Equity Financing

What Is Equity Financing?

Why Equity Financing Is a Smart Option for Small Businesses and Startups

How Does Equity Financing Work

While the principles of equity financing can be acquired by watching a few episodes of Shark Tank, obtaining fair and mutually beneficial equity financing can be difficult, especially if you are a young entrepreneur with no expertise with company fundraising.

In its most basic form, equity financing is a mutual agreement with an investor or investors to provide a specific amount of cash in exchange for a specific number of shares, resulting in percentage ownership.

A higher investment yields a larger interest in your firm, and some investors may be attempting to gain control of your company, which would entail owning 50% or more of it. Therefore, if you want to ensure that you have decision-making power, make sure that you hold at least 50% of your company.

If you’re a startup with a high-risk profile, you can be offered an equity financing package that includes various types of equity financing, such as:

• Preferred shares
• Convertible preferred stock

While these sorts of stock are popular among venture capitalists looking for the highest potential return on their investment, consult a lawyer before signing any agreements to ensure you aren’t setting yourself up for long-term troubles.

Beware: Large Dividends Can Get Expensive Real Fast

While a higher dividend for an investor may not seem like a big deal in the early stages when you’re struggling to meet your company’s needs, it can eat into your long-term profit.

Going public with an Initial Public Offering (IPO) can be very profitable for your company if it is profitable and structured right. You will, however, need to incorporate your company and meet the requirements of one of the major stock exchanges. This is not a viable option for the vast majority of small firms, but if you are rapidly expanding into a larger organization, it may be your best alternative.

As you can see, equity financing is more sophisticated than simply selling a piece of your company for cash. You’re taking on the long-term obligation of someone who has a stake and a say in your business.

Equity Financing vs. Debt Financing: What’s the Difference?

Equity and debt financing are frequently compared because they are the two most prevalent ways to generate capital for a firm. Debt finance is the commitment to pay future interest on upfront capital, whereas equity financing is the exchange of shares for upfront capital (aka debt).

These two funding alternatives have the same basic premise: the lender or investor assumes the upfront risk by lending you money that you don’t have, and you repay the risk as your firm grows. On the other hand, the repayment is a significant difference between equity and debt financing.

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 they still have a way to recoup their money if you default on the loan.
• 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 owe an investor a lot more if you want to buy them out and regain ownership of your company.

If your firm succeeds, you’ll owe an investor a lot more money if you wish to buy them out and retake control of your company.

Consider the following scenario: you require $50,000 to place a large buy order and ramp up production. You may expect to pay around $8,000 in interest if you take out a business loan with a 10% interest rate and pay it off over three years.

Consider this scenario: your company is worth $1 million, and an investor offers you $50,000 in exchange for a 5% ownership. Then, three years later, if your company grew to be worth $5 million, you’d owe that investor $250,000 to buy out their shares. Debt financing is a far better offer in this situation from a purely financial sense.

Choosing Between Debt and Equity Financing

While both equity and debt financing have merits, your choice may come down to available options.

Young enterprises generally may not qualify for debt funding because they lack a good credit rating and a record of fulfilling expenses. But, at the end of the day, both equity and debt financing may help you grow your business—and as long as you consider your company’s potential, you’ll know you’ve made the proper decision.

Types of Equity Financing

While the fundamentals of equity financing usually revolve around exchanging money for ownership, there are various types of equity financing that each have their own set of benefits for investors and owners.

Individual investors, venture capitalists, angel investors, and initial public offerings (IPOs) are all diverse types of equity financing with their own set of characteristics and needs.

1. Individual Private Investor

Reaching out to individual investors is one technique to raise funds for a firm. This can include people like your friends, family, and coworkers. Because they are dealing with people with whom they have a prior relationship and are more likely to be interested in seeing the firm thrive, some business owners believe this is the easiest sort of equity financing.

On the other hand, individual investment will almost certainly necessitate a large number of individual donors to have a significant impact. Individual contributors are less likely to have money to invest in your company than venture capitalists or angel investors, and they may also have fewer resources to give in terms of advice and connections.

2. Venture Capitalists

An individual venture capitalist or a larger venture capital firm can be a venture capitalist. Unlike individual private investors, Venture capitalists often have larger sums of money to invest in a company. Venture capitalists are generally looking for businesses with extraordinarily high growth potential, whether an individual or a firm.

Because venture capitalists can invest larger sums of money, they will most likely want a larger share of ownership in the firm in the future. They may exert significant influence over your company’s growth to safeguard their investment.

Venture capitalists can invest a lot of money in your company while also expanding your network. However, to safeguard their investment, you may find yourself at their mercy regarding how you run your business or how aggressive your expansion ambitions are.

3. Angel Investors

Angel investors might operate alone or as part of a larger group. These are investors who have the financial means to invest a significant sum of money in a business and who prefer to invest in industries in which they are knowledgeable and have worked.

The term “angel investor” refers to someone who can make a significant financial commitment in your company while also providing invaluable advice.

Angel investors are typically interested in getting engaged with enterprises in their early stages and watching them flourish.

Angel investors are more likely to get involved in the planning and execution of your growing business than venture capitalists are. Venture capitalists may help your business with large-scale profiling and networking, but angel investors are more likely to get involved in the planning and execution of your growing business.

4. Public Offering

Some businesses that want to raise money from the public in the form of equity financing may launch an Initial Public Offering (IPO) and sell their stock to the general public. This can be a successful approach for a company to raise the financing it needs to expand, with the extra benefit of increased visibility from being listed on a public exchange.

Some downsides of executing an IPO are:

1. They can be tedious, costly, and time-consuming.
2. They may not serve your actual growth if you cannot afford to spend the effort to get one. Your business’s eligibility for an IPO depends on which sector you operate in.
3. Your annual revenues will play a big role in eligibility (bad for businesses with irregular cash flow).
4. The Internal Revenue Code may lay out its own set of requirements for your business.

However, suppose your company is successful in obtaining an IPO. In that case, you may profit from upfront financial commitments made by smaller-dollar investors who expect to have far less control than angel or venture capitalists.

Pros and Cons of Equity Financing

While stock funding may be the only method to expand your firm without taking on debt, all financing choices have advantages and cons. Equity financing may not be the best option for you, depending on your company’s profile and ambitions.

Pro: Low Financial Risk to Business Owner

Equity financing can be a terrific, low-risk way to get money for your startup company. Investors in your business agree to take on the risks of running it because they swap a percentage of ownership for invested funds.

As a result, investors accept the risk of losing or making money on your project, allowing you to receive their funds without getting into debt. In summary, because investors only gain if your business succeeds, equity financing offers lower-risk finance without the weight of debt.

Pro: Investor Connections & Expertise

The opportunity to link your business with bright and experienced individuals with a background in your sector is an equally significant aspect of equity financing. When a successful restaurateur invests in your new restaurant, you get their money and crucial advice and direction based on their own experiences building businesses.

They are more likely than a lender seeking payback to support you in growing your business because they now possess a part in it.

Con: Losing Part Ownership in Your Company

Because seeking equity funding entails relinquishing some influence over your company, you should be very judicious about who you accept money from. When your firm runs into problems or you have differences in the company’s direction, it can put a strain on your investor relationships.

If you plan on asking close friends or family to invest in your firm, keep this in mind, and make sure you fully trust your potential partners before signing a deal with a seasoned investor.

Con: Pitching Potential Investors

Just because equity financing does not require lengthy, formal applications do not imply that it is quick, simple, or inexpensive. You’ll need to devote a significant effort to creating a solid business plan to show to potential investors.

In fact, finding investors, preparing your presentation, and pitching your firm could take up even more time than obtaining a traditional business loan.

Con: Investors Share Profits

Investors will only invest in your company if they are confident that they will be able to profit from it, ideally a large profit. If you acquire a large sum of money, it will almost always come at a high price over time.

It’s worth noting that investors can help you raise your company’s value.

4 Reasons to Use Equity Financing

1. Funding a Startup

When you’re looking for initial funding for your business, it’s an excellent (and typical) moment to look for equity financing. Angel investors looking for enterprises that can provide a high return on investment are drawn to business ideas that have yet to take off.

Due to its relative availability and potential significant influence on your finances, equity financing is a fantastic alternative for any short-term financing needs that may develop before your organization is completely established.

Equity finance could be a good option for your startup’s early-stage needs, such as:

• Finding a location
• Training staff
• Purchasing equipment

2. Financing Risky Businesses

Another typical use of equity financing is to fund enterprises that banks or traditional lenders would otherwise turn down. Many lenders are hesitant to take a chance on a new concept or an inexperienced proprietor.

On the other hand, equity investors may enable you to raise funds from individuals or groups ready to collaborate with your team to achieve long-term success.

3. Managing Debt

The Benefits and Drawbacks of Equity Financing

Even if you’ve been in business for a while, equity financing can be beneficial, especially when managing your business debt.

Unlike other types of business financing, equity funding is not included in your company’s debt and is repaid in a unique way.

Rather than incurring new debt to obtain emergency cash, equity financing allows you to keep your current balance sheets while adding resources to your organization. In addition, because investors share the risk in equity financing, your debt remains steady and becomes a shared responsibility for your board of directors to resolve.

4. Building Valuable Connections

While other startup funding options such as maxing out your credit card, draining your personal funds, or selling future products through crowdfunding may provide you with the funds you require, only equity financing can connect you with a business expert who can truly serve as an advisor to your growing company.

Angel investors and venture capitalists not only have a lot of expertise in creating startups, but they also have a financial stake in your company’s success. So if your firm requires money as well as advice, this might be a win-win situation for everyone.

What To Do Before Seeking an Equity Investment

Before you begin pitching your company to potential investors, be sure you’ve explored all of your funding choices and determined that equity investment is the best option for your company.

Then, visit a business attorney, who can draft documents for your investors to sign, ensuring that everyone is protected. They can also discuss non-voting shares and convertible notes as choices for limiting an investor’s power level in your company.

Before you bring on new investors, make sure you have a clear set of regulations in place for their contributions and positions in your firm.

What To Do Before Seeking an Equity Investment

Before you begin pitching your company to potential investors, be sure you’ve explored all of your funding choices and determined that equity investment is the best option for your company.

Then, visit a business attorney, who can draft documents for your investors to sign, ensuring that everyone is protected. They can also discuss non-voting shares and convertible notes as choices for limiting an investor’s power level in your company.

Before you bring on new investors, make sure you have a clear set of regulations for their contributions and positions in your firm.