Equity financing is the process of raising money for a business by selling ownership interests in it. Instead of borrowing and promising to repay a lender with interest, the company gives investors shares, and those investors become part-owners who share in future profits and losses. Equity can come from founders, friends and family, angel investors, venture capital funds, private equity firms or, for larger companies, the public through a stock exchange listing.
Equity financing is usually discussed alongside its main alternative, debt financing. Most companies use a blend of the two, and the mix they choose is called their capital structure. The general concept is also covered on the existing entry for equity finance; this entry focuses on the accounting and reporting side.
How equity financing works
A company that needs capital decides how much it wants to raise and what share of the business it is willing to give up. The price investors pay depends on the company's valuation. Early-stage firms often raise money in rounds (seed, Series A, Series B and so on), and each round sets a new price per share. Mature companies may issue new common stock or preferred stock through an initial public offering or a follow-on offering, usually with the help of investment banks.
The key trade-off is dilution. When new shares are issued, each existing owner holds a smaller percentage of the company. If a founder owns 1,000,000 of 1,000,000 shares and the company sells 250,000 new shares to an investor, the founder's stake falls from 100 percent to 80 percent. Dilution is acceptable if the money raised makes the whole company more valuable than it would otherwise be.
When a corporation sells shares for cash, it debits cash and credits stockholders' equity accounts. If the shares have a par value, the par amount is credited to the common stock account and anything paid above par goes to additional paid-in capital. Suppose a company issues 100,000 shares with a par value of $0.01 each at $5.00 per share:
- Cash is debited for $500,000, the total received.
- Common stock is credited for $1,000, which is 100,000 shares times $0.01 par.
- Additional paid-in capital is credited for $499,000, the amount above par.
Costs of issuing the shares, such as underwriting and legal fees, are normally deducted from paid-in capital rather than expensed. The proceeds appear on the statement of cash flows under financing activities, and the new equity increases the equity section of the balance sheet.
Equity versus debt
Equity has several advantages. There are no fixed repayments, so it does not strain cash flow, and it does not raise the risk of default. Investors may also bring advice and contacts. The main drawbacks are loss of control, dilution and cost: because equity investors take more risk than lenders, they expect higher returns, so equity is usually the most expensive part of a company's cost of capital. Dividends paid to shareholders are also not tax-deductible, while interest on debt generally is.
Analysts watch the balance between the two using measures such as the debt-to-equity ratio. A company funded mainly by equity has low leverage and is less exposed to rising interest rates, but its owners may earn a lower return on equity than they would with some borrowing in the mix.
Regulation
In the United States, selling shares to investors is an offer of securities, so it must either be registered with the Securities and Exchange Commission or qualify for an exemption, such as Regulation D for private placements or Regulation Crowdfunding for small online raises. Companies that register must then file regular reports, including the annual Form 10-K.