What is Equity Funding?
It’s a type of mutual or private investment fund – it refers to the sale of ownership interest to raise funds for business purposes. Equity funding is distinct from debt financing – which refers to funds borrowed by a business – where in the “debt money” is borrowed and promised to be paid back. “Equity money”, on the other hand, works pretty similarly, the difference being that it doesn’t have to be paid back. Sounds perfect? Let’s check out the pros and cons.
Pros and Cons
- Equity funding can be a permanent solution to a company’s financial needs. The company’s main aim should be to manufacture the best products or the best services, instead of constantly looking for new investors or raising money again and again. When the company has a constant cash infusion, it can focus on the things that matter the most – the quality of products, or services, and the contentment of customers.
- A company or an entrepreneur isn’t obligated to pay regular and definite dividends – they can choose to pay smaller dividends, or even no dividends, depending on the cash flow in the company. Again, this lets the entrepreneurship focus entirely on its development its offer, which is particularly crucial at the beginning.
- A business mainly financed by equity always has a controlled financial leverage ratio. A financial institution, such as a ban, requires a company to invest 20-25% of its equity to invest 75-80% of its debt.
- Another advantage of equity funding is that a company can retain the trading profit. The earnings the company generates, using this capital, can be kept by the business and used as future capital.
- On the other hand, there are some disadvantages, such as the activation costs, for example. Equity funding is one of the most challenging ways of getting funds to the company. It requires a lot of statutable compliances, alongside a lot of other expense issues.
- In comparison to debt financing, equity funding is considered to be the most costly source of finance. This is due to the higher required rate of return from equity share investors. Because the equity share investment is a high-risk investment, investors will always expect a higher rate of returns.
- Appointments with underwriters, likewise, may also be a kind of disadvantage for an entrepreneur. Why? The cost of an underwriter’s services may be charged in the form of upfront payment or may be a discounted equity share price. Often, a company which offers equity shares to the public requires an appointment with an underwriter to assume the risk of subscription.
- Control dilution – when a company raises funds via equity, the shareholding percentage is reduced when the new shareholders are introduced.
As stated above, there are some advantages of equity funding, but there are also some disadvantages as well. An entrepreneur has a hard nut to crack when it comes to deciding which form of financing to choose when starting a business. There are much more ways of fundraising, such as crowdfunding or looking for an angel investor who may back the project or idea, with equity funding being one such possible option.