The term "equity" in corporate or project finance jargon indicates some share of ownership in a company or project - i.e., some level of entitlement to some slice of the revenues brought in by the company or project. There are different priority levels of this entitlement - typically operating costs must be paid (including, in some cases borrowing costs) before equity investors can get their slice of the net revenues. There are also multiple priority levels of equity investors, which determines who gets paid first if profits are scarce.
The simplest, and one of the most common, forms of equity ownership is through the ownership of company stock. A share of stock is simply an ownership right to a portion of the company's profits. When public stock is initially issued by a company (called an "initial public offering"), the price paid for that stock is effectively a capital infusion for the company.
When you think about shares of stock, you may have in your mind things that are traded on the New York Stock Exchange. Not all stock is traded or issued this way, at least not initially. Often, company founders or owners will decide to sell limited amounts of stock in a company without that stock being available for the general public to purchase or being traded on an exchange like the New York Stock Exchange. A company that issues stock in this way is often referred to as being a "private" company, which means that its stock is held and traded (if it's ever traded) in the hands of individuals or institutions selected by the company. Often times, stock in a private company comes with some sort of voting right or other representation into how the company runs its operations.
A company that issues shares of stock to the general public is called a "publicly-traded" or "public" (for short) company. The term "public" in this case should not be confused with ownership by any government or the mission of the company - the term simply refers to the availability of the company's stock. The decision to "go public" is complicated and has costs as well as benefits. The obvious benefit is that issuing public stock is a relatively straightforward way to raise large amounts of capital. Owners of private stock that allow their stock to be sold in the public offering can also make substantial amounts of money if the demand for the stock among the public is high. There are, however, a couple of big down sides. First, issuing more shares of stock effectively dilutes the value of existing shares. If a company has $1 million in profits and increases the number of shares of stock from 1 million to 2 million, then the value of a share in the company drops from $1 per share to $0.50 per share. People are sometimes willing to pay large sums for company stock if they believe that profits will increase in the future. Second, the more equity investors there are (public or private), the larger the loss of control by the company's original owner.
Raising equity capital can happen through a number of different channels. Brief descriptions of a few of the major channels follow:
- Angel investors
are generally individuals who take equity shares in a company when the company is very young. Often times, friends or family are the original "angel" investors. Angels often take very large stakes in projects or companies, which also gives angels substantial control (in many cases) in how those projects or companies are run.
- Venture capital firms are partnerships that make investments in start-up companies. The big difference between venture capitalists and angel investors is that venture capital firms typically invest in a large number of different start-up companies or projects, and so are more diversified.
- Institutional investors
represent groups (not individuals) that can invest money in companies or projects. Examples include pension companies, endowments and even universities (interestingly, during the financial crisis in 2008/09, many universities lost billions of dollars when their investments went sour). Sometimes, institutional investors make direct investments on their own, and sometimes they do so as part of venture capital firms. Institutional investors are generally more restrictive in the riskiness of the projects that they can take on than individual venture capitalists or angel investors might be.
- Corporate investors
represent companies that buy equity interests in other companies. It is very common for large companies to purchase direct stakes in smaller companies or individual projects.
- Tax equity investors
are especially important to renewable energy projects. These investors provide funds to renewable energy companies or projects in exchange for a share of the tax benefits that those companies enjoy through subsidies and incentives (more on these in Lesson 12). This concept may seem a bit odd - if a company is installing solar PV panels and can claim tax credits for those panels, then why not just claim the credits themselves? The answer is that if the solar PV company is small, then either it does not have a large tax liability in the first place and would not benefit as much from the credits; or it may not be sophisticated enough to wind its way through the maze of tax forms necessary to claim the credits. This is where the tax equity investor comes in. Typically, a tax equity investor will purchase an equity stake in a company (a so-called "joint venture") that is about equal to the value of the tax incentives for that particular investor. Only certain types of entities may act as tax equity investors, and these activities are regulated in the U.S. by the Internal Revenue Service (so-called "passive activity" companies).
The "cost of equity" for a project or company represents the return that an equity investor would need in order to judge that project or company a worthwhile investment. Remember that the cost of equity is really an opportunity cost. Individual investors may have their own criteria for judging opportunity cost, and we can't get into their heads all of the time. So, how do we estimate opportunity cost for a particular project or company? The most common framework is to use a framework called the "Capital Asset Pricing Model" (CAPM). Investopedia has a nice introduction to this framework that includes both the intuition and the equations. Here, we will stick mostly to the intuition.
- First, investments in individual projects or companies are risky, and an investor can always put her money into a safe asset. A bank deposit is typically a safe asset. U.S. treasury bonds are also considered to be pretty safe assets, at least historically. So, the return on equity investment needs to be higher than the return on a safe asset.
- But by how much? One approach that investors sometimes take is to look at similar investments (similar projects or companies) to see how these returns have performed relative to the safe asset. This number is called the "risk premium."
- Finally, there is always some correlation between an individual asset and the market as a whole. This correlation is known as the "beta" and is obtained through statistical analysis of individual project or company returns relative to a market index or average. If a company has a high correlation with the overall market, then returns on that company will be subject to all of the volatility of the market as a whole. In this case, the "beta" for that company would be high, and the cost of equity would also be high.
Using the CAPM to determine the cost of equity, the equation is:
For project evaluation, it is common to use the beta and risk premium relevant to the industry in which the project is going to operate (e.g., utilities for a power plant or gasoline for a refinery). This web page has a nice table estimating the cost of equity for different industries.