Startups and young businesses often need extra funding to grow and expand. However, their limited credit history and time in business makes it difficult for them to qualify for traditional business loans. Additionally, small business owners might not want to risk losing major personal assets by pursuing secured financing options, which leaves limited financing options for small businesses starting from scratch.
Equity financing is a way for businesses to get the funding they need without dealing with strict loan terms or debt repayment. Equity financing exchanges a stake of ownership in your company in return for upfront funding. Unlike many other types of business financing, equity financing is often best suited for startups and young businesses.
What Is Equity Financing?
Equity financing is an investment practice that exchanges a percentage of ownership in your company in return for a lump sum investment in your business, which is based on your current valuation. This is vastly different from other types of business loans, like debt financing, in the sense that you don’t take on any debt by accepting the investment. Instead, you raise money for your business by selling a percentage of ownership to investors, who then become part owners in your business.
The percentage of ownership an investor has is proportionately tied to the size of their investment relative to the company’s current valuation, or the number of shares purchased relative to the company’s total number of shares. For example, if an investor offers you $50,000 for a 10% stake in your company, your business’s valuation is $500,000. If your company grows and your valuation doubles to reach $1,000,000, your investor’s stake in the company is worth $100,000 – or double their initial investment.
A larger investment yields a large stake in your business. If you’re looking to avoid paying back a loan plus interest as your company grows, and you’re willing to share ownership of your business, equity financing can be a great choice for your company, especially if you think it has great growth potential.
Equity Financing vs Debt Financing
Equity financing can be a particularly convenient option for small businesses just starting out as it does not require you to take on the risk of debt.. In debt financing arrangements, business owners take on debts through loans or other repayable investments, placing financial obligations on your company for a period into the future, which can subject you to stringent repayment plans that hurt your cash flow.
Through equity financing, you trade ownership of your business in exchange for a lump sum investment in its growth. Because your investor becomes a stakeholder in your company, they can often add additional value in the form of guidance, but this also means that they have a voice in how you run your operation.
For the purpose of avoiding debt early in your startup’s life, equity financing may be a more favorable option. It’s also important to note that, unlike equity financing, oftentimes debt financing options are not available to young businesses as they typically lack a strong credit profile and history of meeting expenses.
Pros and Cons of Equity Financing
While equity financing can be a great way to get your business off the ground 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.
Pros of Equity Financing
Equity financing is seen as a great, low-risk method of obtaining financing for your young project. 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.
An equally important piece of equity financing is the chance to connect your business with 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.
Cons of Equity Financing
Remember, seeking equity financing does involve giving up some level of control of your business so you have to 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.
Additionally, just because equity financing doesn’t involve lengthy, formal applications, doesn’t mean that equity financing is fast, easy, or cheap. 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.
Consider that investors are putting their own funds at risk to see your project succeed – they’ll likely need some convincing before they do it. If you receive a significant investment, that, too can come at a cost over time. 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. It’s important to note, though, that investors themselves can be instrumental in growing your company’s valuation.
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 their own characteristics and requirements.
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, as private individuals almost surely have much less money to invest than venture capitalist groups or angel investors, and certainly less to offer in guidance and connections.
A venture capitalist can either be an individual person or a larger firm. Unlike individual private investors, venture capitalists typically have larger amounts of money to invest in a business. Venture capitalists, whether it’s 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. This typically entails tremendous resources and network efforts being poured into your business by an investment group, though it also means that your order of operations and distribution plans may be altered at the urging of VC firms hoping to protect their stock.
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 initiative.
Small 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 a business to expand, with the added benefit of publicity from being traded on the public market.
However, executing an IPO can be tedious, costly, and time-consuming, and may not serve your actual growth if you cannot afford to spend the effort to get one. Further, the eligibility of your business for an IPO depends on which sector you operate in, your annual revenues and more factors determined by the Internal Revenue Code. 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.
When to Use Equity Financing
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. For your business’s early-life necessities, like finding a location, training staff, purchasing equipment, equity financing may be a great place to turn.
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.
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.
What To Do Before Seeking Equity Funding
Before you start pitching your business to potential investors, consult a business attorney. A lawyer will be able to create contracts for your investors to sign, which will 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.