Introduction
Raising capital is an important process for startups as the development, scale, and market presence of such entities are underpinned by sufficient funds. Therefore, not only would capital raised from the marketplace be initially necessary to be able to pay for basic operations, but it would also be essential in order to facilitate growth and innovation. Given this kind of high-risk environment and the kind of uncertainty which such startups typically work with, choosing the right financing option is a critical strategic decision. This essay attempts to critically explore various equity financing options available for startup companies by assessing their suitability as well as impact. Equity financing is the issuance of capital through the sale of shares of the company, and so offering a share of ownership and future profits as a payment for the needed funds. Understanding these options is vital for startups to make informed decisions aligned with their long-term goals.
Understanding Equity Financing
Equity finance refers to the process of raising capital by selling shares or stakes in a company. Lin (2022) posits that this approach is in contrast to debt finance since in capital, money is lent, and it has to be paid back with interest and preference shares that pay a fixed dividend but normally without voting rights. Equity financing includes capital injection without immediate negative covenants, implying that it is especially proper for starting business entities that do not possess stable cash flows. Shareholders in equity finance – especially those taking ordinary shares – gain voting rights and a stake in the profits of the company ordinarily, but they also take greater risk as they are last in line to be paid out in case of liquidation. The first and foremost relevant consideration of equity financing for startups must be that it is a pathway through which to raise considerable funds without the necessity of fixed repayments being a pre-condition, giving more flexible options in these early stages of growth and development, which is so crucial.
Ordinary Shares as a Source of Equity Finance
Ordinary shares represent a basic means to raise equity capital. Holders of ordinary shares normally carry with them voting rights and, in such a sense, play an important role in corporate decision-making, as well as the right to participate in the firm’s profits in the form of dividends. However, inherent risks run by the ordinary shareholders are that they are paid lastly in the line after the debt holders and preference shareholders on a liquidation of the company. This risk can be seen in the case of Green plc, which, according to its nominal authorized capital, includes both the preference shares and ordinary shares that total £5 million. All the preference shares of Green plc have been issued, but only £2.5 million of its ordinary shares; thus, £1.5 million are still authorized but unissued (Brown et al., 2019). The structure of these debts emphasizes a strategic approach towards equity financing that then provides the company with the flexibility to raise additional money through ordinary shares in the future. The case of Green plc perfectly illustrates the example of how ordinary shares can perform as a versatile financial instrument in the startup’s financial strategy, allowing fund-raising and giving an opportunity for investors to have an interest in the growing company. However, the dilution of control for existing shareholders and the variability of dividends, which are not guaranteed, usually is a trade-off.
The Role of Preference Shares in Equity Financing
Preference shares combine some elements of debt and equity financing. Often, they pay fixed dividends and are senior to ordinary shares with regard to dividend payments and asset distributions in liquidation but typically carry forfeitable or non-forfeitable voting rights. This hybrid nature of startups gives distinct advantages. The fixed dividend rate can provide a predictable return for the investors and may be attractive in the uncertain early stage of business (Oranburg, 2020). From a company’s perspective, there are several advantages of using preference shares as they do not impose the inflexible repayment schedules of debt financing but attract investors who might be risk-averse to ordinary shares. However, there are also downsides to the use of preference shares. The fixed dividend obligation can become a financial burden if the startup doesn’t generate expected revenues. Belo et al. (2019) argue that while preference shares do not expose one to control loss attaching to ordinary shares, they may appeal less to a person keen on capitalizing on the company’s growth potential. In the startup capital structure, preference shares could be such a strategic tool that would balance the further need for capital without much dilution of ownership or control. They are a hybrid of the high risk inherent to ordinary shares and the rigid debt-like obligations, so they provide some wiggle room to startups feeling their way through the convolutions of early-stage financing.
Equity Financing through Stock Markets
According to Colak and Öztekin (2022), the London Stock Exchange (LSE) represents possibly the best opportunity to raise equity for companies who are operating in the UK. The Main Market of LSE has earned repute as an extremely senior platform that leads reputable corporations to be its members owing to its global visibility and credibility. Requirements for admission to the Main Market are strict, including the need for a track record of profitability as well as adhering to high standards of corporate governance and reporting (Xiang et al., 2022). This market is generally more suited to more mature startups who have experienced quite a bit of early growth and are ready for the next step in their expansion. Smaller, growing concerns are catered to by the Alternative Investment Market (AIM) and PLUS markets. In particular, AIM enjoys a more flexible regulatory environment than its parent market and is therefore regarded as a suitable listing destination for younger, ambitious companies seeking capital, as per Brown et al. (2020). It offers easier admission processes and reduced costs as compared to the Main Market, though invariably with lesser liquidity and visibility among investors. The Main Market, representing prestige and wide access for investors, comes with a level of maturity and transparency that many startups may not possess immediately. Diverging ways for startups are represented by these options on the stock market. Contrastingly, although AIM and PLUS certainly provide far more accessible platforms for younger companies, such platforms may still not offer the same level of visibility or stability as that offered by the Main Market.
Equity Financing through Private Placements and Venture Capital
Equity financing through private placements involves offering securities or shares to just a few sophisticated investors – institutional investors or individual accredited investors. This method often turns out to be faster and cheaper than public offering as it avoids numerous regulatory mandates along with costs relating to the public markets. Private placements are especially appealing to startups due to their flexibility and also because agreements can be made between the issuing companies and the investors themselves (Butticè & Vismara, 2021). Venture capital (VC) is one of the most critical forms of private equity financing, wherein venture capitalists invest in startups that are high in potential growth in lieu of return via equity. VCs not only inject capital but also bring along valuable expertise, mentorship, and networks to the startup. Thus, this can help in guiding the startup across the early growth period. On the other hand, even though the public stock market options provide a wide platform for raising capital as well as more visibility to the firm, this also poses regulatory compliance issues, more public scrutiny, and possible pressures for a larger shareholder base. Private placements and venture capital normally become a better choice for startups since they have less demanding requirements and are able to sustain closer relationships with the investors, rather than just offering financial support when need be, as argued by Yasar (2021). However, these options might involve relinquishing more significant equity and control than public offerings.
Equity financing also comes with several challenges and risks hanging over the startups. Valuation, for example – is how to place an acceptable and attractive price on equity, mainly for early-stage companies, which often come with little financial history. Overvaluation may result in over-dilution of ownership in future funding rounds, while undervaluation gives away too much equity too cheap. Vaznyte and Andries (2019) suggest that another major risk involved includes a possible mismatch of interests between founders and investors, leading to conflicts, especially in strategic decisions. In addition, equity financing often means losing control and decision-making rights to the investors, more so for large equity stakes.
References
Belo, F., Lin, X., & Yang, F. (2019). External Equity Financing Shocks, Financial Flows, and Asset Prices. The Review of Financial Studies, 32(9), 3500–3543. https://doi.org/10.1093/rfs/hhy128
Brown, R., Mawson, S., & Rowe, A. (2019). Startups, entrepreneurial networks, and equity crowdfunding: A processual perspective. Industrial Marketing Management, 80, 115–125. https://doi.org/10.1016/j.indmarman.2018.02.003
Brown, R., Rocha, A., & Cowling, M. (2020). Financing entrepreneurship in times of crisis: Exploring the impact of COVID-19 on the market for entrepreneurial finance in the United Kingdom. International Small Business Journal: Researching Entrepreneurship, 38(5), 026624262093746. https://doi.org/10.1177/0266242620937464
Butticè, V., & Vismara, S. (2021). Inclusive digital finance: the industry of equity crowdfunding. The Journal of Technology Transfer. https://doi.org/10.1007/s10961-021-09875-0
Colak, G., & Öztekin, Ö. (2022). The Financing Role of Private Equity: Global Evidence. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.4228628
Lin, C.-Y. (2022). Fuzzy AHP-based Prioritization of the Optimal Alternative of External Equity Financing for Startups of Lending Company in Uncertain Environment. ROMANIAN JOURNAL of INFORMATION SCIENCE and TECHNOLOGY, 25(2), 133–149. https://www.romjist.ro/full-texts/paper712.pdf
Oranburg, S. C. (2020). Startup financing. Startup Creation, 59–79. https://doi.org/10.1016/b978-0-12-819946-6.00004-7
Vaznyte, E., & Andries, P. (2019). Entrepreneurial orientation and startups’ external financing. Journal of Business Venturing, 34(3), 439–458. https://doi.org/10.1016/j.jbusvent.2019.01.006
Xiang, X., Liu, C., & Yang, M. (2022). Who is financing corporate green innovation? International Review of Economics & Finance, 78, 321–337. https://doi.org/10.1016/j.iref.2021.12.011
Yasar, B. (2021). The new investment landscape: Equity crowdfunding. Central Bank Review, 21(1). https://doi.org/10.1016/j.cbrev.2021.01.001
write