Financing covers the core of what private equity does. In essence, the financing function of private equity serves to provide capital for private capital seekers. Two broad categories of financing are debt financing and equity financing.
Debt capital is simply a private loan to a company. In young start-ups, debt is a common way for entrepreneurs to raise capital for business expansion – commonly through avenues such as marketing and research and development – without giving away equity. The terms of the debt would take into account the level of risk in the company and their ability to service the debt. It is common for private equity firms to invest in convertible debt; this is debt that may be converted into a predetermined amount of shares at the debtholder’s discretion. More mature companies may require debt financing as well – for business expansion or to improve their capital structure.
Equity capital simply represents a stake in the capital seeker’s business. Here, private equity firms reap a return from the vested company’s growth in business performance and valuation. When the private company is sold off at a higher valuation in a trade sale, or goes public through an IPO, the private equity firm may sell off its shares for a profit. For start-ups, equity capital is a generally favoured form of financing, as it represents mutual interests of both the capital seeker and capital provider in the growth of the capital seeker.