Equity financing refers to raising capital by giving away some “ownership” of the company. The firms generally raise equity finance by selling the common stock of the company to a closed group or the public at large. The possession of such stocks is what represents “ownership” of the company or part thereof.
Table of Contents
- 1 What is Equity?
- 2 What is Equity Financing?
- 3 When is Equity Financing the right way to go?
- 4 Advantages Of Equity Financing
What is Equity?
Equity, when translated into layman terms, refers to ownership. Equity represents those assets which are not compromised by any debt or charge against them. Simply put, if you own a house, that is your asset. The entire value of the house will form your equity if you have not taken any mortgage against it. If mortgaged, the value of the home as reduced by the debt component forms your equity. In other words, it represents that proportion of value you undisputably are entitled to.
What is Equity Financing?
Having understood the concept of equity, the meaning of equity financing occurs very instinctively. Equity financing refers to raising capital by giving away some “ownership” of the company. The firms generally raise equity finance by selling the common stock of the company to a closed group or the public at large. The possession of such stocks is essentially what represents “ownership” of the company or part thereof. However the most common, this is one among several means which constitute equity financing.
Some alternate means of equity financing are mentioned here below:
While common stocks represent the purest form of ownership, preferred stocks are a diluted version of the same. Though they constitute ownership shares of the company, preferred stocks very closely replicate debt in their functioning. They are required to be paid a fixed rate of dividend and do not entail voting rights. Companies may find this option attractive since they are available at cheaper costs and does not give rise to any repayment obligation.
It represents the form of equity financing raised from high net worth individuals or investment banks. Venture capitalists step in at the inception or very early stages of a startup. They invest companies which depict fast growth and high potential characteristics. This one of the most expensive forms of financing since the company ends up giving away a significant chunk of its ownership. However, the right venture capitalists may add great value to the firm with which they get associated. They bring in with them a lot of experience, networks, and synergies which go a long way in the success of the firm.
It is a slightly complex form of financing. Mezzanine finance starts off as a debt but may be converted into equity in the event of default by the company. It is opted by sufficiently established companies with predictable cash flows. This option is resorted to when the firm has exhausted its ability to take on senior debt. This form of equity financing is typically costlier than regular debt. However, it gives the company a chance to raise funds without diluting its ownership. The fateful conversion of debt into equity in the worst case scenario provides a tight security to the mezzanine finance investors.
This is the most recent form of equity financing that has emerged with the advent of social media. It refers to raising small amounts of money from a large number of individuals. The fast-paced social network enables small companies to display their products and goals online to a large audience. These individuals, who are people like you and me, contribute in their own capacity to the projects they resonate with. These contributions can be as low as even $1! It is in the multiplicity of such transactions into millions where such crowdsourcing projects find success. Though most of such projects are reward based, equity-based crowdfunding is rapidly gaining momentum. Huge pieces of equity are not required to be sold to the venture capitalists. The small investors are also able to gain some ownership in the projects with high potential.
When is Equity Financing the right way to go?
When the requirement of funds is not emergent
Raising equity finance means bringing on board co-owners to run the show with. It requires pitching and making several presentations before the investor actually steps in. Even in the case of companies opting for an IPO, the process is time-consuming. There is a significant delay between the issue of securities in the primary market to the final receipt of funds.
When more than just money is on your mind
Equity financing means such as venture capital and angel investors bring on board more than just finance. They are pursued for priceless expertise and contacts. Only handsome equity valuations and stakes therein can lure such investors. Simply sourcing debt cannot fetch such strategic partnerships.
When the company is in its infancy
Some startups and new venture prefer giving away some ownership rather than attracting debt. Debt comes with an obligation of fixed interest payments. This may not be appealing to companies who are just starting with their cash flows. Equity financing enables the infant firms to breathe and focus on their operations. They are not charged with any fixed obligations and are only expected to share profits as and when they arise.
Advantages Of Equity Financing
Equity forms a part of the long-term capital structure. No repayment obligation arises during the lifetime of the company.
No Fixed Charge
Maintenance of equity capital does not require fixed payment of any kind. It preserves the cash flows in the business. The shareholders only expect a share of profits as and when they arise. Moreover, the shareholders have no say in the declaration of dividends. Thus the company can maintain total control over the outflow of cash.
Raising equity does not result in the creation of a charge on the assets of the company. The firm can hold a clear title on the assets it owns. Or else they remain available to be mortgaged to raise further capital.
Better Credit Standing
A company majorly financed from equity sources enjoys a good credit score. More ownership funds on the balance sheet leave sufficient room to raise debt capital in the future when the need arises.
Funds disposable at the discretion of the board
The management can spend the funds raised through equity in whatever manner it intends to. Debts are granted for funding specific projects. Therefore their use remains very confined. Also, the company has to remain very cautious of the funds raised by banks. There is always some agency keeping a check over the shoulder in case of debt funds. The management remains free to invest equity proceeds into profitable and new ventures without going through unnecessary hassles.
References: www.entrepreneur.com; www.medium.com; CA Final SyllabusLast updated on : June 8th, 2018