Two Sources of Equity Financing - dummies

Two Sources of Equity Financing

By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

Every business — regardless of how big it is, whether it’s publicly or privately owned, and whether it’s just getting started or is a mature enterprise — has owners. Virtually no business can get all the capital it needs by borrowing. Your firm can obtain equity financing from two sources:

  • Investors: Outside investors can provide the business with both start-up and a continuing base of capital, or equity.

  • Owners: The firms’ founders may provide their own capital in exchange for equity.

Without the foundation of equity capital, a business wouldn’t be able to get credit from its suppliers and couldn’t borrow money. As they say in politics, the owners must have some skin in the game.

Considering what investors want

The equity capital in a business always carries the risk of loss to its owners. So, what do the owners expect and want from taking on this risk? Their expectations include the following:

  • Share in profits: They expect the business to earn profit on their equity capital in the business and to share in that profit by receiving cash distributions from profit and from increases in the value of their ownership shares, with no guarantee of either.

  • Participate in management: They may expect to directly participate in the management of the business, or they may plan to hire someone else to manage the business. In smaller businesses, an owner may be one of the managers and may sit on the board of directors.

    In very large businesses, however, you’re just one of thousands of owners who elect a representative board of directors to oversee the managers of the business and protect the interests of the non-manager owners.

  • Share in sales proceeds: Looking down the line to a possible sale of the business or a merger with another business, they expect to receive a proportionate share of the proceeds if the business is sold or to receive a proportionate share of ownership when another company buys or merges with the business.

    Or they may end up with nothing in the event the business goes kaput and nothing’s left after paying off the creditors.

When owners invest money in a business, the accountant records the amount of money as an increase in the company’s cash account. And, using double-entry accounting, the amount invested in the business is recorded as an increase in an owners’ equity.

Owners’ equity also increases when a business makes profit. Earning profit increases the amount of assets minus liabilities, which is called net worth, and how this increase in net worth (due to profit) is balanced by recording the increase in owners’ equity.

Dividing owners’ equity

Certain legal requirements often come into play regarding the minimum amount of owners’ capital that a business must maintain for the protection of its creditors. Therefore, the owners’ equity of a business is divided into two separate types of accounts:

  • Invested capital: This type of owners’ equity account records the amounts of money that owners have invested in the business, which could have been many years ago. Owners may invest additional capital from time to time, but generally speaking they can’t be forced to put additional money in a business (unless the business issues assessable ownership shares, which is unusual).

    Depending on the legal form of the entity and other factors, a business may keep two or more accounts for the invested capital from its owners.

  • Retained earnings: The profit a business earns over the years that has been retained and not distributed to its owners is accumulated in the retained earnings account. If all profit is distributed every year, retained earnings has a zero balance. (If a business loses money, its accumulated loss causes retained earnings to have a negative balance, which generally is called a deficit.)

    If none of the annual profits of a business are distributed to its owners, the balance in retained earnings is the cumulative profit the business has earned since it opened its doors (net of any losses along the way).

Whether to retain part or all of annual net income is one of the most important decisions that a business makes; distributions from profit have to be decided at the highest level of a business. A growing business needs additional capital for increasing its assets, and increasing the debt load of the business usually can’t supply all the additional capital.

So, the business plows back some of its profit for the year into the business, rather than distributing it to its owners. In the long run, this may be the best course of action, because it provides additional capital for growth.