written by: N Nayab•edited by: Ronda Bowen•updated: 7/14/2010
Equity financing is raising funds for investment through sale of company stock. The many advantages and disadvantages equity financing make this option a tricky one.
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Whether a company needs to mobilize funds through sale of equity depends on the company specific circumstances. The advantages and disadvantages of equity financing usually reverse in the case of debt financing, the major alternative source of funds. Most companies make a tradeoff between debt vs equity financing, and have a mix of both.
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Advantages of Equity Financing
No repayment: The major advantage of taking the route of equity to raise funds for the business is that the promoter is not bound to repay any amount. The investor buys a portion of the company, and gets the proportionate share of the profits or loss, as the case may be. Investors wishing to exit will have to sell their shares to someone else, and the company is not bound to repay the investment. This in sharp contrast to taking the debt route to finance investment, where the promoter will have to repay the amount and interest in fixed monthly installments, irrespective of whether the investment has borne fruit or not.
Immunity: Since investors share profits and loss, equity financing protects the company during times of economic downturn and limits the promoter’s loss. A public listed company is a separate entity distinct from its promoter, and the promoter receives payment paid for the effort put in just as all other employees receive salaries, and shares the profit or loss, just like all other investors.
Good credit ratings: The involvement of many investors or a high equity base improves the credit rating of the company, for this gives the impression of a venture backed by many investors, and having sufficient funds to compensate debtors if things go bad.
Better performance: The presence of ever-watching investors keeps the management of the company on their toes to perform at their best.
Better corporate governance: The law requires public listed companies to maintain impeccable records, hold regular general body and director meetings, audit their accounts, and follow other standard practices. This increases the quality of corporate governance and instills professionalism.
Easy exit: Raising money through equity by listing in the stock exchange makes it easy for the promoter to offload his holdings to any other interested investor and quit the company without closing down the business. Similarly, any investor can recoup his or her investment at will, unlike fixed term debts.
For all the benefits of equity financing, it also comes with many disadvantages.
Loss of decision making powers: While raising equity is a good way to exit the business, it becomes difficult for the interested promoter to retain control of the business. All shareholders of an enterprise have a say in electing the director board, including the CEO, and all major investments require the approval of a majority of the shareholders. The shareholders have the right to question the management regarding any aspect of the company.
Loss of control: If the promoter does not match the investments made by other investors, there is a chance of other investors acquiring more than 51 percent of the company shares and taking control of the company, forcing the promoter out.
Regulatory compliance: The strict adherence to rules and regulations, holding of meetings, filing reports and the like increase the standards of corporate governance but also takes up valuable time, energy, and resources that could be best spend in improving the company core process.
Higher outgo: While profit and loss sharing protects the company during bad economic times and difficult cash flow periods, it also leads to a higher outgo to the investors during good economic times. The profit sharing in is proportion to the investment made by each investor, including the promoter, and the promoter would have to forego of a much higher amount when compared to repayment of bank loan with interest.
Life long obligation: Taking in investors is a permanent obligation, and the investors have a right to stay put and take their cut of profits forever. This is in contrary to debt financing when all obligations end when the loan plus interest is repaid in full.