Equity
Equity
Equity
Equity can be defined as the amount of money the owner of an asset would be paid after selling it and any debts
associated with the asset were paid off. For example, if you own a home that's worth $200,000 and you have a
mortgage of $50,000, the equity in the home would be worth $150,000.
Equity, typically referred to as shareholders' equity (or owners' equity for privately held companies), represents
the amount of money that would be returned to a company's shareholders if all of the assets were liquidated and
all of the company's debt was paid off in the case of liquidation. In the case of acquisition, it is the value of
company sales minus any liabilities owed by the company not transferred with the sale.
Flexible Financing:* Equity financing allows companies to raise substantial capital without incurring debt,
providing flexibility for strategic initiatives and expansion.
No Interest Payments:* Since equity doesn't involve interest payments, the company can use its funds
more efficiently.
No Repayment Obligation:* Unlike loans, equity investments don't require regular repayments, easing
financial pressure on the company.
Shared Risk:* Investors in equity share the risks and rewards of the business, aligning their interests with
the company's success.
Equity financing is the process of raising capital through the sale of shares. Companies raise money
because they might have a short-term need to pay bills or need funds for a long-term project that
promotes growth. By selling shares, a business effectively sells ownership of its company in return for
cash.Equity financing comes from a variety of sources. For example, an entrepreneur's friends and
family, professional investors, or an initial public offering (IPO) may provide needed capital.
An IPO is a process that private companies undergo to offer shares of their business to the public in a
new stock issuance. Public share issuance allows a company to raise capital from public
investors. Industry giants, such as Google and Meta (formerly Facebook), raised billions in capital
through IPOs.12While the term equity financing refers to the financing of public companies listed on an
exchange, the term also applies to private company financing.
KEY TAKEAWAYS
Equity financing involves the sale of common stock and other equity or quasi-equity instruments such
as preferred stock, convertible preferred stock, and equity units that include common shares and
warrants. This action can affect existing shareholders and impact the ability to reach new shareholders.
A startup that grows into a successful company will have several rounds of equity financing as it
evolves. Since a startup typically attracts different types of investors at various stages of its evolution, it
may use other equity instruments for its financing needs.
For example, angel investors and venture capitalists—generally the first investors in a startup—favor
convertible preferred shares rather than common stock in exchange for funding new companies
because the former have more significant upside potential and some downside protection.
Once a company has grown large enough to consider going public, it may consider selling common
stock to institutional and retail investors.
Later, if the company needs additional capital, it may choose secondary equity financing options, such
as a rights offering or an offering of equity units that includes warrants as a sweetener.
Individual Investors
These are often friends, family members, and colleagues of business owners. Individual investors
usually have less money to invest, so more are needed to reach financing goals. These investors may
have no relevant industry experience, business skills, or guidance to contribute to a business.
Angel Investors
Often, these are wealthy individuals or groups interested in funding businesses they believe will provide
attractive returns. Angel investors can invest substantial amounts and provide needed insight,
connections, and advice due to their industry experience. Typically, angels invest in the early stage of a
business's development.
Venture Capitalists
Venture capitalists are individuals or firms capable of making substantial investments in businesses that
they view as having very high and rapid growth potential, competitive advantages, and solid prospects
for success. They usually demand a noteworthy share of ownership in a business for their financial
investment, resources, and connections. In fact, they may insist on significant involvement in managing
a company's planning, operations, and daily activities to protect their investment. Venture
capitalists typically get involved early and exit at the IPO stage, where they can reap enormous profits.
Crowdfunding
Crowdfunding involves individual investors investing small amounts via an online platform (such as
Kickstarter, Indiegogo, and Crowdfundr) to help a company reach particular financial goals. Such
investors often share a common belief in the company's mission and goals.
Equity Financing vs. Debt Financing
Businesses typically have two options for financing when they want to raise capital for business needs:
equity financing and debt financing. Debt financing involves borrowing money. Equity financing involves
selling a portion of equity in the company. While there are distinct advantages to both types of
financing, most companies use a combination of equity and debt financing.
With debt financing, the lender has no control over the business's operations. Once you pay back the
loan, your relationship with the lender ends. Companies that elect to raise capital by selling stock to
investors must share their profits and consult with these investors when they make decisions that
impact the entire company.
Finally, interest paid on loans is tax deductible as a business expense. Loan payments make
forecasting for future expenses easy because the amount does not fluctuate.3
Factors to Consider
When deciding whether to seek debt or equity financing, companies usually consider these three
factors:
If a company has given investors a percentage of their company through the sale of equity, the only
way to remove them (and their stake in the business) is to repurchase their shares, a process called a
buy-out. However, repurchasing the shares will likely cost more than you received when you issued
them.
You're a Startup
Businesses in their early stages can be of particular interest to angel investors and venture capitalists.
That's because of the high return potential they may see due to their experience and skills.
While equity financing has benefits, there are some disadvantages to being funded this way.
Large investors can provide a wealth of business expertise, resources, guidance, and contacts
Pros Explained
Equity financing results in no debt that must be repaid. It's also an option if your business can't obtain a
loan. It's seen as a lower risk financing option because investors seek a return on their investment
rather than the repayment of a loan. Plus, investors typically are more interested in helping you
succeed than lenders are because the rewards can be substantial.
Equity financing offered by angel investors and venture capitalists can provide access to outstanding
business expertise, insight, and advice. It can also provide you with new and vital business contacts
and networks that may lead to additional funding.
Cons Explained
The stakes taken by investors providing equity financing can be significant, and thus, profits going to
the business owners are reduced. Even small common stock investors get a share of the profits.
Moreover, investors may want to be consulted whenever you plan to make decisions that will impact the
company.
In exchange for the large amounts that angel investors and venture capitalists may invest, business
owners must give over some percentage of ownership. That can translate to having less control over
your own company.
The typically higher rate of return demanded by large investors can easily exceed that lenders charge.
Also, shareholder dividends aren't tax deductible. Interest payments on loans are, with some
exceptions.3
Say that you've started a small tech company with your own capital of $1.5 million. At this stage, you
have 100% ownership and control. Due to the industry that you're in and a fresh social media concept,
your company attracts the interest of various investors, including angel investors and venture
capitalists.