The equity capital definition refers to capital that a company owns that is not tied to debt. This type of capital often involves investor money entering the company in exchange for shares. Investors' decision to buy shares in a company is predominantly determined by the amount of influence they will have in the company, the possibility of dividend payments, and how the value of the shares will appreciate.
Types of Equity Capital
The types of equity capital are broadly captured in stocks, surpluses, and earnings.
| Type of Equity Capital | Description |
|---|---|
| Common Stock | The main features of common stocks are the fact that they are securities, and that their owners own a part of the company and are thus entitled to share in the profits. |
| Preferred Stock | Preferred stocks provide investors with scheduled dividend payments at the expense of not having any voting rights in the company. Due to the fact that companies can gain capital from selling preferred stock while maintaining control of the company, they usually prefer to sell preferred stock over common stock. |
| Contributed Surplus | This is a surplus that is generated when a company sells its shares for more than the shares are valued. |
| Treasury stock | Treasury stock is a company's reserve pile of its own stock. This stock is acquired via a stock buyback, which is the process whereby a company repurchases its own shares on the open market. |
| Retained Earnings | These are funds that a company generates from its profits. |
Pros and Cons of Equity Capital
When used strategically, equity capital offers a lot of pros.
Pros:
- No Debt: Since equity capital is not borrowed from an investor, there is no debt that has to be repaid.
- Risk: The risk associated with equity is much lower compared to debt capital, due to the lack of repayment obligations.
- Investor Sentiment: Companies with a lot of equity capital tend to be attractive investments for investors in relation to businesses that are built on debt capital.
There are also cons involved in the use of equity capital.
Cons:
- Cost: It tends to be more expensive to use equity capital in relation to debt capital.
- Ownership: Ownership is decreased when shares are issued to raise equity capital.
- Effort: It takes a greater effort to acquire equity capital compared to debt capital.
Equity Capital Examples
For example, suppose a private mining company, DTL Ltd., is looking to raise capital to fund a new expansion in Uruguay. To meet this need, it issues stock to raise equity. Investors buy these shares of stock with the objective of capitalizing on dividend payments and price appreciation. DTL can use the raised equity to finance its expansion.
A second example of equity capital proceeds from the above. In the days following its IPO, DTL's stock plummets by 20 percent. However, since the company has substantial confidence in its operations, it continues to repurchase its own shares and build up its Treasury stock. The pile of shares stands to be worth 20 percent more once the market price recovers.
Equity vs. Debt Capital
Though equity and debt capital must both comply with securities laws, there are a number of differences between the two types of capital. Debt capital compares very distinctly to equity capital as a tool.
| Debt Capital | Equity Capital |
|---|---|
| Raised via debt | Raised by issuing shares or generating earnings |
| Relates to financial obligations | Is not tied to any financial obligations |
| Is cheaper for generating growth | Is more expensive for generating growth |
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Debt capital is capital that a company acquires by taking on debt. A second type of capital is equity capital, which is not connected to debt. Both must comply with securities laws when administered and traded. Debt capital often involves the company issuing debentures to investors in exchange for capital. These investors who hold debentures, hold a security, are creditors of the company and are entitled to interest payments. Equity capital, on the other hand, refers to the sale of stock to raise equity. Among the characteristics of this stock include its status as a security, and the fact that its owners own a share of the company, and are therefore entitled to share in profits. Companies normally prefer to issue preferred stock over common stock, in that they can gain the capital from selling the stock but do not lose control of the company.
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Video Transcript
Raising Capital through Equity
Meet Lisa. She's an executive chef at a famous New York restaurant. Her friends have convinced her to start a company that produces prepared frozen meals based upon some of her signature creations. Lisa's savings isn't sufficient to cover the startup costs of the new venture. So she needs to raise capital. Capital is simply a financial asset, such as money.
Lisa can raise capital through equity. Equity capital is capital that comes from the sale of stock to investors. Stock is an ownership interest in a corporation. For example, Lisa may form a corporation and issue 5,000 shares of stock and sell some of the shares to her friend for $100 per share. If she sells all 5,000 shares, she will have raised $500,000 in equity capital.
Pros & Cons of Using Equity
Let's assume Lisa decides to raise equity capital. She forms her new company as a corporation and authorizes the issue of the 5,000 shares of common stock that we discussed above. She convinces three of her closest friends to invest $100,000 each for 1,000 shares apiece. She contributes $200,000 of her personal savings to the corporation for the remaining 2,000 shares. Her company now has an infusion of $500,000. Moreover, Lisa's company is not in debt. If she needs to obtain additional financing, lenders will be more willing to lend to Lisa because of the solid financial footing established by the equity capital.
Lisa does have some new business concerns after raising the equity capital. Now, she has shareholders who will expect a return on their investments. In fact, Lisa put herself in a bit of a bind. She holds two-fifths of the shares to her company, and the other shareholders collectively hold three-fifths of the shares. This means that Lisa can lose control over the management of her company to the other shareholders because they control more votes than she does. Lisa could have avoided this problem by issuing preferred shares to her investors that guarantee dividends, but don't empower the shareholders to vote like shares of common stock do.
Raising Capital through Debt
Lisa may not want to deal with meddling investors telling her how to run her business. Instead of raising capital through equity, she may want to raise capital through debt. Debt capital is capital that has been raised through borrowing from a source outside the company.
Lisa can offer debentures to investors to raise money. A debenture is an unsecured debt obligation, such as a promissory note or a corporate bond, that a corporation offers to investors in exchange for a loan. Since debentures are not secured by any property, investors must rely upon the creditworthiness of the company to decide whether to loan money. Investors will receive interest as compensation for use of their money.
Pros & Cons of Using Debt
Now, let's assume Lisa decided to raise capital through offering debentures. Instead of taking on shareholders, Lisa's company becomes a debtor. Her company will be able to deduct the interest payments against its revenue as a necessary and ordinary business expense. And Lisa doesn't have to worry about shareholders demanding a better return or trying to take control of her company.
However, raising capital through debt does present some disadvantages. While Lisa doesn't have to answer to shareholders who may want to take control of her business, she does have to make her scheduled payments. Shareholders are entitled to share in the profits, but if there are no profits, they're not entitled to anything. However, creditors are entitled to their payments regardless of the financial health of the company.
If Lisa fails to make her payments, the company may be sued or even forced into bankruptcy. Additionally, if Lisa takes on too much debt from the issuance of debentures to raise capital, she may have problems raising more money in the future. Both lenders and equity investors don't particularly like to throw money into a company that is already deeply in debt.
Raising Capital & Securities Regulation
Stocks and bonds are securities. This means that Lisa will have to comply with federal and state securities law. She'll have to make sure her offering of stock or debentures comply with the Securities Act of 1933 and related SEC regulations. Lisa must also be sure she complies with state securities laws, often referred to as 'Blue Sky Laws.' This isn't simple, so she'll hire an accountant and lawyer to help her.
Lesson Summary
Let's review what we've learned. Raising equity capital means the company will issue stocks to investors who become part owners in the company. Although raising capital through equity means that the company does not take on debt, its common stockholders have a right to vote and share in the profit of the company.
On the other hand, a company raises debt capital by issuing debentures to investors who become creditors of the company. While holders of debentures have no right to participate in the company's profits, they do have a right to timely payment of the debt. Moreover, raising capital through the issuance of debt may affect the company's creditworthiness and ability to obtain future financing. Finally, compliance with federal and state securities law is paramount whether the capital is raised by way of debt or equity.
Learning Outcome
After watching this lesson, you should be able to identify and discuss the advantages and disadvantages of raising capital through equity and debt.
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