Equity finance is a division of the capital markets that corporations use to raise money in exchange for issuing stock. A company might tap the equity markets if it needs to raise money for an expansion, including a merger; to pursue a project; or for product development. It may also turn to the equity markets if a balance sheet is heavily laden with debt, in order to offset some of that risk. When a company issues additional shares in the equity markets, it is diluting the percentage of stock owned by existing shareholders, but if the endeavor leads to profit growth in the long term, it is usually justified.
The first time a company uses equity finance in the public markets is when it issues an initial public offering (IPO). An IPO is the introduction of stock into the financial markets, and it offers shareholders an opportunity to obtain partial-equity ownership in a entity. Company executives are often the largest equity holders in a corporation, and their stake diminishes as additional shares are sold to the public. Equity shareholders obtain voting rights for major company events.
Once an IPO is complete, a company may choose equity finance again in a follow-on or secondary offering. This is where additional shares are sold in the market for a period of time. The reason that a follow-on offering dilutes the position of current shareholders is that a percentage of shares owned decreases when new shares become available.
When a company needs to raise capital in the financial markets, equity finance may be selected as an alternative to debt finance. By issuing debt, a company is borrowing funds from bondholders and must maintain steady principal and interest payments to those investors. In equity finance, the only distributions that are made to shareholders are dividends, and those payments are optional.
Dividends are cash or stock distributions made by a company to shareholders on a quarterly basis as a reward. If a company is not in a position to distribute cash payouts to its shareholders, it may instead issue stocks as a means of preserving cash. Shareholders may become disgruntled by dividend interruptions and may express that displeasure by selling shares.
Certain sectors in the financial markets depend on equity finance more than others. Oil and gas companies pursue expensive drilling projects around the world, and although a particular field might show tremendous promise, the entity might lack the cash reserves necessary to move forward. A company may attempt to raise equity with the expectation to return future profits to shareholders with revenues generated from the project. Pharmaceutical companies are often faced with lengthy testing and trial periods prior to introducing a new drug to the market. In order to fund the multiple clinical trials involved in the process, this sector might similarly raise money in the equity markets.