What Is Equity Financing?
Lending companies for small businesses may also offer equity financing, which involves selling shares of a company in exchange for capital. These funds are used for immediate business operations or long-term growth. The cost of shares is based on the company’s valuation, or worth, and investors become part owners of the business.
Equity financing can come from a number of sources, such as private equity investors, an IPO (Initial Public Offering), or even your family. If you are raising capital for rapid growth or are in an industry with expensive research and development, you will likely go through several rounds of equity financing during your growth.
Why Equity Financing Is a Smart Option for Small Businesses and Startups
Unlike many other types of business financing, equity financing is often best suited for startups and young businesses, whose limited credit history and time in business makes it difficult for them to qualify for traditional business loans.
Even if debt financing is an option, equity financing can help inexperienced small business owners to raise capital while getting an advisor with connections, expertise, and a stake in the business’s future success. This is why business owners on Shark Tank sometimes choose to give up more stake in their company for the investor with the most experience in their industry.
How Does Equity Financing Work?
While the basics of equity financing can be learned by watching a couple of episodes of Shark Tank, it can be complicated to obtain fair and mutually beneficial equity financing, especially if you are a new entrepreneur with minimal business funding experience.
In its most basic format, equity financing is executed through a mutual agreement with an investor or investors for a set amount of capital in exchange for a set number of shares, totaling percentage ownership.
A larger investment yields a large stake in your business, and some investors may be aiming to obtain control of the company, which is 50% or more of your company. If you want to guarantee that you will have decision-making power, you should ensure that you always own at least 50% of your company.
If you are a new business that presents a high risk to the investor, you may be presented with an equity financing deal that includes other forms of equity financing, such as:
- Preferred shares; and
- Convertible preferred stock
While these types of stock are popular with venture capitalists who want the best possible reward for their risk, be sure to review any agreements with a lawyer to ensure you aren’t setting yourself up for problems in the long run.
Beware: Large Dividends Can Get Expensive Real Fast
While a higher dividend (a distribution of profits by a corporation to its shareholders— which is something you would pay out if you were to go with equity financing) for an investor may not seem like much of a problem in the early stages when you are struggling to meet your business needs, it can really cut into your long-term profit.
If your company is making enough money and is structured correctly, going public with an Initial Public Offering (IPO) can be very lucrative for your business. However, you will have to incorporate your business and meet the qualifying criteria of one of the major stock exchanges. This doesn’t make sense for the vast majority of small businesses, but if you are quickly growing into a larger corporation, it may be your best option.
As you can see, equity financing is more complicated than just trading part of your business for some extra cash. You are taking on the long-term liability of another person with a stake and a voice in your company.
Equity Financing vs. Debt Financing: What’s the Difference?
Equity financing is often compared to debt financing because they are the two most common ways to raise capital for a business. While equity financing is the exchange of shares for upfront capital, debt financing is the agreement to pay future interest on upfront capital (aka debt).
At their core, these two financing options result in the same thing: the lender or investor takes on the upfront risk by giving you capital that you don’t have, and you repay that risk as your business makes money. However, the repayment is where equity financing and debt financing are starkly different.
- What You Owe – Debt Financing
- Regardless of how well your business is doing, you owe that lender their money back, plus interest.
- Lenders will require collateral, like real estate or a vehicle, to ensure that if you default on the loan, they still have a way to recoup their money.
- There’s really no way to get out of repaying a loan and it can hurt your cash flow for years.
- What You Owe – Equity Financing
- Equity financing does not require you to take on debt or make monthly loan payments to repay a lender (a major selling point for most new small business owners).
- If your business does very well, you will end up owing an investor a lot more if you want to buy them out and regain ownership of your company.
Picture this: you need $50,000 to make a major purchase order and ramp up production. If you took on a business loan with a 10% interest rate and paid it off over 3 years, you can expect to pay about $8,000 in interest.
On the other hand, imagine if your business was valued at $1 million and an investor gave you $50,000 for a 5% stake. Then, if your business grew to be worth $5 million three years later, you would owe that investor $250,000 to buy out their shares in your company. From a sheer financial standpoint, debt financing is a much better deal in this scenario
There’s a unique benefit to equity financing: your investor becomes a stakeholder in your company and can often add additional value in the form of guidance, which can help your business grow far faster than it could have without an experienced investor on board.
Choosing Between Debt and Equity Financing
While both equity and debt financing have their advantages, your decision may actually come down to available options.
Debt financing is often not available to young businesses as they typically lack a strong credit profile and history of meeting expenses. At the end of the day, both equity and debt financing can help take your business to the next level—and as long as you take into consideration your business’s potential, you can be sure you made the right choice.
Learn more in our guide to debt financing vs equity financing.
Types of Equity Financing
While the basics of equity financing always revolve around exchanging investment for ownership, there are various forms of equity financing that each offer different perks for investors and owners.
Individual investors, venture capitalists, angel investors, and IPOs are all different forms of equity financing, each with its own characteristics and requirements.
1. Individual Private Investors
One way to raise money for a business is by reaching out to individual investors. This can include your friends, family, and other colleagues. Some business owners feel like this is the easiest type of equity financing to secure since they are working with people they have a prior relationship with and who are more likely to be interested in seeing the business succeed.
However, relying on individuals for investment likely means that you’ll need many individual donors in order to make a serious impact. Individual donors are likely to have less money to invest in your business compared to venture capitalist groups or angel investors and may have less to offer in terms of guidance and connections as well.
Learn more equity financing:
2. Venture Capitalists
A venture capitalist can either be an individual person or a larger venture capital firm. Unlike individual private investors, venture capitalists typically have larger amounts of money to invest in a business. Venture capitalists, whether an individual person or a firm, are generally most interested in finding companies with extremely high growth potential.
Since venture capitalists are able to invest larger amounts of money, they will most likely expect to have a larger share of control in the company going forward and may take significant control over your company’s growth to protect their investment.
Venture capitalists can pour tremendous resources into your business and also widen your network. However, in order to protect their investment, this can mean you’re at their mercy when it comes to how you conduct operations or how aggressive your growth plans are.
3. Angel Investors
Angel investors can also act as individuals or as a larger group. These are investors who are capable of investing a large amount of money in a business and are most typically looking to invest in an industry they are familiar with and have experience working in.
The name “angel investor” reflects the fact that not only can they make a large financial investment in your business, but they can also provide very valuable guidance.
Typically, angel investors are interested in getting involved with businesses in their early stages and overseeing their subsequent growth.
Where venture capitalist groups may provide your business with large-scale profiling and networking assistance, angel investors are more likely to involve themselves in the planning and execution of your growing business.
4. Public Offering
Some businesses looking to receive equity financing in smaller dollar investments from the public may make an Initial Public Offering (IPO) and list their stock for purchase by the public. Doing so can be an effective way for a business to raise the capital needed for them to expand, with the added benefit of publicity from being traded on the public market.
Some downsides of executing an IPO are:
- They can be tedious, costly, and time-consuming.
- They may not serve your actual growth if you cannot afford to spend the effort to get one. The eligibility of your business for an IPO depends on which sector you operate in.
- Your annual revenues will play a big role in eligibility (bad for businesses that have irregular cash flow).
- The Internal Revenue Code may layout its own set of requirements for your business.
If your company does secure an IPO though, you may reap the benefits of upfront capital investments made by smaller-dollar investors who would expect to receive far less control than angel investors or venture capitalists.
Pros and Cons of Equity Financing
While equity financing can be the only way to grow your startup business without taking on debt, there are a number of pros and cons to all financing options, and equity financing may not be your most effective option depending on your business’s profile and goals.
Pro: Low Financial Risk to Business Owner
Equity financing can be a great, low-risk method of obtaining financing for your young business. Because owners trade a percentage of ownership for invested capital, investors in your business agree to take on the risks of operating your business.
In doing so, investors open themselves up to losing or gaining money through your project and therefore allow you to receive their investments without going into debt. In short, equity financing offers lower-risk funding, without the burden of debt, because investors only succeed if your business does.
Pro: Investor Connections & Expertise
An equally important piece of equity financing is the chance to connect your business to talented and experienced individuals with a background in your industry. If a successful restaurateur invests in your new diner, you not only receive the power of their dollar but also valuable advice and guidance based on their own experiences growing restaurants.
Because they now own a stake in your operation, they are more likely to assist you in its growth than a lender expecting repayment would.
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Con: Losing Part Ownership in Your Company
Seeking equity financing does involve giving up some level of control of your business so you should be very selective about who you choose to accept money from. If your business encounters some difficulties or you have disagreements about the direction of the company, it can place a strain on the relationships between investors.
Keep this in mind if you plan on asking close friends or family to invest in your business, and make sure you fully trust your to-be partners before signing an agreement with established investors.
Con: Pitching Potential Investors
Just because equity financing doesn’t involve lengthy, formal applications, doesn’t mean that equity financing is an easy, cheap or a fast business loan. You will need to spend a great deal of time developing a strong business plan to present to potential investors.
In fact, seeking out investors, preparing your presentation, and pitching your business could potentially be even more time-consuming than taking out a regular business loan would be.
Con: Investors Share Profits
Investors will only invest in your business if they are pretty sure they can make some money on it, and ideally make a lot of money at that. If you receive significant investment, it can very likely come at a tremendous cost over time.
It’s important to note, though, that investors themselves can be instrumental in growing your company’s valuation.
Imagine giving up 20% of your business, only for its value to increase from $400,000 to $4 billion in a few years. Suddenly, you’ve not only given up ownership of your brand, but you’ve also given up $800 million in growth to your fellow owners—this is almost certainly a greater cost than you’d incur under a fixed interest arrangement.
4 Reasons to Use Equity Financing
1. Funding a Startup
A good (and common) time to seek equity financing is while you’re finding startup capital for your business. Angel investors, specifically seeking out businesses that can offer a high return on their investment, tend to flock to business ideas that are yet to get off the ground.
Equity financing is a good solution to any short-term financing needs that may arise before your business is fully operational due to its relative availability and its potentially massive impact on your finances.
- Equity financing may be a great place to turn for your business’s early-life necessities like:
- Finding a location
- Training staff
- Purchasing equipment
2. Financing Risky Businesses
Another common purpose of equity financing is to finance businesses that banks or traditional lenders may not engage with. Many lenders aren’t willing to take a gamble on an unproven concept or inexperienced owner.
Equity investors, however, may allow you to get outside money from individuals or groups willing to work with your team to pursue success going forward.
3. Managing Debt
Equity financing can still help even after you’ve already been operating, particularly when you want to manage your business debt.
Unlike other forms of business financing, equity financing isn’t counted into your business debt and is repaid much differently.
Rather than receive emergency funding at the cost of additional debt, equity financing allows you to maintain your current balance sheets while adding resources to your operation. Because investors themselves take on risk in equity financing, your debt not only stays stable but becomes a shared burden for your board to address.
4. Building Valuable Connections
While other startup funding methods like maxing out a credit card, draining your personal funds, or selling future products through crowdfunding may get you the funds you need, only equity financing can connect you with a business expert who can truly serve as an advisor to your growing business.
Not only do angel investors and venture capitalists typically have a good chunk of experience growing startups, but they also have a financial stake in helping your business. This can be a win-win for everyone if financing with a side of advising is what your business really needs.
What To Do Before Seeking an Equity Investment
Before you start pitching your business to potential investors, make sure you have considered all of your available financing options and have decided that equity investment is the right decision for your business.
Then, start by consulting a business attorney, who will be able to create contracts for your investors to sign to protect everyone involved. They can also explain options to you that can limit the level of control an investor has in your business, such as non-voting stock or convertible notes.
It is essential that before you add investors, you have a clearly defined set of rules for their contributions to, and roles in, your company.
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