Equity Financing: Everything You Need to Know
Equity financing and the activities that are implemented to create capital are wide ranging. 3 min read
What is Equity Financing?
Equity financing is when a business raises money by selling shares in the business. Basically, equity financing is when there is a partial sale of the ownership stake in a business so that funds can be raised to assist the business in some way.
Equity financing and the activities that are implemented to create capital are wide ranging. Specifically, there are many ways that funds can be raised. Several thousand dollars may be gathered from friends and family members or something called a large initial public offering (IPO) may be establish with millions or billions of dollars being raised.
The term equity financing is used to talk about public companies that are listed on the stock exchange. However, it can be used to describe private businesses as well and how money is raised by them.
Equity financing is different from debt financing. Debt financing is when money is borrowed while equity financing does not refer to borrowing.
Breaking Down: Equity Financing
Most successful businesses will go through a different number of equity financing rounds. This occurs are the business grows and evolves and needs more money for investments in the company itself. Startup businesses and well established companies will attract different types of people for equity financing. This means that each stage of the money gathering is likely to involve different investors.
Specifically, venture capitalists and angel investors are two types of individuals who will provide the equity for a startup. These individuals will opt for convertible preferred shares in the busy instead of other types of equity. This allows for a great return on the investment in the future.
After the business has become established and is considering going public, it may start to sell common equity to retail and institutional investors. If more money is needed at this point, then there may be a round of secondary financing in exchange for warrants and equity units.
Equity financing is something that is regulated by the local and national securities authority in the vast majority of the country. These regulations are meant to protect investors from bad investments and unscrupulous business practices. In essence, they keep businesses from raising money and then taking off with the proceeds of the business without returning investment money.
How Equity Financing Works
When a company first starts and then wants to grow, they will need additional money. The money is gathered as either a debt or equity.
Equity financing allows for the sale of the company’s stock or the exchange of an owned portion of the business. The company then receives cash for those shares. The amount of the business that is sold during the financing process will depend on the owner of the business and what type of investment was originally made in it.
For example, if an individual decides to invest an initial $600,000 in their own business, then they own the entirety of it. They will own all the shared. As the business starts to succeed and grows, more money is needed and an outside investor can be found. This person may choose to invest $400,000 in exchange for 40 percent of the shares in the business. In this scenario, the entrepreneur will still retain 60 percent of the shares himself.
This type of equity financing allows the business to receive the money they need. In exchange, the investor retains a stake in the business in direct correlation to the money they invest. Basically, the business owner dilutes their own ownership so the business can grow.
This is the simplest example of equity financing. Venture capitalists, angel investors, and venture capital partnerships are the different names for these investors. Each one of these individuals will have a different set of risks, amount of money invested, and the amount of time that is placed in the company. Basically, some investors will actively manage a part of the business while others will essentially become silent partners. While this is true, private venture capitalists are the most common type of investors.
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