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What is equity financing?

Equity refers to a share in the ownership of a business. A proprietorship business is owned by one person and he owns all the shares of the company. Similarly, a partnership business may be owned by two or more people, in which case the ownership is jointly owned by all the partners. All of them own equity in the business. When a proprietorship or partnership firm is in need of funds for their business, they may decide to sell their equity to other investors or financial institutions or to the general public. Such a method of raising money by selling shares is called equity financing.

Equity sale to investors

A new company that has good ideas and is likely to do well will receive support from investors if they are convinced about the business model of the company. Such investors who invest in a startup company are known as angel investors or venture capital investors. They provide funds for the company in exchange for equity. The business owner gets money for his business needs and the investor owns a stake in the company.

Equity sale to institutions

Financial institutions like banks and other financial organizations also may invest in an organization by buying its share or equity. They would do so for businesses that are doing well, have a good track record and have excellent growth prospects. In return, the financial institution would own equity in the business.

Equity sale to the public

When a business wants to expand in a big way and is in need of a large amount of funding, it may decide to sell its equity to the general public. They would do this by getting listed on a stock market and offer their shares for purchase by the general public. The first time such a share offering is made is called an IPO or Initial Public Offering. Once the shares are listed on the market, it can then be bought and sold by the public. This allows companies to raise funds for expansion and new investments.

Since money is being raised from the public, there are laws regulating the process. Companies need to prepare a prospectus, which contains complete details about the company, details of its owners track record and all risk factors. This would help the public and other investors to take an informed decision before investing their money.

Advantages

The biggest advantage of equity financing is that a company can raise funds without applying for a loan. And they do not have to return the money as they are giving a share in the ownership in exchange for the money. Equity financing from institutions and venture capitalists help companies to be more professional and they can gain from the experience and expertise of the investors.

Disadvantages

Since a part of the ownership belongs to others, they would expect to get a share of the profits. They would also have a representation in the governance of the company. Large equity holders would have to be accommodated in the company board of directors. So owners cannot take major decisions on their own, they have to take the views of the equity holders. This is a potential area of conflict.

Equity financing allows companies to raise funds by selling their shares in the business to the general public, institutional investors or financial institutions. This helps them to raise funding for growth and expansion without having to resort to loans.