What is equity financing? (Advantages and disadvantages)

By Indeed Editorial Team

Published 12 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Companies of all sizes and stages of growth may require raising capital at some time. There are different ways to do this, the main two of which are debt (taking out a loan from a bank or lender) and equity (seeking investors to invest in the company in exchange for a share of the profit). If you're interested in a career in investment, banking, finance or business, it can be useful to understand what equity financing is and how it works. In this article, we define the term and explain the advantages and disadvantages of equity investment for businesses.

What is equity financing?

If you're a small business owner or manager or you're interested in a career in finance and investing, you might be wondering what equity financing is. This is simply when an investor gives money to a company in exchange for shares, which they may later be able to sell for a profit if the company grows in value is equity financing. Investors also sometimes receive dividends, which are a portion of the company's profit paid out on a quarterly, biannual or annual basis.

Equity financing can be an attractive option for businesses looking to raise capital, and unlike a loan, it doesn't come with an obligation to repay the money. Since investors only get a return on their investment if the company does well, it's also in their interest to support the company's leadership team to help the company grow. This means that companies can get access to investors' expertise and knowledge and their money.

Related: How to become a private equity associate: a complete guide

Advantages of equity financing

There are many advantages of equity financing for companies who want to raise capital, including:

  • Freedom from debt: By opting for equity financing instead of taking out a loan, companies can focus on growth without the burden of monthly repayments or costly interest charges.

  • Possibility of raising more capital: Companies can generally raise larger amounts of capital with equity finance than with debt.

  • Business experience, contacts and skills: Some investors bring added value to the companies they invest in, in the form of their business expertise, skills and useful contacts they may have made over a long career.

  • Possibility of follow-on funding: Often, investors prepare to provide additional funding in the future as the company grows.

Disadvantages of equity financing

Equity financing also has disadvantages compared to other methods of raising funds. For example:

  • Potential loss of control: Since investors own part of the company after they invest in it, some company leaders worry about losing control over how their business runs.

  • Requirement to split profit: Companies might split their profits with their investors, although this could be worthwhile in exchange for the financial value and expertise they bring.

  • Time-consuming process: Raising the funds required can take several rounds of investment and can be a time-consuming process for companies compared to taking out a loan.

What types of companies use equity financing?

While equity financing can be a great way of raising capital without the obligation of debt, it's not the right choice for every company. Here are some situations when it might be a good idea for a company to seek equity funding:

Early-stage companies

Companies in their early stages may find it harder to get a bank loan than more established companies because they rarely have much of a financial track record. Even if they receive loan approval, they're likely to be able to raise much more capital through investment than through debt. For example, tech startups in the early stages might have plenty of intellectual assets, but few tangible assets they could use to secure a loan. At the pre-revenue stage, investment can get companies off the ground and help them to cover expenses such as research and development.

Established companies with plans for growth

When companies are planning a significant period of expansion, they might require raising significant capital to achieve their goals. Sometimes, this might require more funds than they could secure with a loan. For example, a company might seek to operate in a new market, develop new products or simply expand its operations. In this case, equity finance would allow them to get the funds they need without having to make loan payments, which could hinder their potential for fast growth.

Businesses wanting to buy another company

When one company acquires another, they often raise the funds required through a variety of sources. This is also the case when the management of a company buys out the owner and continues running the company themselves, a process which is known as a management buy-out, or MBO. In both of these cases, equity financing could help a company or management team to achieve its goals.

Related: How to become an investment analyst (with steps and skills)

Businesses seeking acquisition

When company owners want to sell their business, they have a better chance of making a sale if the company is at a stage of growth and expansion. For potential buyers, this reassures them that the company is going to be profitable for them. Business owners might therefore seek out equity investment to help the company achieve its expansion goals before putting it up for sale.

Related: How to become an investment banker

Types of equity investors

Equity finance can come from a variety of different sources, depending on the type of company and its stage of growth. Here are some examples of the types of investors a company might seek:

  • Family and friends: one of the most common sources of funds for foundling companies is the founder's network of family and friends, who might buy into the company to help them get it off the ground.

  • Angel investment: Angel investors are high-worth individuals who invest their own money in companies. They often choose to invest in early-stage companies and may act on their own or as part of a group of investors known as a syndicate.

  • Venture capital: Venture capital (VC) funds invest in companies with the potential for a high level of growth, in exchange for a small stake. They generally engage in high-risk investments, such as investing in new or newly expanding companies.

  • Corporate venture capital: Corporate venture capital is a subcategory of venture capital and refers to large organisations investing in smaller ones for strategic or financial reasons.

  • Private equity: Private equity firms raise pools of capital to invest in companies in the hope of a positive return. They generally invest in more mature companies that are considered safer investments.

  • Equity crowdfunding: Businesses can raise funds through equity crowdfunding by pitching their product or service on a crowdfunding website. The premise is to raise a large number of small investments from several investors.

  • Government funds and schemes: There are several different government funds that provide equity financing to businesses. Generally, these funds help start new small businesses.

  • Tier 1 investment: Tier 1 investors are non-EEA investors who want to move to the UK to become involved in a business. By committing a minimum of £2M to a UK business, these individuals may be able to apply for a Tier 1 visa, which would allow them to live and work in the UK.

  • SEIS or EIS: The Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS) are government schemes set up to provide a tax incentive for individuals to invest in early-stage and growing companies. Investors are offered either a 50% (SEIS) or 30% (EIS) tax break for investments in certain companies.

  • Family offices: Family offices are private firms that are usually set up by wealthy families to manage their finances. Since they are managing wealth that has been built up over generations, family offices can be selective and generally look for long-term investments.

Related: What are private equity funds?

Finding the right investor

When a company enters into an agreement with an investor, they are starting a potentially long-term business relationship with them. Since investors own part of the companies they invest in and may be able to exercise control in some areas, it's important for businesses to choose the right investor. If you're a company leader looking for an investor, it could be a good idea to consider the following questions:

  • How involved do you want the investor to be in running the business?

  • What resources, knowledge, contacts and expertise can they bring?

  • Have they historically made follow-on investments in companies?

  • Are they a good fit for the company's brand and culture?

  • Does their vision for the company align with that of the senior leadership team?

Related:

  • Debt market vs equity market: what is the difference?

  • What is a zero-coupon bond? (Benefits and examples)


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