This guide explains what equity financing is, how it works, and it goes into detail about the different types of equity financing available. To understand more about raising money with debt vs equity, we recommend: Capital Stack Quick Guide, as a companion to this guide. Here are some key takeaways about equity financing:
This guide deals primarily with equity financing. Generally, there are two ways that a business can raise outside capital if it can’t finance its own growth out of cash flow: debt and equity. To learn more about the distinction, we recommend our guide: Capital Stack Quick Guide.
Normally, a business would not seek to raise outside capital if it had the ability to pay for its own growth out of cash flow. Both equity financing and debt financing are ways to raise additional outside capital when cash flow is insufficient to finance growth on its own.
Equity financing is financing through the issuance of stock. When a business chooses to raise capital with equity, they are doing so in return for an ownership stake in the business. Equity financing dilutes ownership in the business because the investors get a partial ownership stake in return for their investment. Put another way, the owners of the business are in effect giving away a partial ownership stake in the company in return for the money they need.
While equity financing dilutes ownership and is normally the most “expensive” type of financing, there is an advantage to equity financing over debt financing. When a company raises money in exchange for equity, they don’t need to pay the money back in installments, with interest over a period of time, like they would with debt. So, the advantage is that they don’t need to make regular payments on the money they’ve borrowed, and cash flow is free for financing growth and operations.
In addition to equity financing, a company can use debt financing to raise capital. When a business chooses to raise capital through debt, they are borrowing money in exchange for interest, as per the lending agreement. When a business raises money with debt, they have to pay interest (an expense) on the principal amount borrowed. Equity is not generally diluted with debt financing, although some types of debt are convertible to equity, meaning that they can dilute equity if certain conditions are met.
There is an inverse relationship to “time in business” (financial track record) and a business’ ability to get debt funding. A profitable business that has been growing for a decade with strong financials would have a strong track record and would most likely find it easy to get debt funding. A brand-new start-up business will have no track record of cash flow and therefore debt investors would have no reason to believe that the start-up would be able to make monthly payments on the debt. This is why start-up businesses almost always rely on equity financing for outside capital. The venture capital industry specializes in providing equity financing to early-stage businesses with high growth potential.
Now that we’ve covered the difference between equity financing and debt financing, we’ll look at how equity financing actually works.
When companies need money for growth, but don’t have the ability to pay for that growth out of cash flow, they can use debt or equity to raise the money they need to finance that growth.
When companies want to raise money with equity, they can do so by issuing new shares and selling those shares to investors. The money the business makes from selling these shares is what they use to finance their operations.
The shares that the owners of the company have legally represent their ownership stake in the company. Each share of stock in the same class has equal rights to the others in the same class. This principle of “equality” among shareholders is where the term “equity” gets its name. If a share of common stock is worth 1 percent of a business, then that share is equal to any other share of the same class—representing 1 percent ownership of the business.
All companies have shares, not just publicly traded companies. Both private and public companies can sell these shares, which represent an ownership stake in the business, in exchange for money.
When companies issue shares to the public, they do so for the first time through an initial public offering (IPO). If the company wants to raise more money again in the future, they can once again issue new shares to the public through a follow-on offering. The proceeds from selling these shares are what the company uses to finance growth.
Both IPO’s and follow-on offerings take place in the primary market. Here, the company issuing the shares, often through an investment bank, raises money by selling them to investors. The primary market is where publicly traded companies actually raise money through the selling of shares.
In addition to the primary market, we have the secondary market. The primary market deals with the issuing of securities for the first time, and the secondary market deals with the day-to-day trading of these already-issued shares between other investors. The New York Stock Exchange is an example of a secondary market where equities are traded. In the secondary market, publicly traded shares of stock are traded between other investors as they wish.
In the secondary market, the business that issued the shares originally does not receive any compensation for them. The profit or loss from the sale of those shares is made and lost between the investors in the secondary market, alone.
The secondary market allows investors to freely trade their shares in an open market with each other. Investors receiving shares in privately held companies can’t trade their shares in the secondary market.
For privately held businesses, capital is raised through equity by giving the shares directly to investors, in exchange for money. Shares of privately held companies are not sold through the primary market or the stock market like publicly traded companies shares are. Private equity firms, venture capital firms, angel investors, and individuals (sometimes operating as silent partners) all invest in private companies that are looking to use equity financing to raise capital.
Now that we understand how equity works, let’s look at how equity financing is accomplished through common shares and preferred shares.
Both common shares and preferred shares represent different classifications of stock which both result in partial ownership of a company. Although both common shares and preferred shares represent an equity position (ownership stake), they work differently.
Common shares are shares that come with voting rights. Meaning that these investors have a say in how the company is managed. Common shares also generally provide the highest return to investors in the capital stack. However, common shares have the lowest liquidity position in the capital stack, making an investment in common stock the riskiest position an investor can take.
Preferred shares have a higher liquidity position than common shares, meaning that preferred shareholders get paid first in the event of a sale. This makes preferred shares less risky as an investment than common shares. However, preferred shares don’t come with voting rights. Some preferred shares are convertible to common shares if certain conditions are met.
This guide was designed to familiarize you with equity financing. To learn more about the types of shares businesses issue for equity financing, we recommend our guides: Common Shares and Preferred Shares, respectively.