Everything You Need to Know About Equity Financing

Updated · Aug 30, 2022

Every business needs capital to grow and expand, and there are different ways to get it.

Below, we discuss one of the most common ones—equity financing.

Read on to learn:

  • How it works
  • What are the different types of investors and equity accounts?
  • Which is better—equity finance or a loan?

What Is Equity Financing?

The definition of equity financing is a method for raising money by selling company shares. Typically, businesses use the funds to reach maturity, expand, or cover a short-term need for cash.

The process can happen in one of two ways:

  • Public stock offering
  • Private placement with investors

Both are regulated by the government.

Generally speaking, the meaning of equity is the value shareholders would receive if the company pays off all debts and liquidates its assets.

That said, businesses can sell different types of accounts, giving investors varying benefits and responsibilities.

  • Common equity—Investors can participate in board elections, basic corporate governing, a vote on corporate policies, and more.
  • Preferred stock—It contains elements of equities (i.e., ownership advantages) and bonds (i.e., dividends).
  • Convertible preferred shares—These are preferred shares that can be converted into common equity after a certain amount of time.
  • Equity warrants—Those give the owner the right to buy company stocks at a specific price and time.

Types of Equity Financing

In addition to the type of accounts sold, equity financing processes may differ according to the investors who buy them.

Individual Private Investors

A common approach of starting business owners is to look for financial support from their personal network.

These may include friends, family, and potential investors they can personally contact. However, this approach is limited and useful only during the initial phases of business formation.

Venture Capitalists

Venture capitalists are groups of people and companies who pull their resources together and buy shares from companies with big potential.

They make major investments and expect to have a say in business operations in exchange. This process is also known as private equity financing.

Angel Investors

Angel investors are individuals who make big investments in companies with potential for growth. They often use their expertise and connections to help the business prosper.

In other words, they are involved in the initial stages, supporting the company’s development, and overseeing subsequent progress.

Initial Public Offering (IPO)

An initial public offering is the process of listing company stocks for purchase by the public. It can be a great way to raise capital for growing businesses with some popularity.

On the other hand, it is a costly, time-consuming process, and not every organization is eligible. Still, it is a great alternative for those seeking funding with less involvement from investors.

Debt and Equity Financing

In finance, debt and equity are the two main business financing methods.

The major difference is that the first requires loan repayment with interest, and the other does not.

Naturally, each has its pros and cons.

Let’s see what they are.

What Is Debt Financing?

Debt financing means that a company takes a bank loan or sells bonds or commercial paper to raise funds.

Then, it can use the funds to expand or cover short-term needs. Unlike with equity, though, the organization needs to pay back the money with interest.

Debt vs. Equity Financing

The biggest advantage of debt finance is that the principal owners retain full control. They can get funds without sharing ownership with third parties.

However, the company doesn’t need to return the money with equity finance. Of course, organizations can buy out shareholders, although that may cost more than the gathered sum.

Still, big amounts of debt make businesses less attractive to investors and lenders.

The debt-to-equity ratio shows how much financing a company has received through loans compared to shareholder equity. In other words, it reveals how much leverage it is using. The lower the ratio is, the better.

Often, the choice comes down to the accessibility of each option. Many organizations use both methods.

Pros and Cons of Equity Financing

Equity financing has a number of benefits.

  • The company can take advantage of the investors’ expertise and resources.
  • Equity finance is not a loan, so the company doesn’t have to give back the money.
  • This method involves low financial risk for businesses.

That said, it also has some downsides.

  • It requires substantial time and effort to set up.
  • Companies share the profit with investors.
  • Investors have a say in business operations.

Wrap Up

Each business financing method has its pros and cons. Which one is more suitable depends on the situation.

Equity financing is a method businesses use to raise money by selling stocks. There are different types of shares and investors, but the main principle is the same.

Investors help the company gather funds and receive ownership rights in exchange. Some companies use debt as an alternative.

Aleksandra Yosifova
Aleksandra Yosifova

With an eye for research, Aleksandra is determined to always get to the bottom of things. If there’s a glitch in the system, she’ll find it and make sure you know about it.