If you follow the world of finance closely, then the chances are you must have heard about the term ‘Equity Financing.’ As the term suggests, it is a method of raising funds by issuing equities of a company. In other words, equity financing is a process of raising capital through the sale of the company’s stocks to the investors. The idea here is to raise funds for business activities by selling ownership interests of a company to shareholders.
In order for a company to grow, it will need additional capital which it can generate either through equity or debt. It is important to note that the two are intrinsically distinct – debt financing involves borrowing funds (usually on an interest rate) while equity financing involves raising funds by selling ownership shares of the company.
The proportion of the ownership interest sold depends directly on the amount invested by the shareholders and how much the investment is worth at the time. For example, an entrepreneur who starts his company with Rs.7,00,000 will initially own all the shares of the company. To put it in another way, he will be the sole owner of the company.
As his company grows, he will soon find himself requiring more capital. At this point, he will look at investors who are willing to invest in his company, for a piece of ownership in the company. If an investor is willing to invest Rs.3,00,000 at a share price of Rs.1, then the total capital of the company will be raised to Rs.10,00,000. In such a case, the entrepreneur will control 70% of the company while the investor will control 30%.
As the company grows and more investors join the team, the total capital of the company will increase significantly, although the entrepreneur’s ownership share may reduce.
Advantages of Equity Financing
There are various advantages of equity financing such as:
- Ease of Generating Capital: When a company is in its early stages, it can be quite difficult to raise funds in order for it to grow. This is particularly true when there is a dearth of revenues or assets to act as collateral. In such a scenario, equity financing serves as a brilliant way to raise the much-needed capital by selling the ownership shares of the company. This attracts the investors who see a potential in the company and are willing to take the risk with the entrepreneur.
- Funds Generated are Meant for the Business Only: Whatever money is raised through equity financing, it will be solely directed towards the business and its intended projects. After all, the investors will be able to realise their investments only if the company is performing well. Consequently, your sole focus is on the business rather than worrying about the finances.
- Creditworthiness is Not an Issue: One of the reasons why equity financing is preferred by many entrepreneurs and startups is because it does not require a good credit score. The credit history here, whether it is good or bad, is simply irrelevant. Investors are more concerned here with the potential of the startup and the ownership share they will receive, rather than the ability of the startup to repay its loans.
- Speaking of loans, there are No Loans to Repay: One of the major advantages of equity financing is that there are absolutely no loans to repay. The funds have been raised by selling the ownership shares of the company and as such, all the profits and losses will be shared with the investors. They enter the agreement with the idea of benefitting from the company’s growth, rather than providing a loan for the activities. This can be particularly helpful in the initial stages when the company is yet to generate a profit. As a result, the money can be channelled towards the growth of the company.
- Forge Valuable Relationships with the Investors: Through equity financing, you form partnerships with experienced angel and venture capitalists. They not only bring in a great deal of experience with them, but their business network can take the startup to the next level. As an entrepreneur, you benefit from their connections and knowledge and learn a great deal in the process. These investors can be your mentors, provided you play your cards right.
Disadvantages of Equity Financing
Now that we know why equity financing is so popular, let us take a look at few of the drawbacks that this method of raising capital offers:
- Profits are to be Shared: One major drawback of equity financing is that whatever profits the business makes, are to be shared with the investors. This is only natural, considering that the investors have put money in the company and have taken a risk, just like the entrepreneur. For their efforts, they expect and most definitely deserve, a share of the profits. However, this can be worth it if the business is benefiting from their business acumen and experience.
- Loss of Control: As an entrepreneur who is looking into equity financing, it is important to realise that the more investors you bring on board, the lesser control you will have over your business. In other words, you will have to share the control of your company with fellow shareholders. While this may not necessarily mean a bad thing, your ideas may not always come to fruition. This may also lead to potential conflicts and tussles over a variety of issues like management style, business operations, finances, et cetera.
- The process can be Demanding and Time-Consuming: Despite its various advantages, equity financing can often prove to be highly time-consuming and demanding. It can also prove to be costly as the investors will expect a higher rate of return for the risk they have taken. Furthermore, when applying for an initial public offer (IPO), factors such as administration expenses, underwriting of shares, et cetera, will have to be considered.
- Once you have raised the funds through equity financing, you will have to keep your investors updated on a regular basis and provide them with all the necessary information about the business. This involves performance and financial data, along with other details like new product launches, future projects, et cetera.
Needless to mention, equity financing has its own set of pros and cons. If you have no objections to sharing your profits and control of the company with others, then this method of raising funds may seem right for you. For more information on equities, you can visit Bankbazaar. On the other hand, you can look into debt financing if you prefer to be the sole owner of the company.