What Is Equity Financing?
Equity financing occurs when a company aims to raise capital by offering investors partial ownership interest in the company. This type of financing allows the company to raise enough funds without taking out loans or incurring any debt. A business that wants to grow – but doesn’t have enough revenue or additional cash – may want to turn to investors to fund its growth.
How Does Equity Financing Work?
Equity financing involves the sale of the company's stock. A portion of the company’s ownership is given to investors in exchange for cash. That proportion depends on how much the owner has invested in the company – and what that investment is worth at the time of financing.
Ultimately, the final arrangement will be up to the company and investor. For smaller and private companies, the process typically involves some form of written agreement. For larger and public companies, the arrangement can be more complex (e.g. IPO offerings).
Is Equity Financing Long Term?
Equity capital is considered long-term. If the equity is publicly traded, investors may sell to other investors at any time, but the company can consider the equity to be long-term financing.
Common Types of Equity Financing
There are multiple ways that businesses can raise capital through equity financing:
1. Angel Investors
Angel investors are individuals who specifically provide funding for businesses. They typically have a sizable amount of cash on hand and are looking for good returns on their investments. Most angel investors look to fund startups or early-stage companies because they can shape the direction of the business from the beginning.
2. Mezzanine Financing
Mezzanine financing combines debt and equity financing. Typically, medium-sized businesses select this type of funding because it counts as equity on a company's balance sheet and provides businesses with a lower debt-to-equity ratio. The less a business relies on debt to fund their operations, the less risk there is. Therefore, this option can help attract more investors.
3. Royalty Financing
Also known as revenue commission, royalty financing occurs when investors provide cash for a company's expenses in exchange for a percentage of a product's sales. Since investors expect to receive immediate payments, the business needs to prove it's already generating revenue.
To determine whether it’s worth the investment, investors will want to look at proof such as profit and loss statements and/or a company’s balance sheet.
4. Venture Capital Firms
Venture capital firms) are entities which provide funding to business in return for ownership or shares. Like angel investors, venture capital firms also look to invest in businesses that offer high rates of return. These firms use combined funds from multiple professional investors.
To “guarantee” growth, some venture capitalists will want to sit on the company board or take a mentoring approach to help its leaders. Venture capital firms will plan to exit from their equity position by selling the company to an acquiring company or by taking it public with its own IPO.
5. Initial Public Offering (IPO)
This type of financing occurs when a company chooses to offer shares on a publicly traded market for the first time. Since the company wants to transition to a publicly-traded company, it needs to comply with SEC guidelines.
Before shares become publicly available, companies will need to publish a prospectus, including detailed financial statements, to attract investors.
Crowdfunding involves selling shares of a company to the public. In other words, privately-held businesses attempt to raise money by selling part-ownership of a company to the public, usually through an unconventional channel such as social media.
Debt Financing vs. Equity Financing
Equity financing offers partial ownership of your business in return for a lump sum of money. The investor becomes a stakeholder in the company and therefore has a say in running it.
Debt financing on the other hand, occurs when business owners raise money by taking on loans. Investors who lend the company money become creditors and the company will pay the investors both the principal and a predetermined amount of interest.
Is Equity Financing More Expensive?
Equity financing is more expensive because the investor has a claim in a portion of the business’ future earnings. In debt financing, a business only has to pay back a loan after a predetermined amount of time.
How to Get Equity Financing
The two main methods of obtaining equity financing are by seeking private funding sources or offering up public shares of the company. Private funding methods tend to be simpler since they don’t require as many formalities as public offerings.
For instance, private sources of funding tend to require that the company strikes an agreement directly with the investor, while offering up public shares is a more complicated legal process. In either case, companies will need to create a business plan (including financial projections) to show potential investors that its leaders have the expertise to grow and sustain the company.
How to Calculate Equity Financing
The shareholder offers an initial amount for a percentage in the company, and the total amount of capital in the company grows. As the company’s valuation continues to increase, so will the shareholder’s.
For example, a company is currently valued at $600,000 and an investor wants to invest $400,000 for a total company value of $1 million. The company owner(s) would then control 60% of the shares of the company, having sold 40% of the shares of the company to the investor through equity financing.
Equity Financing Examples
Let’s take a look at some equity financing examples.
Equity Financing Example #1
Let’s say an investor offers $100,000 for a 10% stake in Company ABC. This means the current value of Company ABC would be $1 million ($100,000 * 10 = $1 million, or 100% of the company’s capital).
In five years, Company ABC is valued at $2 million. This would mean that the investor’s share would be worth $200,000 – twice the original funding amount.
Equity Financing Example #2
Company XYZ generates $1 million in product sales and wants to grow even more. An investor wants to create a royalty financing agreement where it provides Company XYZ with $50,000 for 6% of its revenue each year.
This means if Company XYZ generated $1 million, the investor would receive $60,000 each year. Or, if sales grew to $2 million annually, the investor would make $120,000 annually.
Pros of Equity Financing
There are plenty of benefits of equity financing:
Investors in companies may have access to a large network who can potentially help them grow (whether that’s attracting more investors or mentoring opportunities).
Getting money from shareholders is not as risky as incurring debt. If the business doesn’t generate as much revenue (or worse, goes bankrupt), investors won’t expect repayment.
Flexibility with Funds
Money from investors can be used by the company to grow or increase revenue. Depending on the arrangement, there may also be no obligation to pay it back in regular installments.
Cons of Equity Financing
Although equity financing can be beneficial to many companies, there are some pitfalls to watch out for:
More Time Spent on Bookkeeping
Since investors and/or stakeholders need to see how the company is faring, it’s especially important that accounting and reporting are updated and accurate. To put it another way, investors want to see how the company’s finances are doing, so companies need to be able to show that to them.
To receive funding, companies will have to relinquish control over how some things are run.
Table of Contents
- What Is Equity Financing?
- How Does Equity Financing Work?
- Common Types of Equity Financing
- Debt Financing vs. Equity Financing
- How to Get Equity Financing
- How to Calculate Equity Financing
- Equity Financing Examples
- Pros of Equity Financing
- Cons of Equity Financing