, the shareholders receive ownership interests in the company.
In order to grow, a companywillface the need for additionalcapital, which it may try to obtain in one of two ways:debtorequity. Equity financing involves thesaleof the companysstockand giving a portion of the ownership of the company to investors in exchange forcash. The proportion of the company that will be sold in an equity financing depends on how much the owner has invested in the company and what thatinvestmentis worth at the time of the financing. For example, an entrepreneur who invests $600,000 in the startup of a company will initially own all of thesharesof the company.
As the company grows and requires further capital, the entrepreneur may seek an outside investor, such as anangel investoror aventure capitalist, two main sources of early stage equity financing. If, in this example, the investor is willing to pay $400,000 and agrees to a share price of $1.00 (i.e. that the original $600,000 invested is still worth $600,000), then the total capital in the company will be raised to $1,000,000. The entrepreneur will then control 60% of the shares of the company, having sold 40% of the shares of the company to the investor through an equity financing.
During the early stages of a companys growth, particularly when the company does not have sufficientrevenuescash flowor hard assets to act ascollateral, equity financing can attractcapitalfrom early stage investors who are willing to take risks along with the entrepreneur.
Similarly, when a company is established and has assets and cash flow or has the promise of explosive growth due to new technologies or new markets, it can raise substantial capital through an equity financing such as apublic offeringin thecapital markets. Based on the companys share price, a portion of the company is sold to the new investors. For the entrepreneur, equity financing is a method to raise capital for the company before it is profitable in exchange for diluted ownership and control of the company.
For investors, equity financing is an important method of acquiring ownership interests in companies. Investors are always wary that subsequent rounds of equity financing usually require them to dilute some portion of their ownership as well.
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