Equity Financing

What is equity financing?

Equity financing is a business funding method that involves selling company shares to raise business capital. Businesses use this approach to sell equity instruments like share warrants, preferred shares, or common stock to meet long-term goals, operational capital, or growth investment needs.

Startups raise seed money or expansion funds with equity financing. Some businesses also conduct multiple equity financing rounds or go for an initial public offering (IPO). Organizations use equity management software to track issuance, receive 409A valuations, and manage capitalization tables.

Equity financing investors receive company ownership proportionate to their investments. Each share corresponds to a single ownership unit. For example, an owner with 1,000 out of 10,000 total shares issued owns 10% of the company. Additional shares further dilute the business ownership.

Investors consider a company’s valuation or total worth before investing. Unlike business loans, equity finance doesn’t carry repayment obligations. Once investors buy shares, they can profit from dividends or selling their shares. 

Importance of equity financing

Equity financing helps companies sell stock shares to raise funds for growth. Businesses prefer equity financing because of less risks than debt financing. Plus, they can avoid credit problems or operating cash flow issues. Moreover, equity financing offers businesses the flexibility to sell shares at will.

Types of equity financing

Equity funding comes from multiple sources, including personal assets, savings, inheritance, and external investment. External investors exchange investment for ownership. Businesses turn to the following external equity funding sources for business financing.

• Angel investors are high-net-worth individuals who back small startups in exchange for ownership equity. These investors can guide businesses in planning and execution because of their industry experience. Angel investors are also known as angel funders or seed investors.
• Venture capitalists are private equity investors who invest large amounts of money in well-managed companies with high growth potential. These professional investors aim to maximize their return on investment (ROI) by actively participating in major business decisions. Companies generally raise more than a million from venture capitalists to go public in the long run.
• Equity crowdfunding empowers companies to raise funds from large groups of angel investors. Businesses rely on business finance providers to create crowdfunding campaigns and sell company securities in exchange for capital investments.
• Public offering sells equity shares or company bonds to raise business capital. Companies resort to this financing mode to expand their business, meet operational expenses, or make strategic investments. Young startups issue IPO to sell first-time corporate stocks to the public and participate in public trading. 

Equity financing process

Companies need to prepare key business documents before approaching investors.

• Business plan summarizes the proposal and financials
• Financials reveal a company’s historical and projected financial health
• Use of proceeds shows capital investment deployment methods over time
• Capitalization table states equity holders with ownership percentages and investments

• Identify and qualify prospective investors
• Reach investors with proposals and executive summary
• Write a business plan with full financials
• Organize an initial meeting to pitch in person
• Conduct investor due diligence to validate assumptions and look into return potential
• Close the  investment upon fund transfer

Equity financing considerations

Local or national security authorities govern equity financing rules in most jurisdictions. These regulations protect the public from investing in dishonest companies that may disappear with financing proceeds. For this reason, equity financing requires companies to offer a prospectus or memorandum detailing the company activities, risk factors, investment usage, and financial statements. 

Market conditions affect equity investors' risk appetite. Steady business financing shows confidence, while rapid investment indicates excessive optimism. The financing pace slows during market corrections as investors experience risk aversion. 

Companies seeking equity financing consider three factors:

1. State of company cash flow
2. Easy accessibility of funding source
3. Importance for principal owners to have complete company control

Equity financing advantages

Businesses raise equity money for the following benefits.

• Reduced burden: Unlike loans, equity financing doesn’t require companies to pay loans or interests immediately. This lack of repayment pressure helps them invest in business growth even with no immediate ROI.
• Less credit issues: Businesses with a poor credit history or unstable financial track record are often ineligible for loans. The interest rate on debt can also be too high for them. That’s why businesses with bad creditworthiness often go for equity financing.
• Stabilized cash flow: Debt repayments burn cash and leave little room for financing growth. Equity financing helps businesses stabilize cash flow and realize long-term plans with investments.
• Informal partnerships: Entrepreneurs raising equity investment learn from their investors' knowledge and network over time.

Debt financing vs. equity financing

Equity financing involves selling company ownership stakes for investment. Common types of equity financing include raising funds from venture capitalists, angel investors, equity crowdfunding, and IPO. Businesses consider equity financing to avoid debt, find partners, or inject funds into business operations.  

Debt financing involves borrowing money against capital repayment with interest. Common forms of debt financing include term loans, business credit lines, credit cards, invoice factoring, and business personal loans. This funding method is ideal for companies that don’t want to share ownership control or pay tax-deductible interest.