Equity finance is capital through the sale of shares in an enterprise. Equity financing essentially refers to the sale of an ownership interest to raise funds for business purposes.
Equity finance spans a wide range of activities in scale and scope, from a few thousand dollars raised by an entrepreneur from friends and family, to giant initial public offerings (IPOs) running into the billions by household names such as Google and Facebook. While the term is generally associated with financings by public companies listed on an exchange, it includes financings by private companies as well. Equity financing is distinct from debt financing, which refers to funds borrowed by a business.
Equity finance involves not just the sale of common equity, but also the sale of other equity or quasi-equity instruments such as preferred stock, convertible preferred stock and equity units that include common shares and warrants.
A startup that grows into a successful company will have several rounds of equity financing as it evolves. Since a startup typically attracts different types of investors at various stages of its evolution, it may use different equity instruments for its financing needs.
For example, angel investors and venture capitalists – who are generally the first investors in a startup – are inclined to favor convertible preferred shares rather than common equity in exchange for funding new companies, since the former have greater upside potential and some downside protection. Once the company has grown large enough to consider going public, it may consider selling common equity to institutional and retail investors. Later on, if it needs additional capital, the company may go in for secondary equity financings such as a rights offering or an offering of equity units that includes warrants as a “sweetener.”
How Equity Financing is Regulated
The equity finance process is governed by rules imposed by a local or national securities authority in most jurisdictions. Such regulation is primarily designed to protect the investing public from unscrupulous operators who may raise funds from unsuspecting investors and disappear with the financing proceeds. An equity financing is therefore generally accompanied by an offering memorandum or prospectus, which contains a great deal of information that should help the investor make an informed decision about the merits of the financing. Such information includes the company’s activities, details on its officers and directors, use of financing proceeds, risk factors, financial statements and so on.
Investor appetite for equity finance depends significantly on the state of financial markets in general and equity markets in particular. While a steady pace of equity financings is seen as a sign of investor confidence, a torrent of financings may indicate excessive optimism and a looming market top. For example, IPOs by dot-coms and technology companies reached record levels in the late 1990s, before the “tech wreck” that engulfed the Nasdaq from 2000 to 2002. The pace of equity financings typically drops off sharply after a sustained market correction due to investor risk-aversion during this period.
In accounting, equity (or owner’s equity) is the difference between the value of the assets and the value of the liabilities of something owned. It is governed by the following equation:
For example, if someone owns a car worth $15,000 (an asset), but owes $5,000 on a loan against that car (a liability), the car represents $10,000 of equity. Equity can be negative if liabilities exceed assets. Shareholders’ equity (or stockholders’ equity, shareholders’ funds, shareholders’ capital or similar terms) represents the equity of a company as divided among shareholders of common or preferred stock. Negative shareholders’ equity is often referred to as a shareholders’ deficit.
Alternatively, equity can also refer to the capital stock of a corporation. The value of the stock depends on the corporation’s future economic prospects. For a company in liquidation proceedings, the equity is that which remains after all liabilities have been paid.
When starting a business, the owners fund the business to finance various operations. Under the model of a private limited company, the business and its owners are separate entities, so the business is considered to owe these funds to its owners as a liability in the form of share capital. Throughout the business’s existence, the equity of the business will be the difference between its assets and debt liabilities; this is the accounting equation.
When a business liquidates during bankruptcy, the proceeds from the assets are used to reimburse creditors. The creditors are ranked by priority, with secured creditors being paid first, other creditors being paid next, and owners being paid last. Owner’s equity (also known as risk capital or liable capital) is this remaining or residual claim against assets, which is paid only after all other creditors are paid. In such cases where even creditors could not get enough money to pay their bills, the owner’s equity is reduced to zero because nothing is left to reimburse it.
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