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Equity Financing9:07 with Pasan Premaratne
Another option for financing your company is through an equity financing round. While a little more involved than debt financing, equity financing offers companies the option to finance themselves for the long-term without the worries of having to pay back the money.
Most people are familiar with debt, but what is equity? 0:00 Equity is ownership interest in a company. 0:04 Now, what do we mean by that exactly? 0:07 When a business is set up, 0:10 you can imagine a company comprising of many little units of ownership. 0:11 When you raise money through equity financing, you're basically asking for 0:16 money in exchange for ownership in the company. 0:20 This is pretty important because unlike debt financing, 0:23 you don't have to pay back the money you raised through equity financing. 0:26 Businesses first starting out might find equity more favorable than debt, for 0:30 many reasons. 0:35 Debt on your balance sheet can be seen as a bad thing. 0:36 Equity isn't. 0:39 When you raise equity, 0:40 it puts your company in a better position, on paper at least. 0:42 When you take out a loan to expand your company, 0:46 you immediately have to start paying that loan back. 0:48 This means that whatever you spend that money on has to 0:51 increase cash flow immediately so that you can pay back the loan. 0:54 With equity however, when investors give you money, 0:58 they don't expect returns immediately. 1:01 They understand that they're in a long term agreement, so 1:03 there's less pressure on you to make their money work immediately. 1:06 With equity financing, since unlike a loan, 1:10 you don't have to return that cash immediately, you can use the money for 1:13 long-term purposes, like the expansion of your office. 1:16 Conducting research and 1:19 development or hiring more staff to ramp up revenue growth. 1:20 When you raise funds through equity you give away a portion of the company. 1:25 This means that when you earn profits you have to distribute those profits to 1:29 the investors in proportion to how much of the company they own. 1:33 One thing important to note, is that when you have both equity and 1:37 debt on your balance sheet, 1:41 you pay off the debt before you distribute your profits to your investors. 1:42 If your company goes bankrupt for 1:46 some reason or another, debt is paid off before equity. 1:48 If you don't have enough money after paying off debt, oh well, 1:52 investors don't get anything. 1:55 Debt always has a higher priority. 1:57 There are lots of advantages to raising equity over debt. 2:00 So why doesn't everyone do it? 2:03 Well first off, it's not that easy. 2:05 There are different types of equity. 2:07 Stock that a company issues to its founders is different from stock issued to 2:09 private investors. 2:13 Which is completely different from what is issued to the general public. 2:14 Before we can talk about the different types of stock though, 2:18 let's take a look at what we mean when we say stock. 2:20 Now, the terms used may vary depending on where you are, 2:24 but the concept is the same. 2:27 I'm going to use terminology that you would use here in the United States. 2:29 If you're in another country, don't worry. 2:33 You should still keep watching to understand how equity works. 2:35 The equity of a corporation is called stock. 2:39 Companies can issue and sell stock to investors in exchange for 2:42 money, which as we just discussed is equity financing. 2:45 Once an investor purchases company stock, he or she is an owner of the company. 2:50 Now, stock ownership is considered perpetual. 2:55 This means that a stock has no maturity date. 2:58 You can hold onto that stock and remain an owner until you sell it 3:00 off to someone else or the company buys it back from you. 3:04 So where does stock come from? 3:07 How many units of a company's stock are out there? 3:09 When a company files its incorporation documents, 3:13 it usually has to write down the number of shares it wants to authorize. 3:15 Authorized stock is the total amount of a stock that a company possesses. 3:20 Well, let's say I incorporated my company and 3:24 authorized ten million units of stock or shares. 3:27 Knowing the amount of stock allows you to establish a baseline when raising equity. 3:31 If you didn't have a pool of shares and 3:35 randomly decided to issue 10,000 shares to an investor, what does that mean? 3:37 Do they now own 10% or just 1%? 3:42 By knowing that the total pool is ten million, 3:44 we know that issuing 10,000 shares means giving away less than 1%. 3:47 Some of this initial authorized stock is issued to founders, 3:52 who pay a par value for it. 3:55 Par value is a nominal value that you arbitrarily assign to 3:58 the share when authorizing it. 4:01 You usually assign a low par value so 4:03 that founders have to pay very little to acquire their shares. 4:05 At my company with ten million authorized shares, if I issued myself 4:09 four million founder shares, I could set the par value to $0.001. 4:15 This way I only pay 400 for my four million shares. 4:21 Do not confuse par values with market values of a share. 4:25 A par value is an arbitrarily assigned nominal value. 4:29 While the market value is established in the market and changes over time, 4:33 depending on the valuation of the company, investor sentiment and 4:37 a lot of other things. 4:40 The portion of shares that you give to other people is known as issued stock. 4:42 Issued stock is the amount of authorized stock that is currently in, or 4:47 has been in the hands of founders or investors. 4:51 Once issued, stock is always issued, 4:54 regardless of whether the company has repurchased it. 4:56 That leaves, outstanding stock. 4:59 Shares that are currently owned, either by founders or by investors. 5:01 Let's use those terms in another example. 5:06 At my company, I authorize ten million shares at a par value of $0.001. 5:09 I want to maintain majority control of the company down the road, so 5:14 I issue myself 50% of the shares, or five million. 5:19 To get those five million, I pay five million times 0.001, or $5,000. 5:23 While five million is half of the authorized stock, 5:29 it is 100% of issued stock. 5:33 Which means, currently, I have complete control. 5:36 So we have ten million authorized stock, 5:38 five million issued, and five million outstanding, as well. 5:40 It is now two years later, and I want to raise $1 million to expand the company. 5:45 The market value of the company stock is around a dollar, 5:49 which means that to raise $1 million, I need to issue a further million shares. 5:53 So, as always, our authorized stock rule remains the same. 5:59 There's ten million shares. 6:01 Our issued, as well as our outstanding, go up from five million to six million. 6:03 Earlier I owned five million of the total five million outstanding stock, 6:08 which was 100% ownership. 6:12 Now I own five million of a total of six million outstanding stock, which is 83%. 6:15 This highlights an important point. 6:22 As more stock is issued to investors through equity funding rounds, 6:24 the founders' percentage of ownership is diluted or decreased. 6:28 From the investors' point of view, they own 10% of the authorized shares and 6:32 16.6% of the issued and outstanding shares. 6:37 Now that you have a good understanding of the life of a stock, 6:41 let's talk about some of the different types of stocks. 6:44 When people talk about stocks, whether it's about privately held stock or stock 6:48 in the financial markets, the most common terms used are common and preferred stock. 6:52 What do they mean though and do they apply to all companies? 6:57 When we talk about common and preferred stock, we are referring to 7:01 ownership structures and corporations in the United States specifically. 7:05 While the terminology may differ, common stock in the U.S. 7:09 or ordinary shares in the UK, the underlying concepts are similar. 7:12 Common stock is voting stock, and 7:17 is issued to founders when the company incorporates, to officers, directors, and 7:19 consultants as incentives, and as stock options. 7:24 When the company goes public, common stock is what is offered to the public as well. 7:27 Holders of the common stock are typically entitled to 7:32 one vote per share on all matters that are voted on by shareholders. 7:35 Common stockholders are also entitled to a share of 7:40 the profits if the company decides to hand some of it out. 7:43 Then you have preferred stock. 7:47 Preferred stock can be customized and offers more rights and 7:49 privileges than common stock. 7:52 Preferred stockholders get to be at the front of the line amongst equity 7:55 holders when it comes to profit sharing and that's why investors love it. 7:58 With preferred stock, you can have all sorts of rights, preferences, and 8:02 privileges that allow investors preferential treatment. 8:06 In exchange for this treatment, they give up their voting rights, however. 8:10 So, they don't get everything they want. 8:14 You're probably wondering why all this is necessary. 8:16 Well, now that you know how the moving parts work, 8:19 we can talk about how equity financing works in a nutshell. 8:21 When you raise an equity round, you're essentially getting money in exchange for 8:25 ownership in the company. 8:29 You don't have to pay this money back, so it seems like free money, but 8:31 there are other consequences. 8:35 Depending on how much money you raise and how much of the company you exchange for 8:37 it, you will be handing over a portion of control through your preferred stock. 8:41 So you may now have to run big decisions by other people before you can execute. 8:45 These investors may also dictate a minimum rate of return. 8:50 They want to see the money they gave put to work. 8:53 Which means you may have to take some revenue generating actions that 8:56 you weren't happy with. 8:59 So how do you know whether you should take on debt or raise an equity round? 9:01 Let's go on to the next video. 9:05
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