WHEN EQUITY BECOMES NECESSARY FOR BUSINESS GROWTH
Equity financing is a business strategy for obtaining capital that involves selling a partial interest in the company to investors. The equity, or ownership position, that investors receive in exchange for their funds usually takes the form of stock in the company. In contrast to debt financing, which includes loans and other forms of credit, equity financing does not involve a direct obligation to repay the funds. Instead, equity investors become part owners and partners in the business, and thus are able to exercise some degree of control over how it is run.
Since creditors are usually paid before owners in the event of business failure, equity investors accept more risk than debt financiers. As a result, they also expect to earn a higher return on their investment. But because the only way for equity investors to recover their investment is to sell the stock at a higher value later, they are generally committed to furthering the long-term success and profitability of the company. In fact, many equity investors in start-up ventures and very young companies also provide managerial assistance to the entrepreneurs.
Advantages and Disadvantages
The main advantage of equity financing for businesses, which are likely to struggle with cash flow initially, is that there is no obligation to repay the money. In contrast, bank loans and other forms of debt financing provide severe penalties for businesses that fail to make monthly principal and interest payments.
Equity financing is also more likely to be available to concept and early stage businesses than debt financing. Equity investors primarily seek growth opportunities, so they are often willing to take a chance on a good idea. But debt financiers generally seek security, so they usually require the business to have some sort of track record before they will consider making a loan.
Another advantage of equity financing is that investors often prove to be good sources of advice and contacts for business owners.
The main disadvantage of equity financing is that the founders must give up some control of the business. If investors have different ideas about the company’s strategic direction or day-to-day operations, they can pose problems for the entrepreneur. In addition, some sales of equity, such as initial public offerings, can be very complex and expensive to administer.
Such equity financing may require complicated legal filings and a great deal of paperwork to comply with various regulations. For many businesses, therefore, equity financing may necessitate enlisting the help of attorneys and accountants.
There are several factors entrepreneurs should consider when choosing a method of financing. First, the entrepreneur must consider how much ownership and control heor she is willing to give up, not only at present but also in future financing rounds.
Second, the entrepreneur should decide how leveraged the company can comfortably be, or its optimal ratio of debt to equity.
Third, the entrepreneur should determine what types of financing are available to the company, given its stage of development and equity needs, and compare the requirements of the different types.
Finally, as a practical consideration, the entrepreneur should ascertain whether or not the company is in a position to make set monthly payments on a loan.
Business owners must keep in mind that the more equity they give up to investors, the more they are working for someone else rather than themselves. Some entrepreneurs tend to think of equity financing as a free loan, but in fact it can quite an expensive way to raise capital.
For a business to make equity financing cost-effective, it must be able to command a fair price for its stock. This entails convincing potential investors that the business has a high current valuation and a strong potential for future earnings growth. Entrepreneurs should proceed cautiously and try to use more than one form of financing to ensure business growth.
They should also compare the cost of equity financing to that of other financing options, as well as consider the ramifications of equity financing on company’s current and future capital structure.