Equity Financing Law and Legal Definition (2022)

A company can finance its operation by using equity, debt, or both. Equity is cash paid into the business—either the owner's own cash or cash contributed by one or more investors. Equity investments are certified by issuing shares in the company. Shares are issued in direct proportional to the amount of the investment so that the person who has invested the majority of the money in effect controls the company. Investors put cash into a company in the hope of sharing in its profits and in the hope that the value of the stock will grow (appreciate). They can earn dividends of course (the share of the profit) but they can realize the value of the stock again only by selling it.

Cash obtained by incurring debt is the second major source of funding. It is borrowed from a lender at a fixed rate of interest and with a predetermined maturity date. The principal must be paid back in full by the fixed date, but periodic repayments of principal may be part of the loan arrangement. Debt may take the form of a loan or the sale of bonds; the form itself does not change the principle of the transaction: the lender retains a right to the money lent and may demand it back under conditions specified in the borrowing arrangement.

EQUITY DYNAMICS

The dynamics of investing cash in a business—be it the owner's cash or someone else's—revolve around risk and reward. Under the provisions of bankruptcy law, creditors are first in line when a business fails and owners (including investors) come last and are therefore at a higher risk. Not surprisingly, they expect higher returns than lenders. For these reasons the potential outside investor is very interested in the owner's personal exposure in the first place—and the exposure of other investors secondarily. The more the owner has invested personally, the more motive he or she has to make the business succeed. Similarly, if other people have invested heavily as well, the prospective new investor has greater confidence.

(Video) What is Equity

The liquidity of the investment is another point of pressure. If a company is privately held, selling stock in that company may be more difficult than selling the shares of a publicly traded entity: buyers have to be privately found; establishing the value of the stock requires audits of the company. When a company has grown substantially and thus its stock has appreciated, pressures tend to build to "take it public" in order to let investors cash out if they wish. But if the company pays very high dividends, such pressures may be less—the investors hesitant to "dilute" the stock by selling more of it and thus getting a smaller share of the profit.

Debt-Equity Ratio

If the company also used debt as a way of financing its activities, the lender's perspective also plays a role. The company's ratio of debt to equity will influence a lender's willingness to lend. If equity is higher than debt, the lender will feel more secure. If the ratio shifts the other way, investors will be encouraged. They will see each of their dollars "leveraging" a lot more dollars from lenders. The U.S. Small Business Administration, on its web page titled "Financing Basics," draws the following conclusion for the small business: "The more money owners have invested in their business, the easier it is to attract [debt] financing. If your firm has a high ratio of equity to debt, you should probably seek debt financing. However, if your company has a high proportion of debt to equity, experts advise that you should increase your ownership capital (equity investment) for additional funds. That you way won't be over-leveraged to the point of jeopardizing your company's survival."

Control

For the business owner control is an important element of equity dynamics. The ideal situation is that in which 51 percent of the equity invested is the owner's own—guaranteeing absolute control. But if substantial capital is needed, this is rarely possible. The next best thing is to have many small investors—another difficult condition for the start-up to create. The larger each investor is the less control the owner may have—especially if things get rocky down the ways.

(Video) Equity vs Debt Financing | Meaning, benefits & drawbacks, choosing the most suitable

ADVANTAGES AND DISADVANTAGES

For the small business the chief advantage of equity is that it need not be paid back. In contrast, bank loans or other forms of debt financing have an immediate impact on cash flow and carry severe penalties unless payments terms are met. Equity financing is also more likely to be available for startups with good ideas and sound plans. Equity investors primarily seek opportunities for growth; they are more willing to take a chance on a good idea. They may also be a source of good advice and contacts. Debt financiers seek security; they usually require some kind of track record before they will make a loan. Very often equity financing is the only source of financing.

The main disadvantage of equity financing is the above-mentioned issue of control. If investors have different ideas about the company's strategic direction or day-to-day operations, they can pose problems for the entrepreneur. These differences may not be obvious at first—but may emerge as the first bumps are hit. In addition, some sales of equity, such as limited initial public offerings, can be complex and expensive and inevitably consume time and require the help of expert lawyers and accountants.

SOURCES OF EQUITY FINANCING

Equity financing for small businesses is available from a wide variety of sources. Some possible sources of equity financing include the entrepreneur's friends and family, private investors (from the family physician to groups of local business owners to wealthy entrepreneurs known as "angels"), employees, customers and suppliers, former employers, venture capital firms, investment banking firms, insurance companies, large corporations, and government-backed Small Business Investment Corporations (SBICs). Start-up operations, seeking so-called "first tier" financing, must almost always rely on friends and "angels," private persons, in other words, unless the business idea has real explosive, current, fad-appeal.

(Video) Corporate Finance Laws and Regulations: Module 1 of 5

Venture capital firms often invest in new and young companies. Since their investments have higher risk, however, they expect a large return, which they usually realize by selling stock back to the company or on a public stock exchange at some point in the future. In general, venture capital firms are most interested in rapidly growing, new technology companies. They usually set stringent policies and standards about what types of companies they will consider for investments, based on industries, technical areas, development stages, and capital requirements. As a result, formal venture capital is not available to a large percentage of small businesses.

Closed-end investment companies are similar to venture capital firms but have smaller, fixed (or closed) amounts of money to invest. Such companies themselves sell shares to investors; they use the proceeds to invest in other companies. Closed-end companies usually concentrate on high-growth companies with good track records rather than startups. Similarly, investment clubs consist of groups of private investors that pool their resources to invest in new and existing businesses within their communities. These clubs are less formal in their investment criteria than venture capital firms, but they also are more limited in the amount of capital they can provide.

Large corporations often establish investment arms very similar to venture capital firms. However, such corporations are usually more interested in gaining access to new markets and technology through their investments than in strictly realizing financial gains. Partnering with a large corporation through an equity financing arrangement can be an attractive option for a small business. The association with a larger company can increase a small business's credibility in the marketplace, help it to obtain additional capital, and also provide it with a source of expertise that might not otherwise be available. Equity investments made by large corporations may take the form of a complete sale, a partial purchase, a joint venture, or a licensing agreement.

(Video) Just Wow . . .

The most common method of using employees as a source of equity financing is an Employee Stock Ownership Plan (ESOP). Basically a type of retirement plan, an ESOP involves selling stock in the company to employees in order to share control with them rather than with outside investors. ESOPs offer small businesses a number of tax advantages, as well as the ability to borrow money through the ESOP rather than from a bank. They can also serve to improve employee performance and motivation, since employees have a greater stake in the company's success. However, ESOPs can be very expensive to establish and maintain. They are also not an option for companies in the very early stages of development. In order to establish an ESOP, a small business must have employees and must be in business for three years.

Private investors are another possible source of equity financing. A number of computer databases and venture capital networks have been developed in recent years to help link entrepreneurs to potential private investors. A number of government sources also exist to fund small businesses through equity financing and other arrangements. Small Business Investment Corporations (SBICs) are privately owned investment companies, chartered by the states in which they operate, that make equity investments in small businesses that meet certain conditions. There are also many "hybrid" forms of financing available that combine features of debt and equity financing.

METHODS OF EQUITY FINANCING

There are two primary methods that small businesses use to obtain equity financing: the private placement of stock with investors or venture capital firms; and public stock offerings. Private placement is simpler and more common for young companies or startup firms. Although the private placement of stock still involves compliance with several federal and state securities laws, it does not require formal registration with Securities and Exchange Commission. The main requirements for private placement of stock are that the company cannot advertise the offering and must make the transaction directly with the purchaser.

(Video) Debt vs Equity Capital | Debt Financing vs Equity Financing | What is Equity?

In contrast, public stock offerings entail a lengthy and expensive registration process. In fact, the costs associated with a public stock offering can account for more than 20 percent of the amount of capital raised. As a result, public stock offerings are generally a better option for mature companies than for startup firms. Public stock offerings may offer advantages in terms of maintaining control of a small business, however, by spreading ownership over a diverse group of investors rather than concentrating it in the hands of a venture capital firm.

Entrepreneurs interested in obtaining equity financing must prepare a formal business plan, including complete financial projections. Like other forms of financing, equity financing requires an entrepreneur to sell his or her ideas to people who have money to invest. Careful planning can help convince potential investors that the entrepreneur is a competent manager who will have an advantage over the competition. Overall, equity financing can be an attractive option for many small businesses. But experts suggest that the best strategy is to combine equity financing with other types, including the entrepreneur's own funds and debt financing, in order to spread the business's risks and ensure that enough options will be available for later financing needs. Entrepreneurs must approach equity financing cautiously in order to remain the main beneficiaries of their own hard work and long-term business growth.

FAQs

What is equity financing law? ›

Almost all businesses need to raise finance at some stage. This can be done by either borrowing money, known as debt finance, or selling a stake in the business to an outside party, known as equity finance.

Which do you think is the best reason for choosing equity financing as a source of fund for business? ›

The main advantage of equity financing is that there is no obligation to repay the money acquired through it. Equity financing places no additional financial burden on the company, however, the downside can be quite large.

What are some examples of equity financing? ›

What is equity financing?
  • Angel investment.
  • Venture capital.
  • Corporate venture capital.
  • Private equity.
  • Equity crowdfunding.
  • Initial public offering (IPO)
  • Expansion capital.

What are the major sources of equity financing? ›

Major Sources of Equity Financing
  • Angel investors. ...
  • Crowdfunding platforms. ...
  • Venture capital firms. ...
  • Corporate investors. ...
  • Initial public offerings (IPOs) ...
  • Alternative funding source. ...
  • Access to business contacts, management expertise, and other sources of capital. ...
  • Dilution of ownership and operational control.
13 Aug 2020

What are the 4 types of equity? ›

There are a few different types of equity including:
  • Common stock.
  • Preferred shares.
  • Contributed surplus.
  • Retained earnings.
  • Treasury stock.

What is law of equity in common law? ›

Equity follows the law: Courts will firstly apply common law and if this is not fair then an equitable remedy will be provided. This maxim sets out that equity is not in place to overrule judgements in common law but rather to make sure that parties don't suffer an injustice.

What is the most common method of equity financing? ›

The most common method of using employees as a source of equity financing is an Employee Stock Ownership Plan (ESOP). Basically a type of retirement plan, an ESOP involves selling stock in the company to employees in order to share control with them rather than with outside investors.

What are the two methods of equity financing? ›

Companies use two primary methods to obtain equity financing: the private placement of stock with investors or venture capital firms and public stock offerings. It is more common for young companies and startups to choose private placement because it is more straightforward.

What are the two types of equity financing? ›

Equity financing and the different types of equity finance
  • While equity financing typically comes from angel investors or venture capitalists, it can also be funding from family, friends or the public. ...
  • Angel investors are often wealthy individuals who tend to have some entrepreneurial experience themselves.
19 Oct 2021

What is the purpose of equity financing? ›

With equity financing, there is no loan to repay. The business doesn't have to make a monthly loan payment which can be particularly important if the business doesn't initially generate a profit. This in turn, gives you the freedom to channel more money into your growing business.

What are 5 examples of equity? ›

There are several types of equity accounts that combine to make up total shareholders' equity. These accounts include common stock, preferred stock, contributed surplus, additional paid-in capital, retained earnings, other comprehensive earnings, and treasury stock.

What are three forms of equity financing? ›

Individual investors, venture capitalists, angel investors, and IPOs are all different forms of equity financing, each with its own characteristics and requirements.

What are the 7 types of equity funding? ›

Here are seven types of equity financing for start-up or growing companies.
  • 01 of 07. Initial Public Offering. ...
  • 02 of 07. Small Business Investment Companies. ...
  • 03 of 07. Angel Investors for Equity Financing. ...
  • 04 of 07. Mezzanine Financing. ...
  • 05 of 07. Venture Capital. ...
  • 06 of 07. Royalty Financing. ...
  • 07 of 07. Equity Crowdfunding.
16 Jun 2020

What are 10 examples of equity? ›

10 equity account types
  • Common stock. ...
  • Preferred stock. ...
  • Retained earnings. ...
  • Contributed surplus. ...
  • Additional paid-in capital. ...
  • Treasury stock. ...
  • Dividends. ...
  • Other comprehensive income (OCI)
11 Aug 2021

What is equity in simple words? ›

The term “equity” refers to fairness and justice and is distinguished from equality: Whereas equality means providing the same to all, equity means recognizing that we do not all start from the same place and must acknowledge and make adjustments to imbalances.

What are the key principles of equity? ›

  • Equity will not suffer a wrong to be without a remedy.
  • Equity follows the law.
  • He who seeks equity must do equity.
  • He who comes to equity must come with clean hands.
  • Delay defeats equity.
  • Equality is equity.
  • Equity looks to the intent rather than the form.
  • Equity looks on that as done which ought to have been done.
14 Sept 2020

What is equity law example? ›

An example of this is if someone is infringing on a trademark of yours, you can get monetary damages for the loss, but your business could be ruined if they continue. Equity is the additional solution that allows a court to tell another person to stop doing something via an injunction, among other things.

Who is the father of equity law? ›

Heneage Finch, 1st earl of Nottingham, (born December 23, 1621, Kent, England—died December 18, 1682, London), lord chancellor of England (1675–82), called “the father of equity.”

What is importance of law of equity? ›

The equity is equal between persons who have been equally innocent and equally diligent. This doctrine applies, strictly in all cases, where the title of the plaintiff seeking relief is equitable. The purchaser, however, in all cases, must hold a legal title in order to give him full protection of his defence.

Which of the following is the best definition of equity financing? ›

Description: Equity financing is a method of raising funds to meet liquidity needs of an organisation by selling a company's stock in exchange for cash. The portion of the stake will depend on the promoter's ownership in the company.

What are the three most common forms of equity funding? ›

There are three main types of investors that require equity in return: angel investors, venture capitalists and strategic partners, but let me start off with the most basic way of funding your startup… yourself.

What are the two main sources of financing? ›

Debt and equity are the two main types of finance available to businesses. Debt finance is money provided by an external lender, such as a bank. Equity finance provides funding in exchange for part ownership of your business, such as selling shares to investors.

What are the stages of equity financing? ›

While there is no hard and fast rule that a company has to proceed with their financing in a particular sequence, typically the rounds of equity financing can be viewed as follows: seed/angel round, series A, series B, series C (followed by D, E, etc. as needed), and an exit.

What are two advantages of equity financing? ›

Advantages of equity finance

Investors only realise their investment if the business is doing well, eg through stock market flotation or a sale to new investors. You will not have to keep up with costs of servicing bank loans or debt finance, allowing you to use the capital for business activities.

What is equity financing and types? ›

Equity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. One of the advantages of equity financing is that the money that has been raised from the market does not have to be repaid, unlike debt financing, which has a definite repayment schedule.

What is the difference between financing and equity financing? ›

Debt financing means you're borrowing money from an outside source and promising to pay it back with interest by a set date in the future. Equity financing means someone is putting money or assets into the business in exchange for some percentage of ownership. Each has its pros and cons depending on your needs.

What are the effects of equity financing? ›

Equity financing – raising money by selling new shares of stock – has no impact on a firm's profitability, but it can dilute existing shareholders' holdings because the company's net income is divided among a larger number of shares.

Why is equity financing high risk? ›

Equity Financing Risk of Ownership Loss

That's because investors fund the business in exchange for shares in your company, and those shares represent an ownership stake in the business. If a business raises too much equity capital, it risks losing control of the company.

Which of the following is a type of equity financing? ›

Key takeaway: Equity financing is when you receive funding in exchange for shares in your business. Angel investors, venture capitalists and crowdfunding are common types of equity financing.

What is the disadvantage of equity financing? ›

The major drawback of equity financing is that it requires business owners to relinquish a portion of their ownership and control. If the business becomes lucrative and successful in the future, a portion of the earnings must be distributed to shareholders in the form of dividends.

What are the pros and cons of equity financing? ›

Pros & Cons of Equity Financing
  • Pro: You Don't Have to Pay Back the Money. ...
  • Con: You're Giving up Part of Your Company. ...
  • Pro: You're Not Adding Any Financial Burden to the Business. ...
  • Con: You Going to Lose Some of Your Profits. ...
  • Pro: You Might Be Able to Expand Your Network. ...
  • Con: Your Tax Shields Are Down.
18 Apr 2022

Is equity an asset or liability? ›

Equity is also referred to as net worth or capital and shareholders equity. This equity becomes an asset as it is something that a homeowner can borrow against if need be. You can calculate it by deducting all liabilities from the total value of an asset: (Equity = Assets – Liabilities).

What are the 5 sources of finance? ›

The five sources of finance are:
  • Assistance by the Government.
  • Commercial Bank Loans and Overdraft.
  • Financial Bootstrapping.
  • Buyouts.
  • Personal Investment or Personal Savings.

What are the two parts of equity? ›

What are the components of shareholders' equity?
  • Share capital—Which consists of common and preferred shares and paid-in capital. ...
  • Retained earnings—Which consist of cumulative earnings from previous years plus the current year's after-tax net income, minus dividends.

What does equity mean in land law? ›

A beneficial interest in real property that gives the title holder the right to acquire legal title to the property. Equitable title holders cannot transfer legal title to real property, but they derive benefits from the property's appreciation in value.

How does equity law work in Australia? ›

Simply put, equity served what common law was unable to justify. Equity in principle was made to provide justice to those which were denied proper trial in the common law, because the strict rules may not always create the fairest rulings in the court.

What is equity in Australian law? ›

Introduction The body of law called equity is founded upon the principles of fairness and conscience. Its piecemeal development took place over many years as a direct result of the injustices often caused by a strict application of the common law.

What is equity law in simple words? ›

Equity under Indian Legal System

As a branch of the legal system Equity refers to the essence or rules arising from the administration process of justice specifically in those cases where the areas are not adequately covered by statute. Equity besides supplements the law with quintessence of liberty and goodwill.

What is an example of equity law? ›

An example of this is if someone is infringing on a trademark of yours, you can get monetary damages for the loss, but your business could be ruined if they continue. Equity is the additional solution that allows a court to tell another person to stop doing something via an injunction, among other things.

What is equity in law simple? ›

A legal definition from the Oxford dictionary describes equity as 'a branch of law that developed alongside common law and is concerned with fairness and justice, formerly administered in special courts'.

Why do we need equity law? ›

Creation of the equity as a system of law was to serve as a means through which a legal system could strike the balance between the rule-making process and the need to achieve fair results in individual and separate circumstances (Megha K., 2008).

What happens when equity and common law conflict? ›

It was ruled that, where there is a conflict between the common law and equity, equity will prevail. The conflict was finally put to rest by the setting up Judicature Acts in 1873-75 where the Supreme Court could now administered both rules of common law and equity.

What is the biggest difference between law and equity? ›

In particular, the main distinction between cases in equity and cases in law is the type of relief requested in the lawsuit. Traditionally, lawsuit in equity seek non-monetary relief, for example, an injunction or order from the court requiring a person take or stop a certain action.

What are the five principles of equity? ›

'' This helps frame the size of the problem for audiences and the actions needed.
  • 1 Clarity in language, goals, and.
  • 2 'Equity-mindedness' should be the.
  • 3 Equitable practice and policies are.
  • 4 Enacting equity requires a continual.
  • 5 Equity must be enacted as a.

Does equity law still exist? ›

In the 1870s the primacy of Equity was enshrined in law through the Judicature Acts. This legislation also combined the two courts into one court structure, although the two systems of law remain distinct. The majority of modern courts apply both sets of rules to proceedings.

What is the difference between equity law and common law? ›

Equity follows the law Equity never overrules or invalidates the common law and always, where possible, attempts to follow it. If the common law is defective, equity may provide an alternative Page 3 cause of action but it cannot actually overrule or invalidate a legal principle.

Videos

1. Debt Securities And Equity Securities
(Wei Huang)
2. Business Law 101 Part 2 Equity Financing
(TheCCCBA)
3. Debt vs Equity Financing Joint Ventures
(Coffee with Carl)
4. Raising equity - legal and tax considerations | Scottish Enterprise
(Scottish Enterprise)
5. What is Equity? (Business Financial Terms Explained)
(Neufeld Legal)
6. How a Home Equity Loan Works!
(Andrew Finney Team)

Top Articles

Latest Posts

Article information

Author: Nathanael Baumbach

Last Updated: 12/06/2022

Views: 5597

Rating: 4.4 / 5 (55 voted)

Reviews: 86% of readers found this page helpful

Author information

Name: Nathanael Baumbach

Birthday: 1998-12-02

Address: Apt. 829 751 Glover View, West Orlando, IN 22436

Phone: +901025288581

Job: Internal IT Coordinator

Hobby: Gunsmithing, Motor sports, Flying, Skiing, Hooping, Lego building, Ice skating

Introduction: My name is Nathanael Baumbach, I am a fantastic, nice, victorious, brave, healthy, cute, glorious person who loves writing and wants to share my knowledge and understanding with you.