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Dilution of ownership
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2
Higher cost of capital
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3
Loss of competitive edge
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4
How to mitigate the risks
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5
Here’s what else to consider
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Equity financing is a common way for businesses to raise capital by selling shares of ownership to investors. It can be attractive for entrepreneurs who want to avoid debt, retain control, and access a large pool of potential funders. However, using too much equity financing can also have some drawbacks and risks, especially for investment banking professionals who advise and assist businesses with their capital structure and financing decisions. In this article, we will explore some of the risks of using too much equity financing and how to mitigate them.
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1 Dilution of ownership
One of the main risks of using too much equity financing is that it can dilute the ownership and control of the original founders and shareholders. By issuing more shares, the business reduces the percentage of ownership and voting power of each existing shareholder, which can affect their influence, decision-making, and returns. Moreover, if the business issues preferred shares or convertible securities, it may have to pay dividends or face conversion into common shares, which can further dilute the ownership and value of the common shares.
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2 Higher cost of capital
Another risk of using too much equity financing is that it can increase the cost of capital for the business. The cost of capital is the minimum rate of return that the business needs to generate to satisfy its investors and creditors. Equity financing is usually more expensive than debt financing, because equity investors expect a higher return for taking on more risk and uncertainty. Furthermore, equity financing can also increase the cost of debt, because lenders may perceive the business as more risky or unstable if it has a high equity-to-debt ratio.
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3 Loss of competitive edge
A third risk of using too much equity financing is that it can reduce the competitive edge of the business in the market. By selling shares to external investors, the business may expose its financial information, strategies, and secrets to its competitors or potential rivals. Additionally, by relying too much on equity financing, the business may miss out on the tax benefits and leverage effects of debt financing, which can lower its effective tax rate and increase its return on equity. These factors can affect the profitability and growth potential of the business.
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4 How to mitigate the risks
Equity financing can be a valuable source of capital for businesses, but it is important to balance it with other forms of financing, such as debt, grants, or retained earnings. Investment banking professionals can help businesses evaluate their optimal capital structure and financing mix based on their goals, risks, and opportunities. They can also negotiate the terms and conditions of the equity financing deals to protect the interests and rights of existing shareholders. Additionally, businesses should diversify their sources of equity financing to access different types of investors, such as angel investors or venture capitalists. Lastly, they should monitor and manage their cost of capital and financial performance to ensure they meet or exceed their investors' expectations.
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5 Here’s what else to consider
This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?
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