What is Equity Financing & How is it Different From Debt Financing?
If you’re running a business, chances are that you’ll need financing at some point. Even bootstrapping startups or entrepreneurs with substantial savings often need credit to keep things going.
One of the more common options that businesses take to secure extra working capital is equity financing. This type of financing is often used in combination with debt financing. Though both are a relatively accessible funding option for a company, each has pros and cons to be considered.
Debt and equity financing: It’s a big decision. Let’s take a look at both options.
What is Equity Financing?
The term equity in business can refer to value or ownership rights. Thus, equity financing refers to the raising of funds by a company by selling a percentage of their value or proprietorship. When a business owner uses equity financing, they are selling part of their ownership interest in their business.
Company shares are one of the most common types of equity sold, but there are other options for trading such as convertible preferred stock, and equity units such as warrants. Venture capitalists and angel investors are some of the more prominent equity financiers, but businesses can sell shares to the public through initial public offerings (IPOs), small business investment companies, and even crowdfunding.
A good example of how equity financing works is in the technology industry, where many promising tech startups sell a part of their company to investors. Even Facebook itself relied on this form of financing when in its early stages.
How Does Equity Financing Work?
For a business to sell ownership, it first needs to be incorporated. This means that it is registered as a corporation that is legally separate from its owners. Once this is done, shares of capital stock can be issued that give the holder an ownership right.
Each share represents a single unit of ownership. Each share also holds a unit of financial value. For example, if a company has issued 1000 shares at $50 each, and an investor buys 500 shares, the business has raised $25,000 in equity financing.
What is the benefit of equity to both parties? The premise of selling shares is that if the organization is financially healthy and prospering, the shares are expected to increase in value. Thus, the shareholder gets a return on their investment, while the business raises working capital.
With the help of equity finance management services, equity financing can be done in many rounds, especially if a company is successful. There are five main stages of startup equity financing:
- Pre-Seed Funding
- Seed Funding
- Series A & B (Early Stage)
- Series C, D, and so on. ( Later Stage Investment)
- Mezzanine Financing
On the other hand, larger enterprises do this by offering multiple classes of shares. A company may issue the following for equity financing:
- Class A gives the shareholder voting rights on the decisions of the company and a share dividend.
- Class B shares give ownership, but with no voting rights nor dividends.
- Preferred shares give dividends but no voting rights. They also get a higher claim on assets than regular shareholders, should the company get dissolved.
Debt Financing vs. Equity Financing
Debt vs equity financing, what’s the difference? As mentioned earlier, debt and equity funding are commonly used by companies when raising funds, but that’s where their similarities end. Debt financing is where a company borrows money and pays it back to the lender with interest. Unlike equity financing, where a company does not have to repay the money given by their investors and the bet is on business growth, “debt equity financing” is a bet on future ability to pay back the loan and can significantly increase the company’s expenses.
An example of debt financing is when a company approaches a bank for a business loan of $5 million with an interest rate of 6% and a repayment period of three years. For this debt financing, the only obligation the company has to the bank is the amount owed. Once paid, the relationship between the two parties is over. This is one of the main differences between debt vs equity financing – in the latter, the company partly belongs to the investor until they either buy back their shares or they are sold to someone else.
Equity Financing Pros and Cons
To properly answer the question of what is equity financing, one must take a look at both the advantages and the price you pay to raise money via this method.
Advantages of Equity Financing
- There is no loan to repay. As mentioned before, debt and equity funding differ in this regard. Because a business doesn’t have to repay the investor for equity financing, it has less burden in terms of expenses.
- Because credit-worthiness is not as high a priority to investors as it is to lenders, equity financing is a better option for company owners who have bad debt or poor credit history.
- There is no interest accrued on equity financing.
- Angel investors and venture capitalists often offer companies their knowledge and experience. They also provide a channel for business partnerships.
Disadvantages of Equity Financing
- Because shareholders are part-owners of the company, they are entitled to a piece of its profits.
- Equity financing comes with a loss of control for the company’s owners, especially where shareholders have voting rights. This is one of the main reasons why some business owners prefer debt financing.
- The process of obtaining equity financing is time-consuming. From incorporation to providing detailed business plans and forecasts to potential funders, it is not an ideal method for those looking to raise money quickly.
Debt vs equity: it all depends on what works for your business as well as overall financing needs. However, some people may not have access to lending due to excessive debt. If this is you, CreditAssociates can help. We help people with burdensome personal and business debts and can put together a plan to help you become debt free in 24-36 months. Contact us today and an expert Debt Consultant will walk you a free debt assessment.