16.5 Equity Financing

Selling New Issues of Common Stock

Common stock is a security that represents an ownership interest in a corporation. A company’s first sale of stock to the public is called an initial public offering (IPO). An IPO often enables existing stockholders, usually employees, family, and friends who bought the stock privately, to earn big profits on their investment. (Companies that are already public can issue and sell additional shares of common stock to raise equity funds.)

But going public has some drawbacks. For one thing, there is no guarantee an IPO will sell. It is also expensive. Big fees must be paid to investment bankers, brokers, attorneys, and accountants. Once the company is public, it is closely watched by regulators, stockholders, and securities analysts. The firm must reveal such information as operating and financial data, product details, financing plans, and operating strategies. Providing this information is often costly.

Going public is the dream of many small company founders and early investors, who hope to recoup their investments and have their company become profitable. Intuitive Surgical went public in 2000 trading at just $2 per share. Now, over two decades later, the stock is trading at nearly $500 per share. The company specializes in robotic systems for minimally invasive surgeries, and as the technology has been adopted at over 6,000 hospitals in the United States, the stock has steadily grown.

The number of IPOs can vary based on economic and political conditions, and the decision requires planning and strategic moves, despite the expected lucrative rewards for both investors and entrepreneurs. For example, in 2014, King Digital Entertainment, a mobile game creator, had its IPO with the stock opening at $20.50. By the end of the first day of trading, the stock had dropped over 15 percent and by the end of the first year, it was down 23 percent. The business was eventually acquired by Activision Blizzard in 2016. The decline was attributed to the decreasing popularity of its key game—Candy Crush Saga—and investors became skeptical that the company was too reliant on a single product.⁸

Some companies choose to remain private. Cargill, Publix Super Markets, Mars, and Fidelity Investments are among the largest U.S. private companies.

Dividends and Retained Earnings

Dividends are payments to stockholders from a corporation’s profits. Dividends can be paid in cash or in stock. Stock dividends are payments in the form of more stock. Stock dividends may replace or supplement cash dividends. After a stock dividend has been paid, more shares have a claim on the same company, so the value of each share often declines. A company does not have to pay dividends to stockholders. But if investors buy the stock expecting to get dividends and the firm does not pay them, the investors may sell their stocks.

At their meetings, a company's board of directors will review proposals from the firm's management to determine how much to distribute as dividends. A firm’s basic approach to paying dividends can greatly affect its share price. A stable history of dividend payments indicates good financial health. For example, pharmaceutical company Eli Lilly and Co has increased its dividend for the last 11 years with a growth rate of over 15 percent, giving shareholders a solid return on their investment.⁹

If a firm that has been making regular dividend payments cuts or skips a dividend, investors start thinking it has serious financial problems. The increased uncertainty often results in lower stock prices. Thus, most firms set dividends at a level they can keep paying. They start with a relatively low dividend payout ratio so that they can maintain a steady or slightly increasing dividend over time.

Retained earnings, profits that have been reinvested in the firm, have a big advantage over other sources of equity capital: They do not incur underwriting costs. Financial managers strive to balance dividends and retained earnings to maximize the value of the firm. Often the balance reflects the nature of the firm and its industry. Mature firms with management confidence for positive earnings in the future—such as construction materials firms, companies in the oil and gas sector, consumer goods businesses, and financial services companies—typically pay out a good portion of their earnings in dividends. For example, in the 2025 fiscal year, ExxonMobil paid dividends of $4.12 per share, Altria Group paid $4.24 per share, Apple paid $1.04 per share, and Costco paid $5.20 per share.

Some high-growth companies or those yet to have a profit, such as those in technology-related sectors, finance their company growth through their retained earnings and do not pay out dividends. As the firm matures, some then decide to begin paying dividends, as Dell decided to do in 2022 after being publicly traded for 34 years.¹⁰

Preferred Stock

Another form of equity is preferred stock. Unlike common stock, preferred stock usually has a dividend amount that is set at the time the stock is issued. These dividends must be paid before the company can pay any dividends to common stockholders. Also, if the firm goes bankrupt and sells its assets, preferred stockholders get their money back before common stockholders do.

Like debt, preferred stock increases the firm’s financial risk because it obligates the firm to make a fixed payment. But preferred stock is more flexible. The firm can miss a dividend payment without suffering the serious results of failing to pay back a debt.

Preferred stock is more expensive than debt financing, however, because preferred dividends are not tax-deductible. Also, because the claims of preferred stockholders on income and assets are second to those of debtholders, preferred stockholders require higher returns to compensate for the greater risk.

Venture Capital

Venture capital is another source of equity capital. It is most often used by small and growing firms that aren’t big enough to sell securities to the public. This type of financing is especially popular among high-tech firms in sectors such as fintech, biotechnology, and robotics, that need significant seed money to finance their operations.

Venture capitalists invest in new businesses in return for part of the ownership, typically between 20 and 40 percent. They look for business with high return-on-investment potential. The time frame required for the venture capitalist to see a return varies by the industry and the stage of the business; however, typically returns are realized in 12 to 14 years. By getting in on the ground floor, venture capitalists buy stock at a very low price. They earn profits by selling the stock at a much higher price when the company goes public. Venture capitalists generally get a voice in management through seats on the board of directors. Getting venture capital is difficult, even though there are hundreds of private venture-capital firms in this country. Only about one percent of companies that apply for venture capital funding are financed. Venture-capital investors are strategic when deciding which firms to finance, weighing the risks of the business and economic risks against the probability of getting a large enough return to justify the risk level. In addition to venture capital, other sources of funding, including private foundations, states, and wealthy individuals (called angel investors), are helping start-up firms find equity capital. These private investors are motivated by the potential to earn a high return on their investment.