What is Equity Financing?

October 31, 2020

By

Kevin Valley

The return on equity investment depends on the increase in the value of the shares linked to the value of the business....

Equity Financing refers to raising money for your company’s activities by selling shares to investors in exchange for an ownership interest in the business. 

Return on Equity Investments

The return on equity investment depends on the increase in the value of the shares linked to the value of the business (and dividend distributions) over an indefinite period of time.

Unlike debt that bears a fixed rate and has a repayment schedule, the expected returns of equity investments are generally based on the level of perceived risk of your company achieving its expected growth. 

From an investor’s point of view, equity investments are higher risk, higher returning investments, relative to debt. For this reason, equity tends to be the highest cost of capital that a company can source. 

Why use Equity Financing?

Despite its higher cost, your company might seek equity capital for two main reasons: 

  1. If you do not have further debt capacity; and/or 
  2. When your shareholders prefer the added flexible, less restrictive nature of equity capital, relative to debt. 

Examples of ventures/initiatives that are funded by equity, include: 

  • Seed (R&D and concept) or start-up (commercialization) capital; 
  • Asset acquisition (e.g., machinery, a plant, etc.) for expansion; 
  • New product development, introduction, and commercialization; 
  • Purchase of a competitor (sector consolidation); 
  • Pre-IPO capitalization – issue of equity ownership before going public via an initial public offering; 
  • Management buy-out (MBO) or leveraged buy-out (LBO); and
  • A change in ownership (or the owner’s retirement). 

Note that many of these initiatives can be funded by a combination of debt and equity as a means of balancing the total cost of capital and the total financial risk of the company.

A company’s bankruptcy risk tends to be lower when equity financing is used instead of debt which requires fixed payments.

As such, younger, less mature companies in the business life cycle tend to require a greater proportion of equity in their capital structure, as their cash flows are often inherently riskier.

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