What Is Equity Financing? – Definition Pros Cons Examples

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What Is Equity Financing? – Definition, Pros, Cons & Examples

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Equity financing is as necessary to a business as air is to a person, but because it comes in several forms, it can easily be misunderstood. This article explains the various types of equity financing and explores their advantages and disadvantages for both companies and investors.

If you own a home, you already have a concept of equity. Your home has a certain value, you owe a certain amount on it, and the difference is your equity: that is, the portion of your homes value that belongs to you. Every payment you make adds to your equity, as does every increase in the market value of your home.

Equityin business is similar to the concept of equity that comes from home ownership: It is the portion of the companys assets that belongs to the owners or stockholders. It differs somewhat from home equity because business assets generally are not revalued periodically, so increases in market value do not add to equity. However, the results of the companys operations do have an effect on equity.

The simplest form of business organization is the sole proprietorship, where one person owns a business that is not a separate legal entity from its owner. To start a sole proprietorship, you need only obtain any necessary business licenses and invest enough money to purchase the assets you need to operate the business and have some cash to meet expenses. Lets look at an example that shows how a sole proprietorships equity can increase and decrease. This will help you understand how equity financing works in corporations.

For example, lets say that Stephanie Logan decides to become a flea market dealer, selling items that she crafts at home. In most states, her need for business licenses for this activity is limited, and the costs of these licenses (often just a sales tax number) are negligible. She does, however, need the materials and equipment to produce her craft items. She may need to own a table and chairs for use at the flea market, and she will need some money to pay rent on her booth at the flea market and to make change. Well assume that her initial investment is $1,000. This is all her money, so she also has $1,000 of equity in her business.

After spending several weeks crafting enough items to feel that she is ready to sell at a local flea market, she rents a booth for the weekend at a cost of $40. Over the weekend, she sells $300 worth of crafts that cost her $200 to make. She earns a profit of $60, which we calculate by taking $300 – $200 – $40. If she leaves this money in the business, her equity is increased to $1,060.

At the end of three months, Stephanie starts keeping some of her profits for herself. Well say that by this time her equity in her business has grown to $2,000 and her weekly profits have grown to $100, of which she decides to withdraw half (or $50 per week) for her own use. Even though she is earning $100 per week, her equity is only growing by $50 per week because the other $50 is being taken out of the business for her personal use.

Now, the flea market has five very bad weeks when Stephanie sells nothing but still has to pay her $40 weekly booth rental. This results in a $200 loss to Stephanies business, which is calculated by taking $40 times the 5 weeks. Consequently, her equity decreases by the same $200.

So, in short, equity is increased by investments, in this case the original $1,000, and profits, and is decreased by withdrawals and losses. The same is true for corporations, but the terms used are different. Corporations also use more than one form of equity financing, as were about to see.

Equity financingrefers to raising funds for business use by trading complete or partial ownership of the companys equity for money or other assets. In financing corporations, this is most commonly done by selling either common stock, preferred stock, or some combination of these. Where a proprietorship may be funded entirely by its owner or with money that the owner receives from family, friends, or venture capitalists, corporations will be funded by stockholders who may include individuals, venture capitalists, or institutional investors.

Stephanie Logans investment in her flea market business represented something more than ownership. Since Stephanie was both owner and manager, she had influence over how her business was operated. She could have hired someone to make the crafts and someone else to sell them, and because it was her business, she would still be able to exercise complete influence over her employees actions with regard to her business.

Common stock is the corporate equivalent of Stephanies equity in the business. However, since there may be many stockholders, any one stockholders influence is decided on the basis of one share of stock equals one vote in corporate affairs. As we said before, the same things increase and decrease common stock equity, but in some cases, they have different names. Investment and profits still add, and withdrawals and losses still subtract; but now what we were calling withdrawals are calleddividends, and we combine profits, losses, and dividends intoretained earnings.

Before computers were used to keep such records in real time, stock certificates like the one here were issued to common stockholders.

The certificate shows the issuing company (in this case, the Baltimore and Ohio Railroad), the name of the owner (Goldsmith, Wolf, and Company) and the number of shares owned (10). While some companies still issue stock certificates, they are becoming increasingly rare in our electronic age.

As a common stockholder, the vote that comes with each share of stock you own gives you some voice in the way the company is operated. You can place your votes yourself or assign them to someone else through aproxy. Many common stockholders assign proxies to their broker or to larger (often institutional) stockholders who they deem trustworthy. Some examples of institutional stockholders are mutual funds, insurance companies, and pension funds.

For the company, more equity financing generally means the ability to also borrow more money at a relatively low interest rate. However, common equity is generally the most costly way to finance a business since all profits (other than those promised to preferred stockholders) belong to the common stockholders. For the investor, the generally higher returns and having a voice in corporate governance are advantages, but these advantages come with the risk that, should the company go bankrupt, common stockholders are the last in line to receive any compensation and often lose most or all of their investment.

Preferred stock is legally a form of equity financing, but in some ways it more resembles a form of debt. Preferred shareholders have no vote in corporate governance, but in exchange, they are promised a predetermined return on their investment.

This above preferred stock certificate is for the Boston and Maine Railroad. Like the common stock certificate we saw before, it names the issuing company (Boston and Maine Railroad), the owner (H. Hentz and Company), and the number of shares owned (50). In addition, it states that those shares have a $100 par value and can expect a 5% per share dividend each year.

Companies like preferred stock because it generally has a lower cost than common stock, but since it is considered equity, it never needs to be repaid (unlike debt of any kind). However, companies often prefer using debt financing to preferred stock since interest on debt is tax deductible, but dividends on preferred stock (like dividends on common stock) are not.

Common stockholders like the fact that preferred stockholders do not have a vote in corporate affairs, so their influence is not diminished. In exchange for not having voting rights, preferred stockholders appreciate the known dividends and somewhat better position with regard to compensation in case of bankruptcy. Preferred stock in public utilities and certain very well-established companies are a favorite investment of retirees because of the dependable income they provide.

In their never ending search for ways to make corporate financing more advantageous for the corporation, financial managers have created hybrids of virtually every kind of financing that previously existed. Three of the most common hybrids in equity financing are non-voting common stock, preferred stock that is convertible to common stock, and preferred stock that is convertible to bonds.

Non-voting common stockallows investors who might otherwise invest in preferred stock to share the risks borne by common stockholders and also share in their generally higher returns. This class of common stock is good for investors who are looking for a higher return but dont desire a voice in corporate governance. It also pleases regular common stockholders because it doesnt diminish their voice in corporate governance.

Preferred stock convertible to common stockis meant to attract preferred stock investment in companies where preferred dividends may not be as certain as preferred stock investors might like. In the event that preferred stockholders are unhappy with their returns, they can convert their preferred stock into common stock, gaining both the higher returns and the voice in corporate governance enjoyed by common shareholders. Of course, they trade their slightly preferred position with regard to compensation if the company goes bankrupt.

Preferred stock convertible to debtwas created to attract preferred stock investors when the company is on a less than solid financial foundation. It allows preferred stockholders to convert their shares into corporate bonds, placing them in a preferred position with regard to compensation in case the company goes bankrupt. As long as they are certain of the companys immediate financial future, they can retain the preferred stock and its higher returns (relative to bonds).

Different types of equity appeal to different types of investors, so when evaluating equity investments, consider the risk you are willing to bear as well as the return you require in compensation for undertaking that risk.

It is important to remember a few advantages and disadvantages of equity financing. Lets summarize each type of equity financing we discussed.

First is the common stock. With this stock, the advantage to the corporation includes increases in the companys ability to borrow money, and it never has to be repaid. A disadvantage to the corporation is that it is the highest cost since all income not used for preferred stock dividends belongs to the common stockholders. Advantages to the investor include a higher return than other forms of investing. Common stocks also give the stockholder a voice in corporate governance. A disadvantage to investors is that they are last in line to receive compensation in the event of bankruptcy.

With preferred stocks, advantages to the corporation include a lower cost than common equity, and it never has to be repaid. Advantages to the investor include a predetermined return, and in the event of bankruptcy, preferred stockholders are compensated ahead of common stockholders. A disadvantage to investors is that they have no voice in corporate governance. Remember, however, that this feature is popular with common stockholders since it prevents their voice from being diminished.

The next stock is the non-voting common stock. An advantage as well as a disadvantage for corporations is that these stocks are the same as common stocks. An advantage to investors is that they earn a higher return than with preferred stock. Disadvantages to investors include the same as common stock, with the additional disadvantage of not having a voice in corporate affairs.

There are also advantages and disadvantages for companies and investors of preferred stock convertible to common stock. Corporations find these advantageous because they are the same as preferred stock unless converted to common stock, and then advantages and disadvantages are the same as common stock. In addition, a corporation that is perceived as having difficulty meeting its obligations to preferred stockholders will find this type of preferred stock easier to sell. An advantage for the investors includes the ability to gain a voice in corporate governance by converting to common stock.

In preferred stocks convertible to debt, advantages to the corporation include that they are the same as preferred stock unless converted to debt. In addition, corporations whose financial foundations are somewhat shaky may find this type of preferred stock easier to sell. An advantage to the investor is the ability to obtain a more preferred position for compensation in the event of bankruptcy.

Equity: in business, the portion of the companys assets that belongs to the owners or stockholders

Equity financing: raising funds for business use by trading complete or partial ownership of the companys equity for money or other assets

Dividends: withdrawals from common stock equity

Retained earnings: combination of profits, losses, and dividends

Proxy: someone else you can assign your vote to voice how the company is operated

Non-voting common stock: hybrid stock that allows investors who might otherwise invest in preferred stock to share the risks borne by common stockholders and also share in their generally higher returns

Preferred stock convertible to common stock: hybrid stock that is meant to attract preferred stock investment in companies where preferred dividends may not be as certain as preferred stock investors might like

Preferred stock convertible to debt: hybrid stock that was created to attract preferred stock investors when the company is on a less than solid financial foundation

Learn about equity financing in this lesson and enhance your ability to:

Compare and contrast common stock, preferred stock, and hybrid stock

Recall the advantages and disadvantages for companies and investors of preferred stock convertible to common stock

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