Advantages & Disadvantages of Equity Capital

by Billie Nordmeyer

    Business management and the board of directors determine a company's capital structure, which usually consists of both debt and equity capital. Unlike lenders, equity investors receive an equity share in a business in exchange for a financial or other contribution to the company. In some cases, equity capital originates with angel investors, venture capital firms or venture capitalists. In other instances, a company obtains capital from a private equity firm, an institutional investor -- pension funds and insurance companies – or a corporate investor.

    Equity financing has no fixed payment requirements. As a result, the investments do not increase a company's fixed costs or fixed payment burden. In addition, dividends to be paid to equity investors can be deferred and cash can be directed to business opportunities and operating requirements as needed.

    Equity investors do not require a pledge of collateral. Existing business assets remain unencumbered and available to serve as security for loans. In addition, assets purchased with equity capital can be used to secure future long-term debt.

    Equity investors are focused on future earnings and increasing the value of a business rather than the immediate return on their investment in the form of interest payments or dividends. As a result, businesses can rely on equity capital to finance projects for which the earnings or returns may not occur for some time, if at all.

    A lender is concerned with the repayment of debt. The lender wants to ensure that loan proceeds increase company assets, which generate cash to repay loans. Therefore, lenders establish financial covenants that restrict how loan proceeds are used. Equity investors establish no such covenants; they rely on governance rights to protect their interests.

    Neither profits nor business growth nor dividends are guaranteed for equity investors. The returns to equity investors are more uncertain than returns earned by debt holders. As a result, equity investors anticipate a higher return on their investment than that received by lenders.

    Legal restrictions govern the use of equity financing and the structure of the financing transactions. In fact, equity investors have financial rights, including a claim to distributed dividends and proceeds from the sale of the company in which they invest. The equity investors also have governance rights pertaining to the board of directors election and approval of major business decisions. These rights dilute the ownership and control of a company and increase the oversight of management decisions.

    Each investor in a company has a right to the cash flow generated by the business after all other claims are paid. If the business is sold, the owners share cash equal to the net proceeds of the business if a gain occurs on the sale. The investors’ net return is equal to the net proceeds of the sale less the cash they invested in the business. The legal restrictions that govern the use of equity financing determine the return received by an individual investor.

    References (5)

    • "Economic Development Finance"; Karl F. Seidman
    • "Law of Corporations and Other Business Organizations"; Angela Schneeman
    • "Fundamentals of Financial Management"; D. Chandra Bose
    • "Financial Management"; Prasanna Chandra
    • "Contemporary Business"; Louis E. Boone and David L. Kurtz

    Photo Credits

    • five hundreds image by Valentin Mosichev from Fotolia.com

    About the Author

    Billie Nordmeyer works as a consultant advising small businesses and Fortune 500 companies on performance improvement initiatives, as well as SAP software selection and implementation. During her career, she has published business and technology-based articles and texts. Nordmeyer holds a Bachelor of Science in accounting, a Master of Arts in international management and a Master of Business Administration in finance.

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