Equity financing refers to the purchase of shares in a business by investors in order to provide funding for the organization.
The different types of equity financing instruments that a firm can use include the following:
- Common stock. This is the basic type of stock, which gives its holder the right to share equitably in any dividends and in the final payout from the dissolution or sale of a business. The holder also has the right to vote for members of the board of directors, as well as certain other company decisions.
- Preferred stock. This is a type of stock that usually pays a dividend, and which may contain additional privileges, such as a vote on whether the issuer can accept a buyout offer from a third party.
- Convertible debt. This is a debt instrument such as a bond, that gives its holder the right to convert the debt into the stock of the issuer. The conversion feature is activated by the holder when the price of the issuer's shares makes the conversion profitable.
- Warrants. This is an instrument that conveys to its holder the right, but not the obligation, to purchase the shares of the issuing entity at a certain price and within a certain date range. Warrants are typically issued along with a stock sale, so that investors can profit from any upside in the price of the stock.
A business that is growing at a rapid rate will likely need to go through several rounds of equity financing. The usual progression of equity instruments sold is for early investors to buy preferred shares, since these instruments have more protective rights than common stock. As the business becomes larger, institutional investors are more likely to buy common stock. If the firm has difficulty selling shares, it may need to offer warrants in a package with the shares sold, so that investors can participate in the upside potential of the shares.
When a business has reached a size large enough to qualify for listing on a public stock exchange, it typically converts all preferred stock to common stock, and then goes through the initial public offering process, after which its shares are registered with the Securities and Exchange Commission. At that point, the early investors can sell their shares to the investing public.
A business is less likely to pursue equity financing when the stock market is depressed, since it can only obtain a lower valuation at this time, which means that a large percentage of the business must be sold in order to obtain a reasonable amount of financing.