Written by Team 365 finance
Equity financing is a method of raising capital for a company by selling shares. Companies in need of capital for growth can raise funds by selling shares to investors, giving the investors a certain level of ownership of the company.
One of several methods of financing, equity financing allows a company to raise capital without having to take on debt.
There are several different methods of equity financing. Small companies often raise capital by selling shares to individuals such as friends, family members and investors located within their local area. Larger companies may raise funds through an initial public offering (IPO).
Below, we’ve explained what equity financing is, how it works and why it’s such a widely used fundraising method for companies. We’ve also looked at several of the major advantages and disadvantages of equity financing as a fundraising method.
What is Equity Financing?
Equity financing is a method of raising capital in which a company’s owners sell off some of the company to investors in exchange for capital. This ownership can be in the form of preferred or convertible stock, or common equity in the company.
In exchange for providing capital, investors in the company gain a certain ownership share. This ownership share can increase in value as the company grows, helping the investors to generate a positive return on their investment.
Equity financing is an alternative to debt financing. With debt financing, a company borrows the capital it needs to grow. With equity financing, the company’s owners sell some of their equity in the company in exchange for capital, meaning there’s no need to repay the capital in the future.
There are several different forms of equity financing. When a company gains equity financing in its early stages, it’s commonly known as “angel funding.” Later rounds of equity financing often come from venture capitalists, who seek to make investments in fast-growing companies.
A company might raise several subsequent rounds of equity financing, each at a different total valuation, as it grows.
Equity financing is commonly used by startups, particularly new companies that have massive growth potential. If you look at the funding history of any well-known Silicon Valley startup, you will likely be able to spot one or several rounds of equity financing.
For example, Facebook fuelled most of its growth through equity financing. In 2005, it raised a total of $12.7 million through an early-stage equity investment. The company then followed up with 13 other funding rounds before raising more capital through an IPO.
Because investors don’t get any interest from equity investments (as opposed to a loan, which has active, ongoing interest payments), most investors will only consider equity financing when a company has the potential to grow significantly in value over the near term.
For this reason, it’s common for high-tech companies and other startups to raise capital using equity financing. Small businesses with limited growth potential, such as local retail shops and restaurants, generally aren’t on the radar of most equity investors.
Advantages of Equity Financing
Equity financing offers advantages for companies and their investors. Companies that choose to raise capital via equity financing can:
- Avoid taking on debt. By raising capital through the sale of equity, a company can raise capital without having to take on short-term or long-term debt. This makes it easy for the company to focus on growth without having to worry about short-term cash flow.
- Gain expertise. Equity investment often comes with expertise, especially when it comes from a well-known venture capital firm. As well as gaining capital, a company could also gain expert advisors and access to more experienced entrepreneurs.
- Gain social proof. Gaining investment capital from a well-known equity investor shows that a company has the potential to succeed. This can help to make it a more attractive opportunity for other investors if the company opts to hold additional funding rounds.
Equity financing also offers advantages for investors. Investors that choose to provide capital to companies in exchange for equity can:
- Generate a significant return on investment. If an equity investment is successful, the investor will often enjoy a significantly higher ROI than they would with by lending money via a conventional business loan.
- Diversify their portfolio. Large-scale investors often invest in multiple companies using equity financing, allowing them to increase their chances of generating a good return on investment.
Disadvantages of Equity Financing
Equity financing also has several disadvantages, both for companies that raise capital via equity financing and their investors. For companies, these disadvantages include:
- Giving up equity. When a company’s owners use equity financing to raise capital, they lose some equity in the company. If a company raises capital through several rounds of funding, the founders could be left with a relatively small ownership share.
- Changing direction. Equity investors usually want the companies they invest in to grow quite quickly. This can sometimes mean changing the direction of the company to make short-term growth a major priority.
For investors, the biggest disadvantage of equity financing is the risk of losing an investment if a company fails. If a company isn’t profitable and drops in value, the value of an investor’s equity can decrease, leaving them with a negative return on investment.
In the event that a company completely fails, equity investors could lose all of their investment in their company.
For growth-focused businesses, capital is essential. Equity financing is one of several options for raising capital. Used effectively, it can help small businesses grow into larger ones, creating benefits for both the company’s founders and its investors.
Like all forms of financing, equity financing has advantages and disadvantages. Whether you’re a company founder or an investor, it’s important to consider these before raising capital through equity financing or investing in a company.