What Is Equity Financing?
Equity financing involves owners or executives of a company raising capital through the sale of shares of company ownership. By selling a piece of ownership in their company, a business can raise money for operations, expansion, or development. Usually, equity comes in the form of shares. However, it can also include such things as options or warrants.
Equity financing is different from debt financing. In debt financing, a company takes a loan from a financier and repays it with interest either in installments or in a lump sum. In equity financing, a company sells shares to raise funds, but they are not indebted to the shareholders. Instead, the shareholders get rewarded because their share of ownership rises in value if the company succeeds.
Shareholders who purchase equity in a company can also bring new insights to a business and help with strategy, development, and planning.
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How Equity Financing Works
Equity financing requires a business’s founders to create a company structure that allows for the selling of shares. Both public and private companies can offer ownership in this way. However, a company needs to be incorporated to pursue equity financing. This step is vital because some entrepreneurs begin startups with simpler structures and need to go through the incorporation process before they can start seeking equity financing.
Each piece of equity is a share, and a share entitles the shareholder to a specific portion of the company. If a company issues 10,000 shares, for example, then a shareholder who owns 2,000 shares has a 20% stake in the company. There are different classes of shares. Some entitle owners to a vote on important company decisions at shareholder meetings, while others come with various benefits. There are three major types of shares in equity financing.
Class A shares are the most basic shares issued by a company. These shares give voting rights to investors who hold them. Also, Class A shareholders get dividends whenever a company offers them.
Class A shares are typically more expensive than class B shares. For example, Warren Buffet’s company, Berkshire Hathaway, has Class A and Class B shares. As of this writing, the Class A shares trade at $344,970 while the Bs trade at $230. Some companies use Class A shares to give more control to a single person or group of people in the affairs of the company. These shareholders have more decision-making power than investors in other share classes.
Owners of Class B shares have no voting rights (or limited voting rights, in some cases). They usually do not earn dividends. Owners of B shares can still make money from them by selling them on the open market, but they don’t have a say in company policy or plans like Class A shareholders.
Preferred shares are popular among angel investors and venture capitalists. They offer a fixed dividend, whether the company is paying dividends on other classes of shares or not. When it comes to dividends, preferred shareholders often have priority over other share classes.
At the same time, preferred shareholders do not have voting rights, so they are not involved in the strategic direction or development of the company.
Equity Financing Sources
Equity financing can come from a variety of sources. In many cases, offering shares is not the first step in forming a business, but it is an important step in a company’s development.
An entrepreneur or startup may take on debt to get their company to the point where it can be incorporated and have a product or service to attract investors.
Angel investors are often the first outside investors in a business. Sometimes, they are friends of the business owner or people who have some kind of personal or professional connection to the owner or someone in their company.
In some cases, angel investors are groups or individuals who like to support small business people financially. They often give favorable terms to the owners and do not involve themselves in the running of the company.
Venture capitalists are professional investors and investment management groups that invest in particular types of businesses. They are quite selective and often look for specific qualities in a company before they consider investing in it. They seek firms with a competitive advantage over others in their industries. They also look for high growth potential and competent management and executive decision-makers.
Venture capitalists are looking to maximize the return on their investment. They often hope that the company will go public through an initial public offering or get bought by a larger company. Both these occurrences usually lead to significant profits for early shareholders.
Venture capitalists typically invest millions of dollars and often like to take on an active role in the management of the company through voting and other hands-on strategies.
Crowdfunding involves entrepreneurs recruiting shareholders from members of the general public. Angel investors and venture capitalists usually invest large amounts of money, but with crowdfunding, many investors contribute small amounts of money. Businesses usually seek this type of equity financing through online crowdfunding platforms.
These investors are often similar to angel investors because they are interested in supporting the business, its mission, or its product. They do not approach investing as venture capitalists do.
Crowdfunding is often an option for small businesses that are trying to grow from individual operations or side hustles into legitimate companies.
Why Is Equity Financing Important?
Raising capital can be a complicated process for small businesses. For newcomers, it’s often hard to get the money required for a new business. Debt financing is an option, but it’s also tough for new companies to obtain. Banks and other financial institutions mostly prefer more mature and established companies when offering debt. Moreover, the interest and principal payments may be overwhelming for a startup trying to stay afloat and build positive cashflow.
One of the significant advantages of equity financing is that the company doesn’t have to repay the money they raise. Investors often see returns on their investment in the form of dividends or capital gains when they sell their shares later. This lack of additional financial burden on the company is perhaps the most significant advantage of equity financing.
Equity financing also presents a huge advantage for investors. The equity financing process is strictly regulated, so both investors and companies have protection from unscrupulous operators or fraudulent investment schemes. With these protections, investors can focus on choosing which investments are best rather than worrying about the legitimacy of a company.
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This post was updated January 30, 2020. It was originally published January 30, 2020.