Table of Contents
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?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
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Beware: Large Dividends Can Get Expensive Real FastIf 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.
Sources of equity financingEquity financing refers to the method of raising capital for a business by selling shares or ownership stakes in the company. It involves attracting investors who are willing to invest their money in exchange for a share of ownership, or equity, in the business. Equity financing can come from various sources, including angel investors, venture capitalists, private equity firms, or even crowdfunding platforms. These investors provide funds with the expectation of a return on their investment through dividends, profit-sharing, or capital appreciation.
Equity Financing vs. Debt Financing: What’s the Difference?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.
Choosing Between Debt and Equity FinancingDebt 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 FinancingIndividual investors, venture capitalists, angel investors, and IPOs are all different forms of equity financing, each with its own characteristics and requirements.
1. Individual Private InvestorsOne 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 CapitalistsA 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 InvestorsAngel 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 OfferingSome 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.
Pros and Cons of Equity Financing
Pro: Low Financial Risk to Business OwnerEquity 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 & ExpertiseAn 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.
Con: Losing Part Ownership in Your CompanyKeep 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 InvestorsJust 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 ProfitsInvestors 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. Call-out/Tip
4 Reasons to Use Equity Financing
1. Funding a StartupA 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 BusinessesAnother 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 DebtUnlike 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 ConnectionsWhile 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 InvestmentThen, 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.
FAQs about Equity Financing
Equity financing works by offering ownership stakes in a business to investors in exchange for capital. Businesses seeking equity financing typically go through a fundraising process, where they pitch their business ideas and growth potential to potential investors.
If the investors are interested, they negotiate and agree upon the terms of the investment, such as the percentage of ownership and the amount of capital to be invested. Once the agreement is reached, the investors contribute the funds to the business, becoming shareholders and sharing in the risks and rewards of the business’s performance.
Examples of equity financing include angel investments, where individuals provide capital in exchange for equity, and venture capital investments, where venture capital firms invest in high-growth potential startups in exchange for equity.
Private equity firms also participate in equity financing by investing in established businesses and helping them grow and improve operations.
No, equity financing is not a loan. Unlike debt financing, where businesses borrow funds that need to be repaid with interest, equity financing involves selling ownership stakes in the business. Investors become shareholders and have a stake in the future success of the business. They share in the profits and losses and may have voting rights and influence over key decisions.
Equity financing does not require repayment like a loan but instead provides investors with the potential for a return on their investment based on the business’s performance.