Equity Financing: Sources, Advantages & Disadvantages

  • Bhumika Dutta
  • Aug 22, 2021
  • Financial Analytics
Equity Financing: Sources, Advantages & Disadvantages title banner

Equity Financing

 

Financing is a hot topic of discussion in today’s world. As people are getting more aware of different methods of managing and gaining capital, they are starting to look into different methods. If one is an enthusiast about finance, they might have heard of Equity Finance by now. 

 

Equity finance is a method in financial analytics that raises capital through the sale of shares. To earn cash, the company basically sells ownership of the company by selling shares. They raise the money to fulfill short-term needs like bill payments or long-term needs like an investment of funds for the growth of the company. 

 

To practice equity financing, companies can sell all equity instruments like common stock, preferred shares, share warrants, etc. To fund plant assets and early operational expenditures, equity financing is especially crucial during a company's starting stage. Investors profit from dividends or when the value of their stock rises. 

 

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Some of us might confuse equity financing with debt financing as both of them are used as options by companies to raise funds, but both of these are completely different concepts. Debt financing involves borrowing money, mostly in the form of loans. 

 

In case of debt financing, companies are required to repay the amount along with interest, which is different from equity financing as it carries no repayment obligation. 

 

There are a few advantages of debt financing over equity financing is that the lender has no control over the company’s decisions or operations and on repayment, all the relations between the company and the financial institution ends. This is different in the case of Equity financing as once the companies choose to raise money by selling equity shares to investors must share earnings with these investors and consult with them whenever they make decisions that affect the entire firm. 

 

If a firm sells a percentage of its stock to investors, the only way to get rid of them (and their interest in the company) is to repurchase their shares, which is known as a buy-out. The cost of repurchasing the shares, however, will almost certainly be more than the initial purchase price. Usually companies use a mix of both debt financing and equity financing to raise funds.

 

Just like debt financing, equity financing has its own advantages and disadvantages. In this article, we are going to discuss the working and  list out the sources, advantages, and disadvantages of Equity financing.

 

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Working of Equity Financing

 

The selling of common equity, as well as other equity or quasi-equity instruments such as preferred stock, convertible preferred stock, and equity units that comprise common shares and warrants, is part of equity financing. 

 

On the evolution of any startup to a full-fledged company, it will have several rounds of equity financing. Because a startup generally draws a variety of investors at different phases of its development, it may employ a variety of equity instruments to meet its funding needs. 

 

Let us talk about a practical example. Generally, in the initial period of any startup, Angel investors and venture capitalists are the first investors. When it comes to investing in new businesses, they choose convertible preferred shares over common stock since the former has more upside potential and some downside protection. 

 

When the firm has developed to the point where it may consider going public, it may offer common stock to institutional and individual investors. If the firm needs more money later, it can turn to secondary equity financing alternatives like a rights offering or an equity unit offering with possibilities as an incentive. Let us now define all the major sources of equity financing.

 

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Main Sources of Equity Financing

 

According to CFI (source), the following are the major sources of funding of Equity Financing:

 

  1. Angel Investors:

 

Angel investors are affluent individuals who invest in companies they feel will create better profits in the future. Individuals often bring their business talents, expertise, and connections to the table, which benefits the firm over time.

 

 

  1. Crowdfunding platforms:

 

Crowdfunding systems allow a large number of people to make modest investments in a firm. Members of the public choose to invest in businesses because they trust in their concepts and expect to see a return on their investment in the future. The public donations are added together to arrive at a goal total.

 

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  1. Venture capital firms:

 

Venture capital firms are a collection of investors that make investments in companies they believe will expand rapidly and eventually be listed on stock markets. In comparison to angel investors, they invest a bigger quantity of money and obtain a larger interest in the firm. Private equity financing is another name for this approach.

 

 

  1. Corporate Investors:

 

Corporate investors are major corporations that make investments in private firms to help them raise capital. Typically, the investment is made to form a strategic partnership between the two companies.

 

 

  1. IPOs:

 

An initial public offering (IPO) is a way for more established companies to raise money (IPO). The initial public offering (IPO) allows businesses to raise cash by selling shares to the general public for trading on the stock exchange. (As discussing stock exchanges, explore largest stock exchanges in the world)


 

Advantages of Equity Financing

 

  1. Alternative Funding Source to debt:

 

Alternative funding source to debt is the main advantage of equity financing over any other financing. Angel investors, venture capitalists, and crowdfunding platforms can help startups that don't qualify for significant bank loans meet their expenditures. There is no debt to repay with equity financing. 

 

The company does not have to make a monthly loan payment, which is especially significant if the company does not produce a profit right away. Because the firm does not have to repay its shareholders, equity financing is seen as less risky than debt financing in this situation. 

 

Typically, investors focus on the long term and do not expect a quick return on their investment. Instead of focusing on debt repayment and interest, it allows the firm to reinvest cash flow from activities to develop the business. (From)
 

 

  1. Access to capital sources:

 

The management of a firm can also benefit from equity funding. Some investors are personally driven to contribute to a company's success and want to be involved in its operations. 

 

Their successful histories enable them to offer crucial support in the form of business contacts, managerial knowledge, and access to additional financial sources. 

 

Many angel investors and venture capitalists are willing to help businesses in this way. It is critical throughout the early stages of a company's development. 

 

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Disadvantages of Equity Finance

 

  1. Distribution of Ownership:

 

The major drawback of equity financing is that it requires business owners to relinquish a portion of their ownership and control. If the business becomes lucrative and successful in the future, a portion of the earnings must be distributed to shareholders in the form of dividends. 

 

Many venture funders want a 30% to 50%  ownership investment, especially from businesses with little financial experience. Many business owners and founders are hesitant to give up so much control of their firm, which restricts their equity funding choices. 

 

Hence, to get access to all the advantages of equity financing, the price to pay is to share complete control of the company.

 

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  1. Lack of tax shields:

 

In comparison to debt, equity investments provide no tax benefits. Dividends paid to shareholders are not deductible expenses, but interest payments are. The cost of equity borrowing rises as a result. 

 

In the long run, equity financing is regarded to be more expensive than debt financing. Because investors want a larger rate of return than lenders, this is the case. When investing a business, investors take on a lot of risk, thus they anticipate a larger return.

 

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Conclusion

 

Equity Financing is a great way to raise finances for the benefit of the company. There are a few deciding factors that the company must contemplate on, before starting. This could be a better option to choose if creditworthiness is an issue. 

 

But, the owners of the company will also have to decide if they are actually ready to share the control, decision making and profits of their company with their equity partners. If the owner believes that the company can earn huge profits in the future, they can opt for loans that they can repay, instead of selling shares.

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