Equity financing refers to raising funds for business use by issuing company shares for money or other assets. When a company raises capital, it is most commonly done by selling common, preferred, or some combination of these.
Where a proprietorship may be funded entirely by its owner or with money that the owner receives from family, friends, or venture capitalists, corporations will be financed by stockholders who may include individuals, venture capitalists, or institutional investors.
Standard Features of Equity Financing
- It is expensive for a company to issue fresh equity shares.
- Raising equity finance is time-consuming for both the company and potential investors who need to understand the nature of their potential investment.
- Access to the capital markets could be difficult.
- Stock markets, while always open in theory, may have limited liquidity, dependent upon the macroeconomic environment.
- Sometimes, frequent equity issuance is considered suspicious.
The historical performance of previous equity issuance would be scrutinized and will influence the appetite for future issues, mainly when previous issues had not delivered the expected returns.
Often, equity issuance is combined with a significant corporate event, such as a large acquisition or a general refinancing. The whole company will go through an enormously busy period to tie everything together as it will need to make an unconditional announcement covering all the news at a particular time.
Reasons to Raise Equity Finance
Some of the standard reasons to raise equity finance are: –
- To raise additional funds for investment, e.g., to:
- finance an investment program; or
- finance an acquisition.
- To manage capital structure, e.g., to:
- reduce gearing (levels of debt), possibly caused by losses; or
- optimize the cost of capital.
Methods to Raise Equity Finance
Flotation of Shares
Flotation is when the shares in a company are listed on an exchange for the first time.
Flotation gives a company access to capital and allows a price to be put on the shares. However, it also creates disclosure obligations and short-term pressure on earnings. The most common flotations arise from private equity, venture capital-owned businesses, or foreign companies that wish to list. However, there is also a steady stream of entrepreneurs seeking capital.
Flotation of shares could be done in many ways, as below:-
- Placing the Company’s shares with a group of institutional investors.
- Offer for sale in the form of an IPO.
Of these, a placing is the more common for smaller companies, and IPOs more common for larger companies.
An IPO is a complex, time-consuming, and expensive process that will typically take between four and six months. An IPO involves the board of non-executives and executives, the finance, treasury, legal teams, investment banks, brokers, lawyers, accountants, and PR agents.
Placing of Shares
A placing is an issue of shares directly to selected existing and new shareholders for cash or other consideration. It may be used on flotation or in a significant corporate event such as an acquisition.
A placing of shares may be:
- To one or more institutional investors directly for cash (cash placing); or
- As a consideration to the vendors of a business in a share-for-share exchange (vendor placing).
The allotment of shares to the business vendors is often coupled with an arrangement to sell them to institutional investors, enabling the vendor to receive cash. At the same time, the acquiring company can pay for the acquisition through the issue of shares, and the institutional investor gets shares at a price that is likely below the market price.
Share placings by large companies are generally used to fund small acquisitions or capital expenditure programs. A placing is closely allied to a purchase, underlines the investment case, and usually makes it easier to place the shares.
Placings are typically used for smaller-scale equity issues to avoid triggering pre-emption rights and are usually conducted at a slight discount, say 5%, to the company’s prevailing share price.
It is possible to have large placings which breach pre-emption limits where they exist if existing shareholders are allowed to participate subsequently by giving them a right to apply for the shares being placed. This is known as a ‘clawback’ right.
Types of Equity Shares (also termed as Equity Stock)
Common Stock
With this stock, the advantage to the corporation includes an increase in the company’s ability to borrow money, which never has to be repaid. A disadvantage to the corporation is that it is the highest cost. Advantages to the investor include a higher return than other forms of investing. Common stocks also give the stockholder a voice in corporate governance. A disadvantage to investors is that they are last in line to receive compensation in the event of bankruptcy.
Preferred Stock
Issuing preferred stocks are advantageous to corporations as it includes a lower cost than common equity, and it never has to be repaid. Benefits to the investor include a predetermined return, and in the event of bankruptcy, preferred stockholders have compensated ahead of common stockholders. A disadvantage to investors is that they have no voice in corporate governance.
Non-Voting Stock
An advantage, as well as a disadvantage for corporations, is that these stocks are the same as common stocks. An advantage to investors is that they earn a higher return than preferred stock. Disadvantages to investors include the same as common stock, with the additional disadvantage of not having a voice in corporate affairs.
Equity Financing Channels
Raising equity capital can happen through several different channels. Brief descriptions of a few of the significant channels follow:
Angel Investors
These are generally individuals who take equity shares in a company when the company is very young. Often, friends or family are the original “angel” investors. Angels usually take huge stakes in projects or companies, giving angels substantial control (in many cases) in how those projects or companies are run.
Venture Capital Firms
They are partnerships that make investments in start-up companies. The big difference between venture capitalists and angel investors is that venture capital firms typically invest in many different start-up companies or projects and are more diversified.
Institutional Investors
These represent groups (not individuals) that can invest money in companies or projects. Examples include pension companies, endowment funds, pension funds, etc. Sometimes, institutional investors make direct investments independently, and sometimes they do so as part of venture capital firms. Institutional investors are generally more restrictive in the riskiness of the projects they can take on than individual venture capitalists or angel investors.
Corporate Investors
These represent companies that buy equity interests in other companies. It is widespread for large companies to purchase direct stakes in smaller companies or individual projects.
Individual Investors
These are especially important to corporates. Retail investors form a large base of investors in many big corporates that invest their money at IPO or FPO. Individual or retail investors are well guarded by the guidelines of capital market regulatory authorities like SEBI in India.
Conclusion: Equity Financing benefits both Corporates and Investors
Different types of equity appeal to different types of investors. When evaluating equity investments, consider the risk you are willing to bear and the return you require in compensation for undertaking that risk. Equity investors benefit from business by receiving dividends and capital appreciation in the value of equity shares.
