Equity financing refers to the sale of company shares in order to raise capital. Investors who purchase the shares are also purchasing ownership rights to the company. Equity financing can refer to the sale of all equity instruments, such as common stock, preferred shares, share warrants, etc.
Equity financing is especially important during a company’s startup stage to finance plant assets and initial operating expenses. Investors make gains by receiving dividends or when their shares increase in price.
Major Sources of Equity Financing
When a company is still private, equity financing can be raised from angel investors, crowdfunding platforms, venture capital firms, or corporate investors. Ultimately, shares can be sold to the public in the form of an IPO.
1. Angel investors
Angel investors are wealthy individuals who purchase stakes in businesses that they believe possess the potential to generate higher returns in the future. The individuals usually bring their business skills, experience, and connections to the table, which helps the company in the long term.
2. Crowdfunding platforms
Crowdfunding platforms allow for a number of people in the public to invest in the company in small amounts. Members of the public decide to invest in the companies because they believe in their ideas and hope to earn their money back with returns in the future. The contributions from the public are summed up to reach a target total.
3. Venture capital firms
Venture capital firms are a group of investors who invest in businesses they think will grow at a rapid pace and will appear on stock exchanges in the future. They invest a larger sum of money into businesses and receive a larger stake in the company compared to angel investors. The method is also referred to as private equity financing.
4. Corporate investors
Corporate investors are large companies that invest in private companies to provide them with the necessary funding. The investment is usually created to establish a strategic partnership between the two businesses.
5. Initial public offerings (IPOs)
Companies that are more well-established can raise funding with an initial public offering (IPO). The IPO allows companies to raise funds by offering its shares to the public for trading in the capital markets.
Advantages of Equity Financing
1. Alternative funding source
The main advantage of equity financing is that it offers companies an alternative funding source to debt. Startups that may not qualify for large bank loans can acquire funding from angel investors, venture capitalists, or crowdfunding platforms to cover their costs. In this case, equity financing is viewed as less risky than debt financing because the company does not have to pay back its shareholders.
Investors typically focus on the long term without expecting an immediate return on their investment. It allows the company to reinvest the cash flow from its operations to grow the business rather than focusing on debt repayment and interest.
2. Access to business contacts, management expertise, and other sources of capital
Equity financing also provides certain advantages to company management. Some investors wish to be involved in company operations and are personally motivated to contribute to a company’s growth.
Their successful backgrounds allow them to provide invaluable assistance in the form of business contacts, management expertise, and access to other sources of capital. Many angel investors or venture capitalists will assist companies in this manner. It is crucial in the startup period of a company.
Disadvantages of Equity Financing
1. Dilution of ownership and operational control
The main disadvantage to equity financing is that company owners must give up a portion of their ownership and dilute their control. If the company becomes profitable and successful in the future, a certain percentage of company profits must also be given to shareholders in the form of dividends.
Many venture capitalists request an equity stake of 30%-50%, especially for startups that lack a strong financial background. Many company founders and owners are unwilling to dilute such an amount of their corporate power, which limits their options for equity financing.
2. Lack of tax shields
Compared to debt, equity investments offer no tax shield. Dividends distributed to shareholders are not a tax-deductible expense, whereas interest payments are eligible for tax benefits. It adds to the cost of equity financing.
In the long term, equity financing is considered to be a more costly form of financing than debt. It is because investors require a higher rate of return than lenders. Investors incur a high risk when funding a company, and therefore expect a higher return.
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