Equity Financing

What Is Equity Financing?

Equity financing is a way for a company to raise capital by issuing shares of its ownership to investors. In return for their money, the new shareholders receive a claim on a portion of the company's assets and future profits. Unlike a loan, the company does not promise to repay the principal or make scheduled interest payments. Investors instead earn returns through dividends, if the company pays them, and through any rise in the value of their shares.

How It Works

A company can raise equity in several ways. A privately held business may sell stakes to founders, friends, angel investors, or venture capital firms. A public company may sell new shares through a secondary offering, or raise money through a rights issue offered to existing shareholders. Companies that go public through an initial public offering also use equity financing, since the shares sold to the public bring in new cash for the business.

Ownership is divided among shareholders according to how many shares each holds. When new shares are issued, existing owners may see their percentage of the company shrink, a effect known as dilution, even though the company itself has more cash to use.

Advantages and Disadvantages

For the company, equity financing has the benefit of not creating a fixed repayment obligation. If earnings are weak, the business is not forced to make payments that could strain its cash flow. The tradeoff is that the company gives up a share of future profits and some control over decisions, because shareholders often have voting rights.

For investors, equity can offer significant upside if the business grows, but it also carries risk. Shareholders are paid after lenders and bondholders if a company fails, so they may lose much or all of their money in a bankruptcy. Share prices can also fall for reasons unrelated to the company's performance.

Why It Matters to Investors

Equity financing affects the investor in several ways. Issuing new shares can dilute earnings per share, and the market often reacts to announced offerings. Investors who follow a company may look at how it funds its growth, since a business that relies heavily on new share issuance may be under different pressures than one that funds itself through profits or debt.