In the various forms of financing, the company open to play equity financing a central role. We have therefore taken a closer look at how equity financing can be designed, what options are available and what effects the respective forms of financing have on the company.
What is equity finance?
Any financing of the company that comes from outside and represents equity falls into the category of equity financing . The shareholding relationships in the company shift as a result of the equity financing. The equity is increased, which means that more liable capital is available, which in turn should suggest greater security to potential lenders .
Legal basis according to HGB
According to SPORTINGOLOGY.COM, the legal framework that has to be observed depends on the particular type of company and the company that is ready to raise new capital and thus avail itself of equity financing. For this purpose, partnerships must be based on the conditions in the German Commercial Code (HGB) , while for stock corporations , for example, separate regulations have been made in the Stock Corporation Act.
Participations through contributions in kind
However, shares in the company do not always have to be able to show financial capital in return. A foundation in kind is also possible through the participation of contributions in kind . In concrete terms, this means that financial capital is not brought into the company, but machines, for example, are made available free of charge. In this sense, contributions in kind represent the equivalent value that is offered to support the company and to justify the fact that shares in the company are awarded for this purpose.
Features of equity financing
When it comes to equity financing, it does not matter whether the capital or contribution in kind is made by persons or companies that already have a stake in the company. It is therefore also possible that someone already holds shares in the company and increases them by bringing in additional capital or new contributions in kind. Capital that flows into the company in the course of equity financing is always equity . This form of capital is available on a liable basis. This means that the risk of equity is always higher than that of debt , which is why equity is accordingly more expensive, for example through higher earnings expectations .
At the same time, the increase in equity results in a lower risk of insolvency and the borrowing of debt is made easier, since the higher sum is now available that could theoretically be used in the event of liability and thus the equity ratio has increased and the level of debt has decreased.
Equity finance and the balance sheet
Now that we have clarified the main features of equity financing, let’s see what effects it will have on the balance sheet . The fresh equity increases the balance sheet total and is intended to remain with the company on a permanent basis. In the case of key figures, the effect is that if the profit remains the same, the return on equity falls. To do this, the debt ratio is reduced , so the level of indebtedness improves. At the same time, the balance sheet is the basis for determining the conditions under which new shares are to be issued in an AG. As a result, existing shareholders will be issued with so-called “young” shares treated preferentially to avoid dilution. Put simply, this means that it is intended to ensure that capital increases do not lead to existing investors holding a disproportionately lower stake in the company in the future. If that were the case, we would speak of “ dilution ”.
Equity financing and the balance sheet are thus related to one another in various ways . On the one hand, the balance sheet can be the basis for a new financing round to be considered in the first place, on the other hand, the financings carried out naturally have a direct effect on the next balance sheet.
Equity financing has the most important effects on the equity ratio . How high this should ideally be depends not least on the company’s industry. The phase the company is in can also have an impact. In general, the equity ratio states what proportion of the total capital represents equity. The remaining amount is borrowed capital. However, the assumption that the equity ratio should continue to increase and should ideally be 100 percent does not apply. There are several arguments against it – above all the so-called ” leverage effect ” . This states that the return on equity increases as long as it is possible that the return on total capital is higher than the cost of debt. Sounds complicated, but it is not.
You want to invest your capital in real estate and expect a net return of four percent. As long as you can borrow more cheaply, your return on equity increases. The equity used is then lower in relation to the total capital and you create a kind of leverage effect. For this reason alone, equity ratios that are too high are not always helpful.
Another argument is the skepticism of investors, especially in the case of stock corporations. Hoarding a lot of equity, although the situation on the capital market is such that outside capital could be raised very cheaply, does not bode well. It could be interpreted that the company has no ideas of what to do with additional capital. Unfortunately, this also means that it does not see any growth opportunities in which it could actively invest. For this reason, an excessively high equity ratio can lead to caution and caution among investors.
Aside from these arguments, however, there are also big pros when it comes to increasing equity . Fresh capital shows that people believe in the company and are ready to invest their wealth. In the case of young companies, interest in and trust in the company can increase if a recognized person (e.g. an expert in the industry or an established company) participates in the company with equity. The equity ratio is thus increased and the company is financially stronger.
In the case of a start-up , this can be an important financial cushion that can be used to finance growth if banks are not ready to provide capital in an early entrepreneurial phase. In addition, as already mentioned, the level of indebtedness will be reduced, which will strengthen liquidity and increase the chances that further borrowed capital will be made available.