How Does Equity Financing Work?
Broadly speaking, equity financing is the sale of a company’s equity to investors. In practice, this can mean a lot of different things.
To being with, the investors could be passive (i.e. taking a laissez faire approach to the company) or active (providing managerial input and taking part in the company decision making).
Next, there is the issue of the equity, of which there are several different kinds. There is preferred stock, convertible preferred stock, common shares, common shares, and even warrants. So, depending on the position the company is in, and the investors it speaks to, the equity financing will play out in different ways.
Let’s take the example of a startup company looking to raise growth capital.
For this company, whose owners may be young and relatively inexperienced, it will pay to bring in active investors, who are willing to provide managerial oversight and industry expertise. The investors are also likely to want some say in the decision-making process, so an active investor is chosen.
Next, because the company is most likely high-risk (i.e.burning through cash faster than it is generating it, selling a product or service for which there isn’t a huge proven market, etc.) the investors will probably seek preferred stock as part of the equity financing, giving them increased upside potential and downside protection for taking on that risk.
Of course, how the equity financing process plays out will depend to a great extent on the circ*mstances of the company and its market. In general terms, however, the above show the kind of logic that underpins the process. It then becomes the company’s existing management team to decide on the terms of the equity financing that they’re willing to accept.
Types of Equity Financing
There is a growing spectrum of types (and sources) of equity financing, which includes but is not limited to:
IPO
As outlined in a previous artic, an IPO occurs when a company lists its shares on a public stock exchange (e.g. Nasdaq or NYSE).
Common characteristics of firms opting for equity financing through IPOs usually include a large one-time injection of cash, or are fulfilling a long-term aim, often as part of an agreement with early investors who want to cash out part or all of their investment.
Stock exchange
A company that has already listed can, assuming there is interest in its shares, conduct equity financing by selling its publicly listed common stock.
By definition, these companies will be publicly listed. The financing through sales of shares will usually be linked with a large corporate growth objective, such as a merger or acquisition.
Or the company may feel that its stock is overpriced, and take advantage of the overpricing to cash in some of its equity.
Private equity
Private companies (and on occasion, public companies) can sell their stock to private equity companies for equity financing, such as:
Seed/Angle investors
These companies are usually very early-stage startups, probably pre-revenue, who require capital to bring their company (or concept) to something that is marketable.
Venture capital/Growth Capital investors
These companies will be high growth companies whose growth requires continued investment in marketing, technology, and people. They turn to growth or VC firms in order to acquire the capital required to achieve that growth.
Crowdfunding platforms
Essentially crowdsourced private equity, crowdfunding platforms gained popularity in the last decade a way to achieve equity fundraising.
Here is an annual market value of equity based crowdfunding comparison by Statista.
Companies opting for equity financing through crowdfunding are typically looking to gain low commitment capital from a crowd of investors, often with a ‘cool idea’ with potential. That being said, some of these companies do eventually end up taking on the same characteristics as regular companies (i.e. corporate governance, financial reporting, etc.).
Equity Financing vs. Debt Financing
Equity financing involves the owners of the company giving up an agreed share in the company for funding, whereas debt financing involves a third party extending the company a loan, which it commits to repay with interest.
The only time that any confusion arises between the two forms of financing is in hybrid financing, a form of financing that includes features of both. An example here is convertible debt, where debt can be converted into equity at the lenders’ behest.
Pros and Cons of Equity Financing
PROS
- No obligation to repay the capital raised, unlike with debt financing.
- May allow the company to bring industry experts onboard.
- Less financial burden on the company, with less debt on the balance sheet.
CONS
- Ownership is diluted, with the investor receiving a share of the company’s equity.
- Investors usually have to be consulted before any strategic decisions are made.
- Can lead to clashes on decision making between company owner and investors.
- May make the company less attractive for future investors.
- Unlike debt financing, equity financing provides no tax shield.
Why Would a Company Choose Debt over Equity Financing?
Assuming it has the option to raise capital through either debt or equity, a company’s CFO will consider the cost and benefits of each.
When choosing between the two, the key issues that they will consider include the following:
The cost of debt
In recent years, with interest rates hovering near zero, there was an obvious incentive for companies to opt for debt financing over equity financing. With interest rates now on the rise, this advantage that debt financing held is beginning to diminish.
The amount being sought
Depending on how much capital is being sought will have a big bearing on whether the company opts for debt or equity financing. No company wants to overload their balance sheet with debt, with equity becoming preferable as larger amounts of capital are required.
The terms of equity
Equity financing may come with string attached. For example, the investors may look for preferable treatment in future investment rounds. If company management perceive that there are too many conditions attached to the equity, it may make a debt financing preferable.
Quality of investor
If the quality of investor (i.e.their ability to add value to the company through advice, expertise, and their access to more capital) isn’t deemed of a high standard, a company may decide that it is preferable to opt for debt financing until higher quality investors express interest.
Valuation of company
If the company owners believe that the company isn’t being attributed a value that meets their expectation, a debt financing will become more attractive. As the company’s cash flows grow, and investors valuations begin to align with their own, they may then opt for an equity investment.
When to Seek Equity Financing?
In general terms, companies seek equity financing when they require capital for some reason. In certain circ*mstances, they might also wish to bring investors in to allow them to reach scale (i.e. through the investors’ industry contacts or expertise). Examples include:
- Startups seeking financing to continue growing
- Companies seeking investment so that they have capital for acquisitions
- Mature companies seeking investment for growth (e.g. a company that requires capital to enter new markets, build new factories, etc.)
- Companies seeking extra cash for restructuring of their balance sheet (in extreme cases, these would be ‘distressed companies’)
- Companies seeking to bring in management with institutional-level expertise before going for an IPO
What to Consider Before Equity Financing
Companies’ never-ending demand for money is ultimately what keeps the capital markets in business
This means that, at whatever stage of the business cycle that your company decides to undertake its equity fundraising process, it will face a huge amount of competition. On this basis, it pays to be prepared.
Having worked with thousands of companies through their equity fundraising process - and gleaned in numerous insights from them along the way - DealRoom has fine-tuned its equity fundraising capability to a level beyond virtually any other platform on the market.
Some of the issues to be considered before equity fundraising that DealRoom can aid investors with include:
Data organization
Investors will want access to data. The faster and more organized this process, the better, maximizing the chances of the company achieving its equity fundraising goals.
Investor interest
DealRoom also provides companies with full oversight of how long each investor has engaged with each document, giving you insight into where the most relevant points in your company’s documentation are.
Due diligence
DealRoom is a project management platform designed for M&A and related transactions. Any company involved in the equity fundraising process can benefit from the due diligence capabilities it provides.
How to Prepare for Equity Financing with DealRoom
Our previous experience has enabled us to develop a capital raising playbook, giving users a template for successful equity fundraising. If you want to learn how you can leverage the playbook and DealRoom’s project management tools to ensure that your raise is a resounding success, request a free trial today!
