In a nutshell, equity financing is the process of selling ownership in a company in exchange for money, either to meet short term expenses or long-term expansion plans. Equity finance is an attractive and low-risk path for a business since it doesn’t have any strict repayment schedules and does not result in a charge on any existing company assets.
In this guide, we discuss what equity finance is, how it works and how it is different from other forms of financing.
What Is Equity Finance?
One of the most popular ways to fund a business or project, Equity Finance is a method of raising capital through the sale of the company’s shares to investors.
Businesses need to raise funds for different purposes. They may want capital to pay the bills and expenses or want some funds to achieve long-term goals like growth and expansion.
Equity finance or equity funding can come from various sources like friends and family of the business owner, individual investors, public offering or financial institutions.
The people who buy the shares are called shareholders of the company as they get ownership in the business. Equity Finance generally applies to finance of companies listed on an exchange though it can be used for private companies as well.
How Equity Finance Works?
Start-ups or small businesses may find it difficult to get a bank loan as they don’t have enough assets or revenue. Such organizations turn to equity funding to avoid paying interests on loans and debts.
A start-up generally attracts different types of investors at different stages of its growth and uses various instruments of equity to meet its financial needs.
Apart from public offerings, companies generally use Venture Capital financing to raise funds from accredited investors looking for high-risk high-reward investment opportunities.
These investors generally prefer bigger companies with considerable growth potential. Another source of equity financing is Business Angels who favour small, start-up companies, which may not even be operational or generate any revenue.
As the company grows and makes profits on a consistent basis, it can decide to go public. At this time, the investors can sell the shares to retail investors and institutions at a premium.
For equity finance, a company needs to come up with a prospectus containing its financial details. It also needs to explain what it aims to do with the raised capital.
Why Choose Equity Finance?
This form of fund raising has numerous benefits. When the capital comes from equity finance, it can be put into business operations without having to worry about any repayments. Here are some of the pros of equity finance explained.
Equity finance is less risky as compared to bank loans. Even when your business doesn’t perform as expected and all the investor funding is lost, you don’t suffer from any consequences from the investment. It is not a type of debt so it doesn’t affect your credit history as well.
Funds that you receive from equity financing belong to you and you are free to use it as you like. You don’t need to worry about repaying the money back. Moreover, though investors want the business to grow, you are not legally obliged to do well.
This means equity finance improves your financial condition without having to commit to any legal obligations.
Equity financing adds investors and venture capitalists to the business and involves them directly with the company.
These investors can add their expertise, skills, contacts and knowledge to the business. They can introduce you to a wider network of people to get newer opportunities for finance.
Reasons Not To Choose Equity Finance?
Though there are lots of advantages to equity finance for businesses, there are some drawbacks as well.
The process of finding and attracting investors demands a lot of time and effort. Here are some of the cons of equity finance explained.
Giving Up Ownership
Every time you raise funds by selling shares in your business, you are losing ownership of the business, and overtime, you may no longer hold the necessary majority to control and guide your organization.
There have been numerous instances of startup founders losing their companies to investors, after losing majority ownership of the company.
Focus On Accounting & Reporting
You should devote time to reporting when you have investors. They demand regular accounting of how their investment is performing.
While lenders just care about monthly repayments, investors often want detailed insight into the financials and operations of the business. They might even demand changes to the functioning of your organization in order to raise more funds.
Dealing With Investor Interference
Business owners should give some control over the decision-making in the business to the investors.
They can be difficult to handle as they can disagree with the way you run the business. They can even vote against your ideas at board meetings.
Equity Finance Vs Debt Finance
Any business that needs capital can raise it through two methods – equity finance and debt finance.
Both these modes give the company quick access to funds though they both differ in many respects.
The major difference lies in the idea behind their working – equity gives moderate freedom with cheaper funding while debt incurs a higher cost for a greater level of freedom.
Investors who provide equity funding generally expect profit and growth from the business and are interested in keeping track of how it is doing.
They might also influence the decisions about business operations and finances. Lenders, on the other hand, don’t have expectations from the business.
They are only interested in loan repayments and don’t care about how the business is doing. Once the loan is repaid, the relationship comes to an end and there are no future obligations.
Equity finance is one of the most effective ways for businesses to raise capital to fund their expenses and operations. However, it is more suitable for small-scale and startup businesses that don’t have access to other means of raising capital like bank loans and grants.