Equity Financing and Sources of Equity Financing
India has seen a tremendous increase in startups during the last decade or so and one of the most popular modes of startup funding as well as funding for growing companies in modern times has been equity financing or private equity funding.
During the period 2011-2020, India has witnessed significant growth in the Indian start-up ecosystem where it has really matured and created several unicorns. The deal volumes have increased by 300% in 2020 as compared to 2011. However, deal size has not increased significantly and 80% of deals are less than USD 10 million in value.
Further, not all sectors have seen equal distribution, and only 3 sectors i.e. Technology, Financial Services, and E-commerce have seen significant start-up investments i.e. approx. 69% of deals by value and 58% deals in terms of volume over the last decade.
Various sources of Equity Financing
Various sources of equity financing are as under:
- Bootstrapping or self-funding
- Family or Friends
- Private Investors
- Venture Capital
- Stock Market
When funds are raised by selling equity shares of the company, it is called as equity financing or private equity funding. Besides sale of shares, Equity financing also includes the sale of other instruments like common shares, share warrants, preferred stock, convertible preferred stock, etc.
Difference between Private Equity and Venture Capital
Although the terms Private Equity funding and Venture Capital funding are used interchangeably, however, there are some significant differences between equity funding and VC funding as it is popularly known.
Some of the differences between equity financing and venture capital financing are as under:
- Type of Companies for Investment by Private Equity and Venture Capital
Private Equity Funding is normally done in matured companies or companies who are in the growth stage or established stage. They might be failing to make profits due to inefficiency or lack of capital. With their vast knowledge and expertise, Private Equity firms may purchase these companies and turnaround them to be profit-making.
On the contrary, Venture capital funding is done mostly in early-stage startups which have shown potential for growth.
2. Ownership of Investee Companies
Here, 100% equity financing is done by purchasing 100% ownership of companies in which Private Equity firm invests.
On the contrary, in case of venture capital financing, less than 50% investment is done in the equity of any company. Venture capital firms normally, diversify their risk by making small investment in different companies. The idea is to mitigate risk in case of failure of any one startup.
3. Size of Investment by Private Equity and Venture Capital
The ticket size of Private Equity firms is huge as compared to Venture Capital firms.
Equity funding is done for an amount of USD 100 million and more in a single company.
VC funding, on the other hand is done in multiple companies and size of investment is normally, USD 10 million or less in each company since VC are dealing with early stage startups and there is uncertainty in terms of their success or failure.
4. Type of Industries for funding
Both Private Equity and Venture capital firms have major difference as far as industries in which funding needs to be done is concerned. Although, there is no specific preference of industries when it comes to Private Equity Funding and Private equity firms makes investment in all types of industries.
However, Venture Capital funding is normally done only in startups technology, biotechnology, Information technology and clean technology.
5. Mode of Funding
While making investment in any company, private equity firms make use of both cash and debt in their investment, however, venture capital firms usually makes investment in equity only. However, there is no hard and fast rule and it may differ on case to case basis.
Different types of investors and equity financing options
At this stage, company’s promoters are trying to make the company fully operational. Here, major contributor to seed fund is promoters/founders of the company, close friends, family and supporters. Here, investors generally do not make investment in exchange of equity in the company.
Seed Funding for Startups
Seed fund or Seed capital is the initial official money which is raised by any business venture.
This is similar to planting a seed which will eventually grow into tree. Seed fund is used in early stage of financing of an enterprise. It is used for product development and market research as well as manpower recruitment. Seed funding assists a company in deciding what the final product would be and also its target audience.
Seed capital is normally arranged from Angel Investors, Incubators, Venture capital companies, promoters, friends and family.
Angel investors are those investors who are cash rich and they put their money in startup businesses which has potential to grow and generate high profits in future. They contribute money and take equity shares of the company. Besides providing money, they also bring their skills; knowledge and experience to the business and hand hold the startup companies in achieving their growth targets in future. They also become part of decision making process of the company. But it is not easy to find Angel investors.
Venture Capital Firms
Venture capital firms invest in companies which are expected to grow at high rate and would ultimately go for listing with stock exchanges in future. This is also called as private equity funding. The difference between angel investors and venture capital firms are that venture capital firm’s purchase large stake in business and bring large money to company as compare to angel investors. Since 1988, venture capital has been legalized in India
It includes insurance companies, mutual funds, pension funds, etc. These institutional investors have huge sums of money for making investment in Private Limited companies. Prior to 1990s, DFIs or the Development Financial Institutions were the main financiers.
Another form of equity financing is by way of corporate investors. Many established companies and big organizations invest in younger private companies to fulfill their financial needs and to to develop a strategic partnership or corporate partnership. These corporate investors create a network of companies by investing in different companies at the different span of time.
Another way of equity financing is that instead of distributing profits to owners or shareholders, company can finance itself by retaining its earnings. This becomes part of owner’s equity. In this manner, company can fund itself without looking at outside source. Later on, company may issue bonus shares to its shareholders.
Issuing shares to Parent Company
In case of subsidiary company registration in India, funding is arranged by issuing shares to its parent company.
This is the most common form of funding in case of foreign companies who makes entry into India in form of incorporated entities. They normally opt for private limited company registration or public limited company registration and make them their wholly owned subsidiary company. Further, as and when funding is required in Indian subsidiary, Indian subsidiary issues shares to its parent company which subscribes to such shares and introduce capital in the Indian subsidiary company.
Initial Public Offering
When company has reasonable growth, becomes established and wants to expand even further, it may go for public issue also called as IPO or initial public offering. In this manner, the company offers shares to general public and raise money from them. Many other investors like institutional investors also invest in company’s IPO. However, as compare to other means of equity financing IPO’s are costly affair and time consuming; therefore, normally company goes for IPO only when other sources have been utilized.
Thus, equity financing or private equity is very important source of funding for any company be a startup, growing or well established company. However, the company should be vigilant as to how much equity to be diluted for funding received as otherwise, the real owner of company will be sidelined by the new investors.