Equity Financing

March 24, 2020 12:17 AM


Kevin Valley

From an investor’s point of view, equity securities are higher risk, higher returning investments, relative to...

Equity Financing refers to raising money for a company’s activities by selling shares to investors who, in return, will receive an ownership interest in the corporation for their money. 

Return on Equity Investments

The return on equity investment is usually not fixed, but rather, dependent on the increase in the value of the shares linked to the value of the business (and dividend distributions) over an unknown period of time. Unlike a debt that bears a fixed rate and has a repayment schedule, the expected returns of equity investments are generally commensurate with the level of risk associated with the financial instrument. 

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

Despite its higher cost, companies seek equity capital for two main reasons: 

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

Why Companies use Equity Financing?

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); 
  • A change in ownership (or the owner’s retirement); 

Many of these corporate activities are 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, post-financing. A company’s bankruptcy risk tends to be lower when equity financing is used. Younger, less mature companies in the business life cycle tend to require a greater proportion of equity in their capital structure, given that their cash flows are often inherently riskier.

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