A company has the option of financing operations by using equity, debt, or both. Equity is the value of a businesses’ assets after deducting liabilities. Essentially, it is cash that is paid into the business by the owner or by investors. This cash can be used for short term expenses, long-term needs, or simply to cover operational costs. Examples of business equity may include common stock, preferred stock, retained earnings, additional paid-in capital, and more. Equity financing can be defined as a method of gaining working capital by selling shares of the company. Shares are typically issued in the amount of the investment provided. Investors will provide cash into a business, in hopes that the value of the stock will appreciate. This financing may be provided by alternative financing companies, angel investors, or even family/friends.
Components of Equity Financing
Equity financing is more favorable to startup businesses that are seeking growth. This financing can fund a business, finance risky businesses, help manage existing debt, and overall will help build valuable connections with investors.
Investors are actively seeking opportunities with growing businesses, indicating a mutual dedication to elevating the business. Since investors are receiving a portion of shares, businesses and investors may run into differences. Whether it is from the strategic direction they want the business to go in, or how to manage everyday operations.
Having aligned goals, similar ideas, and an understanding partnership is key to building a strong business. Business owners should invest 51% of the equity themselves to maintain control over their business. Business owners seeking equity financing may need to create a formal business plan, including current and future financial projections, to present to potential investors.
Equity Financing Methods
There are two methods that businesses can use to obtain equity financing; they can use private placements of stock with investors or initial public stock offerings (IPO).
Companies release private placements of stocks for sale to investors such as investment banks, pensions, or mutual funds, instead of on the open market. Startup businesses typically use private placements when seeking a smaller amount of capital. This method does not require formal registration with the Securities and Exchange Commission, and has few regulatory requirements.
For a public stock offering, the registration process tends to be longer and more expensive. This method is most used by mature companies. Multiple investors share ownership, rather than just one venture capital firm maintaining sole ownership. An IPO will have access to help from an underwriting firm. This firm can assist businesses in determining what security to issue, setting favorable pricing for offers, determining the number of shares to be issued, and more. In contrast to private placements, an IPO is under regulation by the Securities and Exchange Commission and businesses must report criteria regularly.
Debt vs. Equity Financing
Equity financing places no financial burdens on a company, but a business will sell a portion of their equity. The business has no obligation to return the cash provided by investors; however, in return, investors will have some control over the company.The only way to omit investors, is to buy them out. For debt financing, a business sells fixed-income loans or securities to investors. Businesses must repay the amount borrowed, plus interest. Essentially, this type of financing is a gamble on a businesses’ ability to pay back a loan. A lender will own no shares of the company, and once the loan is repaid, the partnership may end, without the need of buying them out.