Every company needs money to grow, and one common way to raise it is through equity financing. So, what is equity financing? It is when a business sells part of its ownership to investors in exchange for capital. Instead of borrowing and repaying loans with interest, the company offers investors a share in its future profits and a role in key decisions.
In this blog, we will explain what equity financing is, the main types, IPOs, venture capital, and private equity. We will also discuss how it compares with debt financing, when companies usually seek it, and the role of investment bankers in the process.
Table of Contents:
What is Equity Financing?
Equity financing happens when a company raises funds by selling a part of its ownership to investors. The business provides investors with a stake in the company and a role in its future growth instead of taking on debt.
This type of capital can be obtained from friends, relatives, angel investors, venture capitalists, or through an IPO (initial public offering). It is often used by startups to meet initial costs such as purchasing equipment, developing the product, or covering initial salaries. Investors earn money in the form of dividends or by selling their shares later at a better price.
The Role of Equity Financing in Growing a Business
For founders, equity financing can be a way to finance expansion without accumulating too much debt. Understanding equity financing is essential for gaining insight into how businesses grow and structure ownership.
Key Concepts to Know
- Shares: Units of ownership in a company.
- Valuation: The approximate value of the company.
- Dilution: When new shares are issued, the ownership percentage of existing shareholders decreases.
Let’s look at an example of a mobile company. The company needs to expand its warehouse. But instead of borrowing, it sells 10% of its ownership to an investor. The company receives the money to expand, while the investor gets an ownership share in the business and a say in important decisions.
Types of Equity Financing
Equity financing in India has developed at a rapid pace over the last twenty years. It presents numerous opportunities for companies to raise capital depending on their stage of development and strategy.
1. 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. It helps firms generate significant capital and provide an exit to the original investors. In India, the IPO of Zomato in 2021 was a landmark in the startup ecosystem, and LIC’s ₹21,000 crore IPO in 2022 was the largest ever by issue size.
2. Follow-on Public Offering (FPO)
A company may issue more shares to raise funds through an FPO after becoming public. This method is often used for acquisitions, market expansion, or debt reduction. For example, Yes Bank raised ₹15,000 crore in 2020 through an FPO to strengthen its balance sheet.
3. Private Equity
In India, private equity plays a central role in the funding landscape, especially in sectors like infrastructure, healthcare, and technology. These funds typically invest large amounts in established businesses to help them scale further or restructure.
4. Seed and Angel Investors
These investors provide initial funding to startups, often before they generate revenue. In the case of Flipkart, the early angel investors helped the company rise to the top of Indian e-commerce before becoming one of its greatest success stories.
5. Venture Capital and Growth Investors
High-growth companies raise multiple funding rounds from VC and growth funds. Byju’s, Paytm, and Swiggy have drawn major funding from global investment firms like Sequoia Capital, SoftBank, and Tiger Global. Such investors not only invest money but also bring networks and knowledge that help businesses to grow within a short period of time.
6. Private Placements
In private placements, shares are sold to a few accredited or institutional investors. This is the path that is usually taken by mid-sized companies in India, which require quicker access to capital without the same level of compliance as a public issue. For example, Adani Enterprises has raised funds from institutional investors in the form of private placements.
7. Crowdfunding
Equity crowdfunding in India is still at an early stage and is limited by regulation, although it has attracted startups with a high consumer appeal. Although not yet as common as in the US or Europe, platforms such as Tyke have experimented with models that would enable retail investors to invest in early-stage rounds.
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How Equity Financing Works
In its simplest form, equity financing operates as follows: a firm determines the amount of funds it requires and how much control it is willing to give up. Investors are offered a stake in the company in exchange for money.
Some investors just give money and don’t get involved in daily decisions, while others help guide the company’s plans. It also depends on the kind of shares. Preferred or convertible shares provide additional rights and protection to the investors, whereas common shares usually offer standard voting rights and dividends.
For example, a startup may issue preferred shares to give investors a say in key decisions, since the venture is risky. This provides investors with some protection along with the chance of higher returns if the company succeeds.
Ultimately, equity financing is a negotiation: control in exchange for capital, and terms must be determined by the requirements of the business and the risk-taking and control-seeking appetite of the investor.
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
Equity financing refers to giving up part of the company in exchange for capital. Debt financing refers to a loan taken by a third party and has to be paid with interest. Hybrid instruments, such as convertible debt, blur the line because they start as loans but can later convert into equity.
A company can choose to raise capital in two different ways. Generally, the Chief Financial Officer (CFO) evaluates the risks and benefits. Availability of money, cash flow of the company, and control significance are all contributory factors in the decision. Equity is permanent except when shares are bought back, and debt is temporary, except for the obligation of debt repayment.
The key considerations that lead to the decision are:
1. Cost of Debt
Debt is often attractive when interest rates are low. As rates rise, that advantage weakens.
2. Amount of Capital Needed
The larger the funding needed, the more likely it is that equity financing makes sense. Firms would not wish to burden their balance sheets with much debt.
3. Terms of Equity
Equity comes with certain requirements, like preferential treatment of investors in future rounds. In case terms are restrictive, debt can seem better.
4. Quality of Investor
Good investors bring not just money but also experience, contacts, and future funding. If a company doesn’t get that, turn towards debt.
5. Company Valuation
The owners would not be keen to sell equity at low prices when they think their company is undervalued. Debt can provide temporary funding till valuations match expectations.
In the end, the right choice between debt and equity financing depends on a company’s goals, risk tolerance, and how much control it wants to maintain.
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The Right Time to Consider Equity Financing
Equity financing is most appropriate where the company needs more than just money. Besides capital, investors usually come with experience, contacts, and credibility that can help a business rise faster than it would have without the investors.
Situations where companies turn to equity financing:
1. Startups looking to grow: The young businesses tend to raise equity to build cash reserves, develop products, or expand their customer base.
2. Funding acquisitions: Companies can use equity financing as a means of financing strategic takeovers without incurring a lot of debt.
3. Growth of established companies: Existing companies increase funds through equity when venturing into new markets, constructing factories, or undertaking any other large projects.
4. Strengthening the balance sheet: Certain companies increase equity to enhance their financial standing when their cash flow is under pressure.
5. Preparing for an IPO: Institutional investors bring experience and contacts, which professionalize management and prepare the company to go public.
Equity Financing in Investment Banking
Equity financing refers to the raising of funds through the sale of company shares. Unlike lenders, investors get a stake, not interest. Organizations tend to expand or venture into new markets with it. Equity provides ownership interests to the investors as opposed to debt, where a person must repay the borrowed money along with the interest. It is applied by companies to grow, innovate, or venture into new markets.
The role played by investment bankers in raising equity
Investment bankers manage the process by identifying the financing needs and matching the company with suitable investors. They pitch the business to venture capitalists, institutional investors, or the public, depending on the stage of the company.
One of the key tasks is valuing the shares, which bankers do through financial models, market comparisons, and growth projections. They also plan how to attract the right investors without undervaluing the company.
Equity Financing in the Real World
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.
The Intellipaat IIM Ranchi Investment Banking Certification puts these concepts into practice. You learn how to negotiate a deal, create a financial model, and navigate capital markets to align transactions with business objectives. By the end, you will be able to manage an equity raise from start to finish, whether advising companies or making investment decisions.
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 the shareholders with the right to vote and claim the 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 financing mechanism through which investors raise capital in projects (usually in the renewable energy sector) by allowing them to receive tax credits and a portion of project revenues. It helps companies to generate revenue while investors reduce their taxes.
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.