What key factor influences the cost of equity for smaller companies?

The cost of equity for smaller companies is primarily influenced by greater perceived risk. Investors often view smaller companies as riskier investments compared to larger, more established firms due to several factors. These can include limited operating history, smaller market share, and potential volatility in earnings and cash flows. Because of this higher risk, investors typically require a higher return on their equity investments in smaller companies to compensate for the additional uncertainty.

This perceived risk reflects the company's ability to withstand economic fluctuations, its dependence on a limited number of customers or products, and greater sensitivity to market conditions. As a result, smaller companies generally face higher costs of equity capital. Understanding this element is crucial for evaluating investment opportunities and for companies to appropriately price their equity during fundraising or IPO processes.