It takes a village to raise a child, and it often takes stockholders to lift a company off the ground.
Selling shares to stockholders is a type of equity financing—a way to generate capital without accruing debt. In short, companies that sell shares get equity capital in return.
What is equity capital?
Companies generate equity capital by selling part of their company, or company equity, to investors. The company can then use the money from selling equity to get its business off the ground, leverage growth, or simply fund day-to-day operations. Together, equity capital and debt capital make up a company’s capital structure.
Although equity capital dilutes ownership in a company, with good planning it can be a useful tool for companies looking to balance their finances for expansion. Let’s take a look at the different ways they can do so.
Three types of equity capital
- Common stock
- Preferred stock
- Retained earnings
How do companies use equity capital?
For the most part, companies that want to generate equity capital sell stock. Business owners give up a little bit of ownership per stock and receive capital in exchange.
This stock can come in the form of common or preferred stock. A company’s retained earnings also count as equity capital. Each form has its pros and cons.
TIP: Learn more about cost of equity.
Common stock is the most popular way that companies generate equity capital. Before going public, a company may sell stock to its employees in the form of stock options. After a company’s initial public offering, or IPO, it can sell stock on the primary market. This means that people can buy stock directly from the company, and the company receives equity capital in return.
This type of stock grants shareholders voting rights (the ability to elect company board members), and often earns dividends. When companies sell common stock to earn equity capital, they should plan for these things.
From a stockholder’s perspective, preferred stocks are more like corporate bonds, a form of debt capital rather than equity capital. However, from a company’s perspective, selling preferred stock remains a way to sell part of itself in exchange for equity capital. The only difference is that the stocks earn dividends at a fixed rate and do not grant stockholders voting rights. The dividend payments must be part of the company’s budget.
Unlike stocks, retained earnings are not bought and sold by a company. They can be thought of simply as the company’s profits that remain after it has paid out stockholders. It is money the company itself owns and can plan on spending to finance operations and growth without having to sell a thing.
Equity capital vs debt capital
Companies typically have capital structures that consist of both debt capital and equity capital, although the balance, or debt to equity ratio, varies by industry and company. Some companies prefer to sell equity because they don’t want to risk going bankrupt due to debt financing. On the flip side, companies that finance primarily with debt don’t dilute ownership as much. Some business owners would rather keep that equity for themselves.
What are equity capital markets?
When a company decides to sell stock to generate equity capital, on what platform does it do so? Equity capital markets, or ECM, advise companies and individuals on the sale and purchase of stocks. On the primary market, companies that have made their IPOs sell stocks directly. On the secondary market, stocks can be traded between stockholders.
50,000,000 stockholders can’t be wrong
Through the process of dilution, every stock sold by a company on the primary market results in less ownership per stock. However, each one of those shares earned the company some equity capital, and each stockholder trusts the company use that capital to continue operations, grow, and prosper into the future.
Decisions related to equity capital can’t be taken lightly. Find out if you’re ready to take the next step into equity financing with the guidance of a financial consulting provider.