Equity Financing

Equity financing is the raising of funds by issuing shares, which give the holder a residual claim on the earnings and assets of the firm. Equity financing contrasts with debt financing, in which the firm borrows and commits to fixed payments.

Forms

Equity financing may take the form of an initial public offering, in which a firm sells shares to the public for the first time, or a seasoned offering, in which a listed firm issues additional shares. It may also take the form of private placements, in which shares are sold to a small number of investors.

Other forms include venture capital, in which investors provide equity to young firms in exchange for a stake, and private equity, in which investors acquire established firms. These forms differ in the stage of the firm, in the degree of control exercised by the investors, and in the liquidity of the investment.

Advantages and Disadvantages

The main advantage of equity financing is that it does not create a fixed obligation. The firm is not required to make payments to shareholders, and it can retain earnings when necessary. Equity also strengthens the balance sheet, reducing the risk of financial distress.

The main disadvantage is that equity financing dilutes the ownership and the control of existing shareholders. New shareholders share in the future earnings of the firm, and they may have voting rights and influence over its decisions. The cost of equity, which reflects the return required by investors, is typically higher than the cost of debt, partly because of the tax deductibility of interest and partly because equity is riskier.

Cost of Equity

The cost of equity is the return that investors require to hold the shares of the firm. It reflects the risk-free rate, the market risk premium, and the systematic risk of the firm, as captured by the beta coefficient. It can be estimated using the capital asset pricing model or other approaches.

The cost of equity is relevant to the firm's investment decisions, since it provides the hurdle that projects must exceed to create value. It is also relevant to the choice between equity and debt, since the firm will prefer the source with the lower cost, subject to the constraints imposed by the need to maintain a sound financial structure.

The Pecking Order

The pecking order theory holds that firms prefer internal finance to external finance, and that when they raise external finance they prefer debt to equity. The rationale is asymmetric information: managers know more about the firm than investors, and the issue of equity may be interpreted as a signal that the shares are overvalued.

The theory explains why profitable firms tend to borrow less, since they have more internal funds, and why the announcement of an equity issue is often followed by a fall in the share price. It is one of the leading theories of capital structure, alongside the trade-off theory, which emphasises the balance between the tax benefits of debt and the costs of financial distress.

Initial Public Offerings

An initial public offering is the first sale of shares to the public by a firm. The offering transforms the firm from private to public ownership, and it provides the firm with capital and with access to the public markets.

The process involves several steps, including the selection of underwriters, the preparation of a prospectus, and the marketing of the offering to investors. The underwriters assess the demand for the shares and set the offer price, often seeking to ensure that the shares trade at a premium on the first day.

The pricing of an initial public offering is a subject of research. The tendency for shares to be underpriced on average, so that the first-day return is positive, has been documented and explained by information asymmetry, by the desire to reduce the risk of a failed offering, and by the interests of the parties involved.

Seasoned Equity Offerings

A seasoned equity offering is the sale of additional shares by a firm that is already listed. The offering raises additional capital, and it dilutes the ownership of existing shareholders.

The announcement of a seasoned offering is typically followed by a decline in the share price. The decline is consistent with the pecking order theory, which holds that the issue of equity conveys negative information about the firm, since managers are more likely to issue shares when they believe the shares are overvalued.

The terms of the offering matter. A rights issue, in which existing shareholders are offered the new shares in proportion to their holdings, is less dilutive for those who participate. A placing, in which the shares are sold to institutional investors, is faster but more dilutive for existing shareholders who do not participate.

Equity and Corporate Control

The issue of equity affects the control of the firm, since new shareholders acquire voting rights and may influence decisions. The dilution of control is a cost of equity financing, and it is particularly significant for founders and for controlling shareholders.

The market for corporate control provides a discipline on managers, since a firm that is poorly managed may become a target for acquisition. The ability to raise equity affects the threat of takeover and the incentives of managers.

The structure of ownership also affects the governance of the firm. Concentrated ownership can align the interests of owners and managers, but it can also allow controlling shareholders to extract private benefits at the expense of minority shareholders. The design of corporate governance must address both problems.

Summary

Equity financing provides firms with capital and with access to public markets, and it involves the dilution of ownership and of control. The analysis of initial and seasoned offerings, and of the relationship between equity and corporate control, informs the understanding of corporate finance.

See also

• Financial Asset
• Dividend
• Capital Market