Definition
Equity financing is the process of raising capital by issuing or transferring an ownership interest in a company to investors. In a startup context, this commonly occurs when founders sell shares or other equity interests to angel investors, venture capital funds, strategic investors, or other capital providers.
Unlike debt financing, equity financing does not ordinarily require the company to repay the invested capital as a loan. Instead, investors receive an economic interest in the company and may receive additional rights relating to governance, information, future financing, or distributions depending on the security and investment agreement.
The precise legal structure of equity financing varies by company type and jurisdiction.
How does equity financing work?
A company seeking equity financing generally:
Determines its capital requirement and the purpose for which the funds will be used.
Identifies potential investors whose investment focus and requirements fit the company.
Determines the financing structure, including the type of equity or security being offered.
Negotiates the investment terms, which may include valuation, ownership, governance, and investor rights.
Completes due diligence and legal documentation.
Closes the investment, after which the company receives the capital and the investor receives the agreed ownership interest or security.
The process differs depending on the company's stage, security, investor type, and jurisdiction.
What are the main forms of equity financing?
Ordinary or common equity
Investors receive ordinary shares or an equivalent ownership interest in the company.
Preferred equity
Investors receive shares with contractual rights or preferences that differ from ordinary shares. These can include liquidation preferences, voting provisions, or other rights.
Convertible instruments
Some early-stage investments begin as instruments that can convert into equity later rather than establishing the final ownership position immediately.
Examples include convertible notes and SAFEs, where legally applicable.
The terminology and legal characteristics of these instruments differ across jurisdictions.
Who provides equity financing?
Equity capital can come from many types of investors, including:
Founders
Angel investors
Venture capital firms
Family offices
Corporate or strategic investors
Private equity investors
Institutional investors
Crowdfunding investors, where legally permitted
The appropriate investor depends on the company's stage, sector, geography, capital requirements, and objectives.
Why do companies use equity financing?
Equity financing can be particularly useful when a company needs capital for growth but does not want, or is not able, to take on conventional debt obligations.
It can provide capital for:
Product development
Hiring
Research and development
Customer acquisition
Market expansion
Infrastructure
Acquisitions
Working capital
Long-term growth
For young companies without substantial revenue or assets, equity financing can sometimes be more suitable than conventional debt because repayment does not operate in the same way as a loan.
Equity financing vs. debt financing
The fundamental difference is what the capital provider receives in return.
Equity financing | Debt financing | |
|---|---|---|
Investor/lender receives | Ownership or an equity-related interest | Right to repayment |
Repayment | Generally no scheduled repayment of principal | Generally required according to the debt terms |
Ownership dilution | Can dilute existing shareholders | Does not ordinarily create equity dilution |
Cost of capital | Depends on future company value and negotiated terms | Usually includes interest and other financing costs |
Governance rights | May include voting or other rights | Usually based on creditor protections |
Financial risk | Shared through ownership | Company retains repayment obligation |
The distinction can become more complex with hybrid or convertible instruments.
Does equity financing dilute founders?
It can.
When a company issues new shares to investors, the percentage ownership of existing shareholders can decrease.
For example, if a founder owns 100% of a company before a financing and new investors receive 20% of the company after the financing, the founder's percentage ownership will decrease.
However, dilution is not necessarily equivalent to a loss of value.
If the company raises capital at a valuation that reflects significant growth in the company's overall value, founders may own a smaller percentage of a substantially more valuable company.
What determines the terms of equity financing?
Several factors can influence the terms of an equity investment:
Company valuation
The negotiated value of the company affects the price and ownership associated with the investment.
Amount raised
The amount of capital sought influences the percentage of the company that may be issued to investors.
Security type
Common shares, preferred shares, SAFEs, convertible notes, and other instruments can produce different economic and legal outcomes.
Investor rights
Investors may negotiate rights relating to governance, information, future participation, liquidation, or other matters.
Market conditions
Investor demand, capital availability, economic conditions, sector sentiment, and comparable transactions can influence financing terms.
Company characteristics
Growth, traction, market opportunity, business model, team, competitive position, and capital requirements can all affect negotiations.
Equity financing at different startup stages
Equity financing can occur throughout a company's lifecycle.
Early stage
Founders may raise capital from angels, accelerators, seed funds, or early-stage venture investors.
Growth stage
Companies may raise larger institutional rounds to expand their teams, markets, products, and operations.
Later stage
More mature private companies may raise additional equity from growth investors, private equity firms, strategic investors, or other institutions.
Public markets
Some companies eventually raise equity through public markets, although this represents a substantially different financing and regulatory environment from private startup fundraising.
Example
A startup has developed its product and established early customer demand. The founders want to hire additional employees and expand into new markets but do not want to take on significant repayment obligations.
They raise capital from a venture capital fund in exchange for a minority ownership interest.
The company receives capital for growth.
The investor receives an ownership interest and the rights specified in the investment agreement.
The founders' percentage ownership decreases, but the company now has additional capital to pursue growth.
Common misconception
Equity financing is free money because the company does not have to repay it.
No.
Equity financing generally does not involve loan-style repayment, but the capital is exchanged for ownership and potentially significant investor rights.
The economic cost to existing shareholders depends on the company's future value, the percentage sold, the financing terms, and the rights attached to the investment.
Equity financing can therefore be an important source of growth capital, but it is not costless.
