What Is Equity Financing? Advantages And Disadvantages
Updated 22 August 2023
Equity financing allows a business to raise money through the sales of shares. Raising funds for enhancing business operations, paying short-term bills and achieving long-term financial goals provides flexibility as there is no loan to repay and investors become part owners of the business. Understanding everything about equity financing is essential to understand the advantages of using this financing method for raising capital.
In this article, we answer ‘What is equity financing?', discuss how it works, review the types of equity financing, outline its advantages and disadvantages, see the difference between equity and debt financing and explore the factors to consider when choosing between financing types.
What Is Equity Financing?
Knowing the answer to ‘What is equity financing?' can help you choose between equity financing or debt financing for raising capital. Equity financing is when a business sells shares in return for upfront capital. It primarily refers to the sales of equity instruments, such as preferred shares, common stocks and share warrants. Unlike a loan or debt finance, equity finance has no replacement obligation. Instead, investors buy shares to make money through dividends.
The business can use these funds to fulfil its short-term or long-term obligations. Typically, equity financing comes from several sources, like initial public offering (IPO), private equity investors and family members.
How Does Equity Financing Work?
New and small businesses and startups that do not have substantial assets or revenue might find it challenging to get a loan. Often, such businesses prefer to avoid debt and turn to equity financing. An equity financing agreement gets executed when a business owner signs a mutual agreement with an investor for a set amount of capital for a total percentage of business ownership.
Typically, a larger investment involves a larger stake or ownership percentage. An investor might ask for over 50% stake, so the decision-making power shifts towards the investors. After the first round of equity financing, if a business still requires capital, it can go for a second equity financing round.
Types Of Equity Financing
Here are a few types of equity financing:
Angel investors are wealthy professionals and can be family members or close friends. These investors purchase stakes in a business that they believe has the potential to generate higher returns in the future. Typically, every individual or group that provides financial funding to a business is an angel investor. These investors do not get involved in the day-to-day operations or management of the business.
This type of equity financing includes a group of experienced investors who invest in a business they think might grow at a rapid pace and might get listed on the stock exchange. Before investing, a venture capitalist analyses the concerned industry based on benchmarks. They are selective and focus on investing in well-managed businesses. Venture capitalists invest in a business at a nascent stage and leave when the firm converts to a public company.
In crowdfunding, a business sells its shares to a crowd of people rather than selling them to one or a few key investors. Several people in public can invest small amounts. Typically, the public invests in a business because they plan to earn money back. The owners of a private business sell a part of business ownership to investors on a crowdfunding platform.
Initial public offerings
Established and reputed businesses can raise capital and funding using an initial public offering (IPO). In an IPO, a business offers its shares to the public for trading in the capital markets to generate funds. A business focuses on an IPO only after raising funds through other equity financing methods. This is because the IPO is expensive and time-consuming for a startup.
Advantages Of Equity Financing
Here are a few advantages of using equity financing:
Equity financing is less risky than a bank loan. A business might not face negative repercussions even if it goes bankrupt and loses all the investor's money. Investors cannot expect any money from the business. Because it is not debt, it does not reflect in their credit reports. Equity financing lowers the risk of the burden of debt because investors succeed only when a business succeeds.
Decreases credit problems
If a business has credit issues, equity financing can help the business generate the financial funds required for growth and expansion. When a business faces credit problems, debt financing might not be workable because the interest rate might be too high. It might also be an issue because and payments might be too high to become acceptable.
Expands professional network
Reaching a larger audience can be beneficial when looking for any kind of help in the future. Equity financing introduces business owners to angel investors and venture capitalists, increasing their professional network. These investors might also introduce owners to a broader audience to which they have access.
Provides access to capital sources
Apart from receiving capital, equity financing benefits the management of a business. Some investors might focus on contributing to a company's success and get involved with its operations. The experience of these investors can offer crucial support in terms of knowledge, business contacts and access to financial sources.
Disadvantages Of Equity Financing
Here are a few disadvantages of equity financing:
Results in dilution of ownership
The major disadvantage of equity financing is that business owners give up a portion of their ownership, diluting the control. When a business becomes successful, it shares a certain percentage of profits with shareholders as dividends. An investor might seek a higher equity stake for businesses lacking a solid financial background. This means further dilution of control and ownership. Eventually, when the ownership dilutes by more than 50%, investors hold the decision-making power.
Becomes challenging to handle investors
A business might find it challenging to handle different investors' personalities and opinions. They might disagree with the way an owner runs the business. As investors have voting rights, managing and handling them becomes even more challenging. This primarily means investors can go against a business owner's decision at shareholding meetings.
Takes time to develop a business plan
Even though equity financing does not involve a formal application or lengthy procedure, it is challenging to impress investors and encourage them to provide funding. Before presenting a business to an investor, owners spend a lot of time developing a creative business plan to impress investors. Pitching a business to investors can be more time-consuming and challenging than getting a business loan approved.
Offers no tax shield
Equity investments offer no tax shield. Typically, dividends a business distributes to shareholders are not tax-deductible expenses, whereas interest payments on a loan are tax deductible. In the long term, equity financing is more costly than debt. Investors who invest in a company incur a higher risk, so they expect a higher return.
How Is Equity Financing Different From Debt Financing?
When planning for growth and expansion, a business has two financing options, debt financing and equity financing. In equity financing, a business sells a portion of its ownership, whereas debt financing involves borrowing money. A frequently used debt financing option is a loan, which carries repayment obligations and requires a business to make interest payments along with repaying the principal amount. Often, a business might prefer debt financing because it does not dilute control and ownership.
In debt financing, lenders and creditors have no control over business operations. After repaying the loan, the relationship between a lender and a business ends. Equity financing carries no repayment obligations and shareholders have control and ownership in the decisions. When a business uses equity financing, they consult investors before making decisions that affect the entire business. Investors have certain expectations from a business and they carefully track how it is doing. Often, they might want to influence decisions that the business makes.
What Are The Factors To Consider When Choosing Between Debt And Equity Financing?
Here are a few factors to consider when choosing between debt and equity financing:
Equity financing is a better option if a business's creditworthiness is low.
Use debt financing if a business does not intend to share control and ownership with outsiders.
Use equity financing if a business is more comfortable sharing ownership than repaying a large loan with interest.
If a business is confident of generating a healthy profit, consider opting for a loan than sharing profits.
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