Equity financing is used to describe the process by which a company raises capital by issuing shares in the business to investors in exchange for money.
Investors can be members of the general public (also known as retail investors) and institutional investors. These investors become members (shareholders) in the company and receive an ownership interest.
The shares that are issued are held for income and/or a capital gain. Income is received in the form a dividend distribution from available profits (if any). A capital gain arises when the shares are sold to a third party at a higher price than the price paid.
Pros and cons of equity financing
The main reason for using equity finance is that it can be deployed for long term use in funding the business and is not repayable on demand.
Unlike debt financing, there is no scheduled repayment date and there is no interest (or coupon) payable on the equity capital raised.
The downside of equity finance is that the investors’ capital is at risk and there is no guarantee of the investor getting their money back.
In the event of the company failing then an equity investor ranks behind other stakeholders (for example secured lenders or priority creditors) in having their original investment returned.
Sources of equity finance
There are many potential sources of external equity financing available to businesses. Deciding which one works best can depends on a number of factors:
- where the company is in its growth cycle;
- how risky an investment it is considered to be and
- how much equity the owner is prepared to give up in exchange for funding.
Angel investors tend to be part of a network of high net worth investors (HNWI) who provide equity finance to high-risk, start-up businesses.
Because of the risks associated with unproven businesses, with little or no revenues, the owners could find themselves giving away more equity than they would like in order to obtain the finance they need to prove up the concept.
In addition to introducing equity capital, angel investors also bring relevant skills and operational know-how that can be helpful in growing early-stage businesses.
Venture capital tends to be used for more established companies with a proven business model, where additional equity finance is needed to scale up and expand the business or perhaps to fund a management buy-out or buy-in.
Venture capitalists tend to be private equity funds who have significant amounts of capital to deploy in fast-growing businesses.
Their investment time-horizon is typically four to six years and they look to exit their investment either through a trade sale, a stock market listing or a sale to another financial buyer.
Initial Public Offering (IPO) is the process by which shares are issued by a private company to members of the general public (retail investors) and institutional investors in exchange for equity finance.
Investment-based crowdfunding has emerged as a relatively new source of equity finance which allows companies to take advantage of innovation in the Fintech sector to reach vast numbers of individuals (the ‘crowd’) online.
These individuals each contribute or invest small amounts of capital to finance a wide range of businesses from start-ups to more established businesses who have pitched their idea, concept or investment proposition on a crowdfunding platform.
The platform will screen the applicants, manage the collection and disbursement of investor payments and facilitate initial and ongoing communication between the investors and
Crowdfunding usually takes place through a website. The platform will manage any online payments and may often offer services such video hosting, social networking and enabling contact with contributors.
Types of equity financing:
A company can issue many different classes of shares to raise equity finance from investors.
Each class of share has different rights regarding voting, dividends, and capital participation (what shareholders are entitled to receive) on the sale or winding-up of the company.
The class of shares that investors are usually familiar with are common shares or ordinary shares and it is this class of share that are acquired when investing in an AIM listed company for example.
However, it would be helpful to run through the main types of shares that are used when structuring equity finance:
Ordinary shares give the holder an equitable interest in the ownership of the profits and assets of the company. Each ordinary shareholder has the right to vote on company matters, appoint or remove directors and receive dividends (if declared).
Preference shares give the holder specific priority claims over ordinary shares; for example, an entitlement to receive a dividend before ordinary shareholders. However, voting rights may be restricted.
Cumulative preference shares as above, for preference shares but where the dividend is not paid out in a given year, it is rolled up to be paid at a later date.
Convertible preference shares give the holder the option to convert them into a specified number of ordinary shares on or after an agreed date.
Redeemable shares are shares that have been fully paid-up which can be bought back at the discretion of the company or the shareholder on terms stated in the articles of the company (for example, the shares can be redeemed at the same price as the issue price).
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