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equity financing

Also called: equity funding, raising equity, selling equity

Raising money by selling a share of the company. There is no interest to pay, but the owners' share and future profits are diluted.

Equity financing raises money by selling a share of the company to investors. There is no interest and no repayment date, and the investor shares the bad years: if there is no profit, nothing is owed. The price is a share of every future profit and of the company's value if it is ever sold.

The deal is described by two numbers that set each other. If an investor pays X for a share s of the company, the company is valued at X ÷ s once the money is in (the post-money valuation); take away the new money and you get the pre-money valuation, what the investor thinks the company is worth today. Every existing owner's share shrinks in proportion: that is dilution.

Equity suits uncertain plans, where a fixed interest bill could sink a weak year. It is usually the more expensive money when things go well, because the investor's share of a large profit or exit exceeds what interest would have cost. It also buys more than cash: an investor may bring advice, contacts and a board seat, and with it a say in decisions.

Example

An investor offers Klasna 6,000,000 UAH for 12.5% of the company.

  • Post-money valuation: 6,000,000 ÷ 0.125 = 48,000,000 UAH.
  • Pre-money valuation: 48,000,000 − 6,000,000 = 42,000,000 UAH.
  • Dilution: everyone keeps 87.5% of their stake. Founders 80% × 0.875 = 70%; early investors 20% × 0.875 = 17.5%.

In a strong year with 5,000,000 of operating profit the founders' part is 3,500,000 (a loan would have left them 3,040,000); in a weak year with 800,000 it is 560,000 (a loan would have left them −320,000). The investor's 12.5% also applies to any future sale of the company.

Common mistakes

  • Calling it free money. No interest, but a permanent share of every future profit and exit.
  • Confusing pre-money and post-money. The new money is inside the post-money valuation; the share is computed on it.
  • Forgetting existing owners. Early investors are diluted too, and may have rights that change the terms.
  • Raising more than the plan needs. Size the round from the deepest point of cumulative cash in the weak case plus a buffer.
  • Ignoring control. A board seat and investor consent rights are part of the price.

Learn it in the course