What it is:
How it works (Example):
In order to grow, a company will face the need for additional capital, which it may try to obtain in one of two ways: debt or equity. Equity financing involves the sale of the company's stock and giving a portion of the ownership of the company to investors in exchange for cash. 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 that investment is 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 the shares of the company.
As the company grows and requires further capital, the entrepreneur may seek an outside investor, such as an angel investor or a venture 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.
Why it Matters:
During the early stages of a company's growth, particularly when the company does not have sufficient revenues, cash flow or hard assets to act as collateral, equity financing can attract capital from 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 a public offering in the capital markets. Based on the company's 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.