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Equity Financing Definition
Equity financing is the process to raise funds for a business by issuing shares (selling stock) in the market.
A Little More on What is Equity Financing
When a company needs funds beyond what is available from operations, it generally has two options: 1) issue debt instruments (or take a loan), or 2) sell an ownership an ownership interest in the company. The latter is known as “equity financing”.
Equity financing varies in scope and size. Entrepreneurs raise million and even billion of dollars in funding through selling an equity interest at various stages of their business’s lifecycle.
When the company is incorporated and it issues shares for the first time, the process of raising funds for the first or selling shares for the first time is referred as “subscription” or subscribing.
Later, the startup may raise funds by selling equity to friends and family investors, angel investors, or later-stage venture capitalists. Once the company reaches the maturity stage, it may have the potential to raise capital by selling its shares to the public through a direct public offering (DPO) or through an Initial Public Offering (IPO).
Equity financing may entail the sale of common equity (or common shares) or the issuance of preferred stock with special rights for the investor. The founder of a business entity generally receive common shares or some form of founder’s shares. The same is true for early-stage, friends and family investors. Angel investors and venture capitalists generally require some form of preferred share. The most common characteristics of the preferred shares are liquidation preferences, conversion right, redemption rights, anti-dilution protection, and registration rights. These shares rarely entail dividend rights, as it is rare of a startup company to have profits or to issue dividends. All available funds are used for growth.
How Equity Financing Is Regulated
Equity markets are regulated by the Security and Exchange Commission (SEC) to protect investors from fraudulent practices. This is the main function of Security and Exchange Commission to make certain that companies selling their shares publicly make full and accurate disclosures to potential investors. It is also worth noting that securities exchanges engaged in selling public securities also have very extensive requirements for companies listing their securities for sale.
References for Equity Financings
Academic Research on Equity Financing
- ● Capital market imperfections, high‐tech investment, and new equity financing, Carpenter, R. E., & Petersen, B. C. (2002). The Economic Journal, 112(477), F54-F72. New equity financing has several advantages over debt, but may be costly compared to internal finance. We examine an unbalanced panel of over 2,400 publicly traded US high‐tech companies over the period 1981–98.
- ● Convertible bonds as” back door” equity financing, Stein, J. C. (1992). (No. w4028). National Bureau of Economic Research. This paper argues that corporations may use convertible bonds as an indirect (albeit possibly risky) method for getting equity into their capital structures in situations where adverse selection problems make a conventional stock issue unattractive. Unlike other theories of convertible bond issuance, the model of this paper highlights: 1) the importance of call provisions on convertibles; and 2) the significance of costs of financial distress to the Information content of a convertible issue.
- ● The impact of cash flow volatility on discretionary investment and the costs of debt and equity financing, Minton, B. A., & Schrand, C. (1999). Journal of Financial Economics, 54(3), 423-460. This paper shows that higher cash flow volatility is associated with lower average levels of investment in capital expenditures, R&D, and advertising. This paper suggests that firms do not use external capital markets to fully cover cash flow shortfalls but rather permanently forgo investment.
- ● Do equity financing cycles matter? Evidence from biotechnology alliances, Lerner, J., Shane, H., & Tsai, A. (2003). Journal of Financial Economics, 67(3), 411-446. In periods characterized by diminished public market financing, small biotechnology firms appear to be more likely to fund R&D through alliances with major corporations rather than with internal funds (raised through the capital markets). We consider 200 alliance agreements entered into by biotechnology firms between 1980 and 1995. Agreements signed during periods of limited external equity financing are more likely to assign the bulk of the control to the larger corporate partner, and are significantly less successful than other alliances. These agreements are also disproportionately likely to be renegotiated if financial market conditions subsequently improve.
- ● The Puzzle of Equity Financing Preference in China’s Listed Companies [J], Zhengfei, L., & Kangtao, Y. (2004). Economic Research Journal, 4, 50-59. This paper aims to show the reason why Chinese companies prefer equity funding to other funding sources using a Logit model.
- ● Effects of family ownership and management on small business equity financing, Wu, Z., Chua, J. H., & Chrisman, J. J. (2007). Journal of Business Venturing, 22(6), 875-895. This paper explores the impact of equity financing on small firms with family involvement. It goes on to examine the effects of family ownership and management on two dimensions of small business equity financing, the use of equity financing and the use of public equity financing within the agency theory of financing. The results show that family involvement and agency issues interactively and separately influence equity financing in small business.
- ● Direct equity financing: A resolution of a paradox, Hansen, R. S., & Pinkerton, J. M. (1982). The Journal of Finance, 37(3), 651-665. When raising new equity capital managers have historically rejected the direct offer method favoring instead the seemingly more expensive underwritten public issue. This paper provides a resolution for this equity financing paradox by demonstrating empirically that firms which engage in direct offers enjoy a comparative cost advantage that is more than sufficient to account for the absolute reported cost differences between the two methods of equity financing.
- ● Equity financing in a Myers–Majluf framework with private benefits of control, Wu, X., & Wang, Z. (2005). Journal of Corporate Finance, 11(5), 915-945. This paper generalizes the Myers and Majluf (1984) model by introducing an agency cost structure based on private benefits of control. This new model predicts that many corporate finance variables each have opposing effects on under- and overinvestment.
- ● Strategic considerations, the pecking order hypothesis, and market reactions to equity financing, Viswanath, P. V. (1993 Journal of Financial and Quantitative Analysis, 28(2), 213-234. Myers and Majluf (1984) showed that in a world of asymmetric information, managers of overvalued firms issue equity, while managers of undervalued firms use cash, if available. This paper shows that, in a multiperiod world, managers of undervalued firms may find it optimal to issue stock, even though cash is available. Consequently, the market does not interpret all announcements of equity issues as signals of firm overvaluation. The paper also generates predictions regarding the effect of information asymmetry and investment opportunities on i) dividend policy, and ii) the cross-sectional distribution of market reactions when an equity issue is announced.
- ● Equity financing and corporate convertible bond policy, Jalan, P., & Barone-Adesi, G. (1995). Journal of Banking & Finance, 19(2), 187-206. This paper explores the uses of the co-operative game playing model. It shows that the differential tax treatment of coupon interest and dividend payments, coupled with market friction and incompleteness, provides sufficient reason for convertible debt issuance.
- ● Equity financing and innovation: Is Europe different from the United States?, Martinsson, G. (2010). Journal of Banking & Finance, 34(6), 1215-1224. During the mid and late 1990s young, high-tech firms in the US experienced a supply shift in both internal and external equity fueling a finance-driven boom in corporate R&D. This paper examines whether R&D spending in Europe in a similar way was sensitive to fluctuations in the supply of internal and external equity during the late 1990s and early 2000s using estimates from the UK. The findings of this paper suggest a channel through which market-based financial systems outperform the bank-based economies of Continental Europe.
- ● A theory of negotiated equity financing, Giammarino, R. M., & Lewis, T. (1988). The Review of Financial Studies, 1(3), 265-288. We examine the sale of equity within the context of a model of negotiation between a firm and a less well informed purchaser. We introduce a simple form of negotiation by allowing the firm to set the price of the issue and by assuming that the purchase is a financier-underwriter who acts strategically. This transaction is analyzed as a noncooperative game, and we identify sequential equilibria that are consistent with observed behavior: namely that negotiations occasionally fail, that market reactions to equity offers are not uniformly negative, and that equity placements are often underpriced.