Bringing any business idea to life requires money. Founders and CFOs must decide whether to borrow funds or give up equity. Equity financing, which involves selling a part of your company in exchange for capital, is a key decision that determines who controls your business.
In this blog, we will explain exactly what equity financing is, how it differs from traditional debt, the key types (from IPOs to angel investors), and how companies in India are using it to scale their business.
Table of Contents:
What is Equity Financing?
Equity financing is how a company raises capital by selling shares of ownership to investors. Rather than taking a loan with fixed repayment terms, the company offers investors a share in its future growth.
The funding can come from various sources, including friends, family, angel investors, venture capitalists, or through an Initial Public Offering (IPO). For startups, this is a common way to fund expenses such as equipment, product development, and paying initial salaries. In exchange for their investment, equity investors earn a return either through dividends or by selling their shares for a profit as the company grows.
Role of Equity Financing in Growing a Business
For founders, equity financing can be a strategic way to grow quickly without taking on too much debt. It is important to understand how equity influences a company’s ability to manage its growth and ownership structure effectively.
Key Concepts to Know
- Shares: Units of ownership in a company.
- Valuation: The approximate monetary value of the company, determined before (pre-money) and after (post-money) an investment.
- Dilution: The reduction in the ownership percentage of existing shareholders when new shares are issued. While it dilutes the founder’s equity, a successful equity round can grow the company overall, making the smaller stake more valuable.
Let’s look at an example with a mobile company. The business needs ₹1 crore to expand its warehouse. Instead of borrowing, it offers a venture capital firm 10% of its ownership in a deal that values the company at ₹100 crore. The company receives the money to expand, while the investor receives a stake in the business, strategic advice, and a voice in major decisions. Finally, the founders, who once held 100% of the company, now own 90%, but it is a 90% stake in a more valuable and well-equipped company.
Types of Equity Financing
Equity financing in India has developed rapidly over the last twenty years, offering numerous opportunities for companies to raise capital depending on their stage of development and strategy. The type of financing often changes as the business grows, from private funds in early stages to public listings after maturity.
Here are the main types of equity financing:
1. Seed and Angel Investors
These investors provide initial capital to startups, often before they generate revenue. In the case of Flipkart, early angel investors helped the company rise to the top of Indian e-commerce before it became one of India’s greatest success stories.
2. Venture Capital and Growth Investors
High-growth companies raise multiple funding rounds from VC and growth funds once they have a proven business model. Byju’s, Paytm, and Swiggy have received major funding from global investment firms like Sequoia Capital, SoftBank, and Tiger Global. These investors bring not only money but also networks and knowledge that help businesses grow rapidly.
3. Private Equity
In India, private equity funds typically invest large amounts in established businesses, often in sectors like infrastructure, healthcare, and technology, to help them scale further, restructure operations, or acquire other companies.
4. Private Placements
In private placements, shares are sold directly to a few accredited or institutional investors rather than the public. This path is usually taken by mid-sized companies requiring faster access to capital without the extensive compliance of a public issue. For example, Adani Enterprises has raised funds from institutional investors this way.
5. Crowdfunding
Equity crowdfunding in India is still at an early stage and limited by regulation, although it has attracted startups with high consumer appeal. Platforms such as Tyke have experimented with models that allow retail investors to participate in early-stage rounds.
6. Initial Public Offering (IPO)
An IPO is when a privately held company lists its shares on a public exchange, such as the NSE or BSE. This helps firms generate significant capital and provide an exit for the original investors. In India, the IPO of Zomato in 2021 was a landmark for the startup ecosystem, and LIC’s ₹21,000 crore IPO in 2022 was the largest ever by issue size.
7. Follow-on Public Offering (FPO)
After becoming public, a company may issue more shares to secure more funding through an FPO. This method is often used for major acquisitions, market expansion, or debt reduction. For example, Yes Bank raised ₹15,000 crore in 2020 through an FPO to strengthen its balance sheet.
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How Equity Financing Works
In its simplest form, equity financing is a negotiation where a company trades ownership and some control over the company in exchange for capital. The process typically includes these steps:
A firm determines its funding needs and how much ownership it is willing to exchange. Investors are then offered a stake in the company in exchange for money.
Different shares come with different rights. While common shares offer standard voting rights and dividends, preferred shares or convertible shares can provide investors with extra rights and protections. For example, preferred shares often give investors priority in receiving dividends or proceeds from a sale or business exit.
Negotiating the Term Sheet: The negotiation of an equity investment is documented in a term sheet, highlighting the main aspects of the deal. Alongside valuation, it includes important provisions like:
- Investor Control: This can involve board seats or approval rights on major decisions.
- Liquidation Preference: Decides the payment order and the amount received in a sale or liquidation.
- Anti-Dilution Measures: Keep an investor’s share as the company raises more funds.
The Capitalization Table: Issuing new shares updates the company’s cap table, which tracks each shareholder’s ownership. Founders’ stakes are diluted with each round, but if the company’s overall value grows, even a smaller share can become more valuable.
Ultimately, the deal terms reflect a balancing act between capital and control negotiated according to the business’s and the investor’s appetite for risk.
Advantages and Disadvantages of Equity Financing
Equity financing is the process of raising capital by selling part of your company. It may lead to capital and growth facilitation, but it comes at the cost of losing a portion of your ownership and control.
Advantages of Equity Financing
- No repayment pressure: No interest or monthly payments, freeing up cash flow to grow the business.
- Availability of capital: Makes funds available to startups or businesses that have minor credit history.
- Expert mentorship and network: Investors bring experience, mentorship, and contacts.
- Long-term growth focus: Shareholders are concerned with long-term prosperity rather than short-term profitability.
Disadvantages of Equity Financing
- Ownership dilution: Founders give up a part of the company and decision-making.
- Profit sharing: The investors may demand a portion of profit, usually in the form of dividends.
- Conflict possibilities: Differences in vision and mission between founders and investors can slow decisions.
- Higher long-term cost: Dividends are not tax-deductible for the company, unlike interest payments on debt. This makes equity financing more expensive over the long run from the company’s perspective.
Debt Financing vs Equity Financing: How Companies Decide
Choosing to pursue equity or debt financing is an important choice for any business owner. Equity financing involves selling a part of the company in exchange for capital, while debt financing involves borrowing a loan that must be paid with interest. Hybrid instruments, such as convertible debt, can blur the line, starting as loans but later converting into ownership stakes.
Generally, the Chief Financial Officer (CFO) evaluates the risks and benefits, considering things like available funding, how steady the cash flow is, and the significance of retaining control.
The key considerations that lead to the decision are:
1. Cost of Debt
Debt is often more attractive when interest rates are low. However, equity can sometimes be the only option for startups with no credit history. The real cost of equity (high investor return expectations) in the long term versus debt (interest payments and possible collateral) needs a careful look.
2. Amount of Capital Needed
The larger the funding needed, the more likely it is that equity financing makes sense. Firms often avoid burdening their balance sheets with too much debt to fund large-scale expansion or acquisitions.
3. Terms of Equity
Equity comes with requirements such as preferential treatment of investors or board seats. If these terms are viewed as too demanding and restrictive by founders, debt financing might seem better, provided the business can manage the repayments.
4. Quality of Investor
Good equity investors bring not just money but also experience, contacts, and future funding opportunities. If a company only needs money and not mentorship, debt often makes more sense.
5. Company Valuation
Owners are often unwilling to give up equity at a low price when they think their company is undervalued. Debt can provide temporary funding until the business achieves better metrics and a valuation that matches expectations.
Ultimately, the choice between debt and equity financing depends on a company’s goals, immediate needs, risk tolerance, and the level of control its founders wish to maintain.
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When to Consider Equity Financing
Equity financing is most suitable when a company requires more than just capital. Besides capital, investors usually provide the experience, contacts, and credibility that can help a business grow faster than it could on its own.
Situations where companies turn to equity financing:
1. Startups looking to grow: Young businesses often raise equity to build cash reserves, develop products, or expand their customer base when traditional loans are not an option.
2. When debt is unavailable: Startups often do not meet the credit or collateral requirements for bank loans, making equity the only option to secure significant capital.
3. Funding acquisitions: Companies can use equity financing as a means of paying for strategic takeovers without incurring a lot of debt and burdening their balance sheet.
4. Growth of established companies: Existing companies raise funds through equity when venturing into new markets, constructing factories, or undertaking any other large projects that require significant capital without taking on repayment obligations.
5. Strengthening the balance sheet: Companies raise equity to improve their financial standing and debt-to-equity ratio, making them a lower-risk choice for future lenders when their cash flow is under pressure.
6. Preparing for an IPO: Institutional investors bring experience and contacts, which professionalize management, enhance corporate governance, and prepare the company to go public.
Role of Investment Bankers in Equity Financing
When a company is ready to raise funds through equity, investment bankers often play a key intermediary role, especially for high-value transactions like IPOs. They serve as advisors to help the company handle the complexities of the process and achieve a successful raise.
Managing the Process and Matching Investors
Investment bankers manage the entire process, from identifying the company’s financing needs to matching it with suitable investors. They connect the company with potential investors, pitching the business to venture capitalists, institutional investors, or the public, depending on the company’s stage and funding strategy.
Valuation and Pricing
A major part of an investment banker’s job is valuing the company’s shares. They use market comparisons, growth projections, and financial modeling to determine a proper valuation. They also strategize the pricing to attract the right investors without undervaluing the company.
Attracting and Negotiating with Investors
Investment bankers are experts at marketing the equity offering and negotiating with potential investors. Their job is to help secure the best possible terms for the company while satisfying the investor’s expectations.
Real-Life Examples of Equity Financing
Equity financing is easier to understand with these practical examples.
Example 1: A startup’s journey with angel and VC funding
Startups in their early stage usually depend on angel investors and venture capitalists to get started. By selling equity to such investors, founders secure funding to develop products, hire staff, and scale operations. Each funding round involves valuation, negotiation, and a growth plan.
Example 2: An established company’s decision to go public via an IPO
Going public is a major step for established companies. An initial public offering (IPO) allows a business to raise significant capital from the public while giving investors a chance to own a part of the company. Investment bankers help prepare financial statements, determine the offering price, and launch the IPO in the market.
The Bottom Line
Any business owner or finance professional must understand equity financing to grow a business or succeed in the industry. It enables corporations to raise capital by selling ownership interests, instead of by incurring debt. Understanding how firms finance themselves, how they structure deals, and how to get the attention of investors provides you with a competitive advantage in finance.
Now that you understand the fundamentals, the next step is putting these concepts into practice. Programs like the Investment Banking Certification from IIM Ranchi can provide the practical skills needed to negotiate a deal, create a financial model, and navigate capital markets to manage an equity raise from start to finish.
What is Equity Financing – FAQs
Q1: What is equity in finance?
The meaning of equity in finance is ownership in a company. It is the worth of the shares the owners or investors have upon accounting for the debts and liabilities. Simply put, it’s what you truly own in a business.
Q2: How many types of equity are there?
There are two broad categories of equity: common and preferred equity. Common equity provides shareholders with voting rights and a claim to profits. Preferred equity typically has fixed dividends and precedence of payment over common shareholders.
Q3: What is tax equity financing?
Tax equity financing is a mechanism where investors provide capital to projects (usually renewable energy) in exchange for the project’s tax credits and a portion of the revenues. It helps the operating company secure funding while investors reduce their tax burden.
Q4: What is equity financing for startups?
Equity financing is a method by which startups raise funds by means of selling ownership to investors. New companies typically do not have a credit history or a consistent cash flow, which is why equity is a practical way to fund product development, marketing, and staffing, while also bringing in expert investors.
Q5: How do equity investors get paid back?
Equity investors do not get regular repayments like lenders. Instead, they get returns in the form of dividends when the company declares them, or by selling their shares at a premium if the company grows.
Q6: Is equity financing always better than debt financing?
Not always. Equity works well for startups that need capital plus investor support, while debt suits businesses with steady cash flow that can handle repayments. Most companies end up using a mix of both.
Q7: How do founders decide how much equity to give away?
It depends on how much money they need, the company’s valuation, and how much control they want to retain. The goal is to raise enough funds to grow without giving up too much ownership too early.