private, this type of financing can be raised through:
- Corporate investors
- Angel investors
- Venture capital firms
Eventually, when the company goes public, shares can be sold through the public as IPOs (initial public offerings). We’ll look at each of these below:
A crowdfunding platform allows the public to invest small amounts into the company because they believe in their ideas and hope to earn their money back with returns. These contributions are added up to reach a goal.
A corporate investor is a large company that invests in a private one to give them the funds they need. This investment typically establishes a partnership between the two companies.
An angel investor is a wealthy individual who purchases stakes in a business that they believe has the potential to produce high returns. These individuals typically bring connections, business skills, and experience which ultimately help the business.
Venture Capital Firm
A venture capital firm is a conglomeration of investors who invest in a business they believe will grow quickly and ultimately appear on stock exchanges. They invest a large amount of money into the business and receive a larger stake in the business than an angel investor. This is also known as private equity financing.
Initial Public Offering (IPO)
Once a company is established, it can raise funding through IPOs, or initial public offerings. This allows them to offer shares to the public to raise money.
Equity Financing Benefits
There are a couple of benefits of equity financing. We will look at these below:
The Alternative Source of Funding
The primary advantage of this type of financing is that it’s an alternative way to cover their startup costs. If a startup is unable to qualify for a traditional loan, it can turn to angel investors, crowdfunding, or venture capital firms to obtain the funds. Since the company does not have to pay back the shareholders, this type of financing is less risky than debt financing.
Most investors don’t expect an immediate return on investment but focus on the long term instead. This allows the company to reinvest its cash flow to grow the business instead of having to worry about paying back debt with interest.
Access to other sources of capital, business contacts, and management expertise
Another advantage of equity financing is that provides access to additional capital, business contacts, and management expertise. Many times, investors want to be involved with the company’s operations and are motivated to help the company grow.
Their backgrounds give them the ability to offer assistance that is critical to the startup period of the company.
Equity Financing Drawbacks
Of course, as with other types of financing, there are some drawbacks as well. We’ll look at some of those below:
Dilutes Ownership and Control
The primary disadvantage of this type of financing is that the owners must dilute their ownership and control of the company. If the company does become successful and profitable, it must pay dividends to the shareholders.
If the startup doesn’t have a very strong financial background, venture capitalists typically request an equity stake of 30% to 50%. However, many owners are not willing to give up that much, so their options for equity financing are limited.
No Tax Shields
Debt financing has tax shields- equity financing does not. The dividends paid to shareholders are not tax-deductible. Interest payments on debt financing do offer tax benefits. This increases the cost of equity financing.
In the long run, equity financing is more expensive because of the rate of return required by investors.
If you are starting a business and need assistance with financing options, including equity financing, turn to WCK Financial. We can help you get the funds you need.