What Investors Need to Know About Equity Financing

What investors need to know about equity financing

Equity financing is a method for businesses to obtain funds to start or expand their operations.

It's quite popular because it works like this: the firm sells shares of itself to people who wish to invest in it. These individuals become owners of a small portion of the corporation.

Now, equity financing has advantages and disadvantages. On the plus side, it allows the corporation to make a lot of money and expand its activities. Furthermore, unlike a loan, the corporation is not required to repay the funds. Investors expect that if the firm succeeds well, the value of their shares will rise and they will be able to sell them at a greater price later.

However, there are some disadvantages. When a firm sells shares, it gives up ownership as well as some control. The original owners may be required to share decision-making authority with the new investors. Furthermore, if the company does poorly, the value of the shares may fall, and investors may lose money.

Common Stock

Common stock is a method that companies use to gather funds by selling shares to interested investors. By purchasing common stock, you become a common stockholder, which means you have a stake in the company and become a part-owner.

Being a common stockholder comes with certain privileges. You have the right to participate in significant company decisions, such as selecting the board of directors and making important business choices. Additionally, you may receive dividends, which are bonuses given to stockholders when the company performs well and shares a portion of its profits.

Companies like common stock financing for a few reasons. It's a simple way for them to get money without borrowing it and adding more debt. Smaller companies that don't have steady money coming in find it helpful because they don't have to worry about paying interest to lenders. Instead, they can focus on making their products better and growing their business. Plus, for startups, common stock financing can bring in investors who have experience in managing and growing young companies. These investors can be like mentors, giving advice and helping the company get started.

But there are some downsides to common stock financing too. If a company goes bankrupt, common stockholders are at the bottom of the list to get any money back. Sometimes they don't get anything at all, so their shares can end up being worth nothing. Also, the value of common stock can change a lot. It might fluctuate based on factors like the state of the market and the performance of the organization. This can make it riskier than conventional investments such as bonds. And for the company itself, issuing common stock can make each share worth a little less, which they need to think about.

So, that's the lowdown on common stock financing. It has its benefits, but there are also some things to consider.

Preferred Stock

It's a special type of investment that companies offer to preferred stockholders. These stockholders get some extra advantages compared to regular stockholders.

One cool thing is that preferred stockholders get paid first when it comes to receiving dividends. So, if the company is giving out profits, preferred stockholders are at the front of the line. This makes it a safer investment because there's a better chance of getting some money back.

But here's the catch: preferred stockholders don't have the same voting power as regular stockholders. They can't make important decisions for the company like regular stockholders can. So, they have less control over what the company does.

Another thing to consider is that when a company offers preferred stock, it can be expensive for them. They have to pay fixed dividends to preferred stockholders, and that can be a big cost for the company.

Now, let's talk about equity offerings. These are ways for big companies to get money from investors. There are two main types: Initial Public Offerings (IPOs) and Follow-on Offerings.

An IPO happens when a company becomes publicly traded for the first time. They sell shares to the public and get a lot of money in return. Their shares can then be bought and sold on the stock market. It's a big deal for a company, but there are some things to consider. The company needs to follow certain laws and rules, which can increase costs and affect how much money they make.

But there are benefits too! Going public gives the company a lot of recognition and free publicity. It can help boost sales and profits. Plus, if the company does well, the stock price can go up, which is good for investors and can motivate the company's management and employees.

After a successful IPO, companies sometimes do follow-on offerings to raise more money for expansion. They use their own stock as currency and issue more shares. But when they do that, it dilutes the ownership of existing shareholders, which means the stock price may go down a bit. To minimize this, companies prefer to do follow-on offerings when their stock price is high, so they don't have to issue too many new shares. Preferred stock has some advantages but also some drawbacks, and equity offerings are ways for big companies to raise money through IPOs and follow-on offerings.

Evaluating the Cost of Equity

It's basically the profit that investors expect when they invest their money in a company. So, if you're thinking of putting your money into a company by buying shares, you want to know how much profit you can expect in return.

Now, when companies want to raise money by selling shares, they need to figure out how much profit investors would demand. There are two main ways to calculate this cost of equity: the dividend discount model and the capital asset pricing model (CAPM).

The dividend discount model looks at the current value of the dividends that a company is likely to pay in the future. It assumes that the company will actually share its profits with the investors through dividends, although not all companies do that.

So, by using these methods, companies can estimate the profit investors would want and determine the cost of equity. It helps both the companies and investors make informed decisions about investing in the company.

The dividend discount model has the following formula:

Cost of equity = (Dividend per share / Current market price per share) + Expected growth of dividends

The second technique, CAPM, calculates the cost of equity by taking into account various parameters. It considers the risk-free rate of return (the return on a safe investment), the market's predicted return, and the company's beta (a measure of its volatility in comparison to the market). CAPM is calculated as follows:

Cost of equity = Risk-free rate + Beta x (Expected Market return – Risk-free rate)

Let us now discuss dilution. When a firm issues additional shares, it can dilute existing shareholders' shareholding. This means that each share's value decreases slightly. Companies can compute the dilution percentage, which is the amount of ownership that will be lost owing to the issue of new shares, to estimate the impact of dilution. If a corporation has 10,000 shares and issues 1,000 new shares, the dilution percentage is 10%. This implies that each share is worth 10% less.

Anti-dilution techniques are frequently used by businesses to avoid or minimize the dilution of existing shareholders. They may repurchase shares or utilize other safeguards to protect shareholders. Share buybacks reduce the number of shares in circulation immediately, which can mitigate the negative impact of dilution.

So, when companies decide to raise money through equity offerings, they need to consider the cost of equity and the potential impact of dilution on existing shareholders. It's important to balance the need for funding with the cost and potential risks involved in issuing new shares.

The biggest protection is provided by the full ratchet anti-dilution clause, which increases the conversion price of convertible securities based on the price at which new shares are issued. This means existing shareholders receive additional shares to compensate for the dilution they have experienced. For example, suppose a company issues 1,000 shares of common stock at $15 and also issues 100 convertible bonds that can be converted into common stock at a conversion price of $15. Later, the company issues an additional 100 shares of common stock at $10 each. With a full ratchet anti-dilution provision, the conversion price of convertible bonds will be adjusted down to $10 per share to compensate for the dilution of existing shareholders. 

Another anti-dilution technique is the weighted-average anti-dilution provision, which adjusts the conversion price of the conversion bonds based on a weighted average price of the new shares issued and the existing shares outstanding. In the above example, the old shares are still 1,000, and the new shares are $10 apiece. (1,000 x $15 + 100 x $10) / (1,000 + 100) = $14.54 is the weighted average price. To compensate for the dilution experienced by current shareholders, the conversion price of the conversion bonds will be reduced to $14.54 per share. 

Some companies also use anti-dilution provisions for employee stock options. This ensures that employees do not experience dilution when a company issues new shares to expand its operations. For example, an anti-dilution provision may adjust the exercise price of employee stock options based on the prices of the newly issued shares. 


Equity financing is one of the main tools companies use to raise funding to expand their operations. There are several equity financing options such as common stock financing, preferred stock financing, and public equity offering. Every company is different, has different needs and goals, and is in a different growth stage, meaning there is no single best equity financing option for every business. 

Equity financing has several benefits such as helping companies avoid debt and attract experienced investors who can provide guidance. However, companies should consider the impact of dilution which can be significant if they issue too much stock. By understanding the various forms of equity financing and how to evaluate their impact, companies can make informed decisions about how to raise capital and build a successful business. From an investor perspective, understanding how equity financing works is important for investing in companies that follow investor-friendly practices and keep dilution to the bare minimum.