When the capital is raised by the sale of shares of the enterprise, it is termed as equity financing. Equity financing is selling a stake in the company to raise funds.
The equity, or ownership position, that investors receive in exchange for their funds usually takes the form of stock in the company. In contrast to debt financing, which includes loans and other forms of credit, equity financing does not involve a direct obligation to repay the funds.
Instead, equity investors become part-owners and partners in the business, and thus are able to exercise some degree of control over how it is run. Since creditors are usually paid before owners in the event of business failure, equity investors accept more risk than debt financiers.
As a result, they also expect to earn a higher return on their investment. But because the only way for equity investors to recover their investment is to sell the stock at a higher value later, they are generally committed to furthering the long-term success and profitability of the company.
In fact, many equity investors in startup ventures and very young companies also provide managerial assistance to the entrepreneurs.
In contrast, bank loans and other forms of debt financing provide severe penalties for businesses that fail to make monthly principal and interest payments. Equity financing is also more likely to be available to concept and early stage businesses than debt financing.
Equity investors primarily seek growth opportunities, so they are often willing to take a chance on a good idea. But debt financiers primarily seek security, so they usually require the business to have some sort of track record before they will consider making a loan.
Another advantage of equity financing is that investors often prove to be good sources of advice and contacts for small business owners. The main disadvantage of equity financing is that the founders must give up some control of the business. In addition, some sales of equity, such as initial public offerings, can be very complex and expensive to administer.
Such equity financing may require complicated legal filings and a great deal of paperwork to comply with various regulations.
For many small businesses, therefore, equity financing may necessitate enlisting the help of attorneys and accountants. In the Small Business Administration publication Financing for the Small Business, Brian Hamilton listed several factors entrepreneurs should consider when choosing a method of financing.
First, the entrepreneur must consider how much ownership and control he or she is willing to give up, not only at present but also in future financing rounds. Second, the entrepreneur should decide how leveraged the company can comfortably be, or its optimal ratio of debt to equity.
Third, the entrepreneur should determine what types of financing are available to the company, given its stage of development and capital needs, and compare the requirements of the different types.
Finally, as a practical consideration, the entrepreneur should ascertain whether or not the company is in a position to make set monthly payments on a loan. Some entrepreneurs tend to think of equity financing as a free loan, but in fact it can be quite an expensive way to raise capital.
For a small business to make equity financing cost-effective, it must be able to command a fair price for its stock. This entails convincing potential investors that the business has a high current valuation and a strong potential for future earnings growth.
Schilit recommended that entrepreneurs proceed cautiously and try to use more than one form of financing to ensure business growth.
Venture capital firms often invest in new and young companies. Since their investments have higher risk, however, they expect a large return, which they usually realize by selling stock back to the company or on a public stock exchange at some point in the future.
In general, venture capital firms are most interested in rapidly growing, new technology companies. They usually set stringent policies and standards about what types of companies they will consider for investments, based on industries, technical areas, development stages, and capital requirements.
As a result, formal venture capital is not available to a large percentage of small businesses. Closed-end investment companies are similar to venture capital firms but have smaller, fixed or closed amounts of money to invest.
These companies themselves sell shares to investors, then use this money to invest in other companies. Closed-end investment companies usually concentrate on high-growth companies with good track records rather than startup companies.
Similarly, investment clubs consist of groups of private investors that pool their resources to invest in new and existing businesses within their communities. These clubs are less formal in their investment criteria than venture capital firms, but they also are more limited in the amount of capital they can provide.
Large corporations often establish investment arms very similar to venture capital firms. However, such corporations are usually more interested in gaining access to new markets and technology through their investments than in strictly realizing financial gains.
Partnering with a large corporation through an equity financing arrangement can be an attractive option for a small business. Equity investments made by large corporations may take the form of a complete sale, a partial purchase, a joint venture, or a licensing agreement.
Basically a type of retirement plan, an ESOP involves selling stock in the company to employees in order to share control with them rather than with outside investors.
ESOPs offer small businesses a number of tax advantages, as well as the ability to borrow money through the ESOP rather than from a bank. However, ESOPs can be very expensive to establish and maintain.Some possible sources of equity financing include the entrepreneur's friends and family, private investors (from the family physician to groups .
Private investors are another possible source of equity financing. A number of computer databases and venture capital networks have been developed in recent years to help link entrepreneurs to.
Equity Financing Definition: Equity financing is the strategy for raising capital by offering companies stocks / shares to investors, public, money lenders, institutions etc. Generally those who receive the shares or stocks are known as shareholders of the companies.
For instance: A startup might require different rounds of equity financing to address liquidity issues. Equity capital comes from the sale of ownership pieces in the company. A small business may sell shares to investors or bring on investor-partners to provide money in exchange for ownership and sharing of future profits.
Nov 21, · A home equity loan is a second mortgage that allows you to borrow against the value of your home. Your home equity is calculated by subtracting how much you .
Apr 23, · There are many sources of equity – and nearly all are difficult to tap. But some are more difficult than others. Some are more expensive than others. Some are more controlling than others. So find the right source for you if you want to create wealth and control it.
The first and most obvious source is your own savings.