Unless you’re lucky enough to stay bootstrapped, or have been making a profit from day one, raising capital to fund business growth can be a daunting, yet essential, task. Issuing equity is part of the process, which can often add to the challenge. However, you don't have to blindly navigate your way through this. By understanding the capital raising process and how to manage equity in your company, you can make the journey much smoother and simpler.
In this article, we'll explain how equity financing works and some things to know if you are considering raising capital. We'll explain different forms of equities you may encounter on your path towards financing success so that when the time comes to raise money for expansion or other purposes, you feel confident about what's possible with an equity-based approach.
What does raising capital and issuing equity mean?
Companies choose to raise capital for a variety of reasons, including the short-term need to pay suppliers or long-term goals that necessitate funds to invest in their growth.
Raising capital is the term for a company approaching current and prospective investors to request financial investment in the form of either equity or debt.
Raising capital through the selling of shares is known as equity financing. A company that sells shares effectively sells ownership in their company in exchange for cash. When a company raises funds in this way, it is referred to as issuing equity. This process enables investors to take partial ownership of the company, and in contrast to debt, any funds raised do not have to be repaid.
Equity funding can come from a variety of sources, including a startup's friends and family, angel investors (wealthy individuals who invest in high growth businesses), venture capital funds and crowdfunding (such as Snowball Effect).
Finally, an IPO (initial public offering) is the process that private companies go through to offer shares of their company to the public in the form of a new share issuance. This path is typically utilised by more established companies. For example, major corporations, such as Google and Meta (formerly Facebook), have raised billions of dollars in capital through IPOs.
How does equity financing work?
Equity financing taps into a business' ownership rights to unlock funds. A startup that develops into a profitable company will generally undergo multiple rounds of equity financing as it evolves. Because a startup typically attracts different types of investors at different stages of its development, it may use a variety of equity instruments to fund its operations.
Because of this, creative equity instruments such as preferred shares, convertible notes, and warrants - all crafted with unique advantages tailored to an investor's needs - are now commonplace.
For instance, angel investors and venture capitalists—who are typically the first investors in a startup—prefer convertible preferred shares over common equity because the former has greater upside potential and some downside protection.
If the company needs more capital in the future, it may look at secondary equity financing, such as a rights offering or an equity unit offering that includes warrants as an added incentive.
If you’re considering equity financing, here are the steps involved in the process:
- Preparation: Establishing financial projections, creating a business plan and determining the amount of capital needed to be raised.
- Valuation: Determining the company's valuation through methods such as comparable company analysis or discounted cash flow analysis.
- Identifying investors: Networking with potential investors, seeking introductions from existing investors, your directors and advisors or people in your network.
- Negotiating terms: Determining the terms of the investment, such as the number of shares offered, the price per share, and the rights of the investors.
- Due diligence: Prospective investors will review the company's financials, operations, and other relevant information.
- Closing: Finalising the investment terms and closing the transaction by issuing shares or accepting investment funds.
- Post closing: Ongoing reporting and communication with investors and potential for future rounds of financing.
Why do companies raise capital?
Companies typically set out to raise capital from investors for three primary reasons: growth, acquisition and capital rebalancing.
Organisations may require capital to expand operations and/or to meet demands for working capital. This is particularly common among companies that undertake projects or venture start-ups with significant upfront costs and lengthy timelines for execution.
Capital raising for acquisition is a common strategy for businesses to increase value for their shareholders. This strategy allows businesses to use funds to either increase the value of an existing asset or to procure an external asset that will benefit the organisation.
To rebuild their capital mix
Businesses may undertake equity raising in order to rebalance their capital structure. This is a common strategy for companies with outstanding liabilities that want to use the proceeds of a capital raise to pay off debt.
Learn more about effective strategies to raise capital in your own organisation.
Advantages of raising funds by issuing shares
Unlocking the potential of private equity raising can have a major impact on business growth and success. From mergers and acquisitions to expansion opportunities, this type of funding provides companies with resources for pursuing their ambitions more effectively. Here are some of the key benefits;
- No debt repayment: Unlike debt financing, there is no need to repay the invested capital.
- Shared risk: By bringing in outside investors, the risk of the business is spread among a larger group of people.
- Access to expertise: Investors may bring expertise and industry connections to the table, which can benefit the company.
- Increased credibility: Bringing in outside investors can increase a company's credibility, making it easier to secure additional financing or business partnerships.
- Potential for high reward to investors: Equity shares offer the potential for higher returns, particularly amongst earlier stage, high-growth businesses, making them attractive to investors looking for more adventurous investments. If the company appreciates significantly in value investors have the potential to be paid at an impressive rate of return - a real draw card for those with an appetite for risk!
- Better financial flexibility: Companies have the flexibility to decide how they best allocate funds to drive returns and also whether they pay dividends from any profits. This allows them to maintain reserves and become financially secure, putting their future success on a sure footing.
Cons of raising funds by issuing shares
Issuing shares in order to raise funds can bring drawbacks, so it’s important to weigh up the advantages and disadvantages before determining if raising capital by issuing equity is right for your organisation. The main cons are;
- Dilution of ownership: Issuing new shares reduces the ownership stake of existing shareholders, potentially affecting their control over the company.
- Loss of control: Bringing in outside investors means giving up a portion of control over the company and its decision-making.
- Complexity: Equity financing can be complex and time-consuming, involving negotiations over terms and due diligence by investors.
- Cost: Equity financing can be costly, with expenses such as legal and accounting fees and ongoing reporting requirements (see how Orchestra can help).
- Long-term commitment for investors: Equity financing is a long-term commitment, and the company may not be able to buy back its shares or go public for a significant period of time. This is why equity investors will expect high growth in the value of the company, to trade-off the illiquid nature of buying shares in an unlisted company.
When it comes to weighing the advantages and disadvantages of capital raising by issuing equity, it’s crucial to remember that every organisation is different. Look at your options carefully and consult with an expert before making a decision on which method of capital raising is right for you and your business.
If you’re interested in issuing equity with shares, Orchestra software can help simplify share management. Get in touch today to learn more about how we can help you navigate the process of selling equity while staying compliant with all regulations.
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