16.5 Equity Financing

Equity financing is a crucial way for companies to raise capital. It involves selling ownership stakes to investors, ranging from initial public offerings to venture capital investments. This approach can provide significant funding and strategic benefits, but also comes with costs and potential loss of control.

Companies must carefully weigh the pros and cons of different equity financing options. Decisions about dividends, retained earnings, and types of stock offered can impact a company's financial position and growth potential. Understanding these choices is key for business success.

Equity Financing

IPO Process and Costs/Benefits

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• Initial Public Offering (IPO) process of offering shares of private company to public for first time company sells portion of ownership to public investors shares listed on stock exchange for trading
• IPO process company selects investment bank (underwriter) to manage IPO due diligence and regulatory filings prepared underwriter sets initial price for shares shares allocated to investors and begin trading on stock exchange
• Benefits of IPO raises significant capital for growth and expansion increases company's public profile and credibility provides liquidity for existing shareholders enables company to use stock as currency for acquisitions and employee compensation (stock options)
• Costs of IPO underwriting fees paid to investment banks (7-10% of IPO proceeds) legal, accounting, and marketing expenses ($1-3 million) ongoing regulatory compliance costs (annual reports, audits) pressure to meet short-term expectations of public investors potential loss of control and increased scrutiny from shareholders

Dividends vs Retained Earnings

• Dividends portion of company's profits distributed to shareholders represents return on investment for shareholders paid in cash or additional shares of stock reduces company's retained earnings and cash reserves
• Retained earnings portion of company's profits not distributed as dividends reinvested in company for growth and expansion (research and development, capital expenditures) increases company's book value and shareholders' equity provides source of internal financing for future projects
• Impact on financial position
  • Dividends reduce cash reserves and retained earnings may signal financial stability and attract income-seeking investors (retirees) excessive dividends may limit growth opportunities
  • Retained earnings increase assets and shareholders' equity provide cushion against future losses or economic downturns may be used to finance growth and expansion without additional debt or equity

Preferred Stock and Venture Capital

• Preferred stock hybrid security with characteristics of both debt and equity provides fixed dividend payment, prioritized over common stock dividends lacks voting rights in most cases offers preference in asset claims during liquidation attractive to investors seeking stable income and lower risk compared to common stock (institutional investors)
• Venture capital financing provided by venture capital firms to high-growth potential, early-stage companies venture capitalists invest in exchange for equity stake and often provide strategic guidance suitable for companies with innovative products or services and significant growth potential (technology startups) allows companies to scale quickly without relying on debt financing or going public venture capitalists typically aim for high returns (10x) and exit strategy within 5-7 years (IPO or acquisition)
• Role in equity financing
  1. Preferred stock provides alternative to common stock for raising capital attracts investors with lower risk tolerance or income-seeking goals can be used to raise capital without diluting common shareholders' voting power
  2. Venture capital offers significant funding for early-stage companies with limited access to traditional financing (banks) provides strategic guidance and industry expertise to help companies grow enables companies to scale quickly and achieve key milestones before pursuing IPO or acquisition