Equity financing is a way to raise money to fund the growth or operations of a company, especially a startup business. Investors who provide equity capital will be looking to finance companies that have high growth potential in the long term. Businesses can raise a significant amount of money through equity financing, and unlike debt financing, there will be no obligation for repayment.
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What is equity financing?
Equity financing is the process of selling shares of your company in order to raise funds.
Your company gives ownership away in exchange for cash. Capital can be raised through a variety of different sources including family and friends, angel investors, venture capital, and an initial public offering (IPO). Equity financing does not have to be paid back, though investors will likely expect a high rate of return.
How does equity financing work?
Equity financing involves selling part ownership of your business, and typically this involves the sale of common stock. If a business owner decides to sell 100 shares out of a total 1,000 shares of his company, that would mean selling 10% ownership of the company. The investor(s) that provide the capital in return for those 100 shares will now own 10% of the company.
There is no obligation to repay the equity funding as there would be with the other major type of financing, debt financing (e.g., a small business loan). However, investors will likely expect a high rate of return. Moving forward, the original owner may need to consult with investors on any significant company decisions and share in future profits.
Sources of Equity Financing
There are many sources of equity financing that each has its advantages or disadvantages. Some will be easier to obtain funding from while others may require more scrutiny of your company’s financials, business model, and team.
Friends and Family
Individual private investors such as family, friends, and colleagues may be one of the more accessible sources of capital for business owners as they are leveraging existing relationships. These types of investors usually don’t have as much money as angel investors, venture capitalists, or institutional investors so it may be necessary to find more donors.
Angel investors are high net worth individuals or groups of individuals who can provide significant financing for a startup or small business. They typically have $1 million or more in assets and an “accredited investor” status with the U.S. Securities and Exchange Committee (SEC).
Angel investors take on a lot of risk to provide capital to startups in the early stages. Their investments focus on helping the founders of startups get off the ground rather than the tangible future profits of the company.
Angel investors usually have a strong understanding of the industries they invest in. They get involved with the business they invest in and can provide guidance and resources to the company.
Venture capital is a type of equity financing that’s aimed at emerging companies with high growth potential. Venture capital could be supplied by an individual or a firm that pools the funds of many professional investors. Investors in venture capital funds are typically large institutions such as pensions and financial firms.
Venture capital funding can typically invest a larger amount than what an individual private investor or angel investor can offer. They can also provide significant resources and guidance for the growth and day-to-day operations of the business.
Since venture capital often provides large amounts of funding to emerging companies, they will exert more control over the decisions of the companies and may want a seat on the board.
Initial Public Offering
A private company makes an “initial public offering” when it decides to “go public” by listing its shares on a stock exchange such as the New York Stock Exchange. Having an IPO is a way to raise a significant amount of money from the public.
However, there are many regulations that govern whether the company is eligible to be listed on a publicly-traded market, and the process of filing for an IPO is labor-intensive, requiring many financial disclosures to the SEC.
Equity crowdfunding sells ownership of the company to the public in small amounts, typically through crowdfunding websites or social media. Rather than more conventional crowdfunding in which the benefits might be perks or products, investors gain shares of the company and potentially a promise of future returns.
Advantages of Equity Financing
Equity financing has many benefits and drawbacks, and it’s useful to compare it to debt financing or bootstrapping. Depending on your own business and its particular needs, you may find that equity financing is the best option for you. Here are the advantages:
- No repayment. Equity financing has no obligation for repayment.
- Lower risk. It’s lower risk for the company owner because it’s not a debt. If the company fails, then that is the risk that investors took on for themselves.
- No monthly payments. You can obtain money for your business without the responsibility of monthly payments as you would with a loan.
- Easier to secure funding. It may be easier to secure equity funding, particularly for newer businesses that don’t have an established track record for revenue.
- Large amounts of funding. Access to potentially large amounts of capital for the growth of the company.
- Guidance and resources. Emerging companies get access to the mentorship and resources of seasoned investors in the case of angel investments and venture capital.
Disadvantages of Equity Financing
- Sharing ownership. Founders will have to share ownership with investors.
- Sharing profits. Founders may need to share future profits with investors.
- Loss of control to investors. Venture capitalists and angel investors will want some decision-making power in the company to protect their investment and help the company grow more profitable.
- Potential for conflict. Investors and company managers could have different ideas about how to run the business, leading to conflict and tension.
- Cost of regaining ownership. You can buy out investors later to regain ownership of the company, but it will usually cost more than the original amount you raised from them.
Debt Financing vs. Equity Financing
Debt financing is the process of securing funds from a lender that must be paid back with interest over time. Debt financing can be:
Debt financing typically requires an application process, in which business owners will submit credit scores, financial statements, and put up some type of collateral. Unlike equity financing, in which business owners are vetted by investors through a variety of means, debt financing applications are a fairly standardized process coordinated by banks, lenders, and credit reporting agencies.
With debt financing, company owners do not give up any ownership. There’s no loss of control to the investors, sharing decision-making powers, or sharing profits. The relationship between the lender and the company ends once the debt is repaid.
Debt financing can be easier to plan for because the obligations for repayment are defined and can remain predictable over time. However, since the repayment is usually made on a regular schedule, the company would still have obligations to make payments even if the business is struggling with cash flow or a downturn for a period of time. Equity financing doesn’t have the same obligations since equity does not have to be repaid, which makes it easier to be flexible.
Debt financing is often appropriate for small businesses in traditional industries with some track record of profitability and expectations of enough revenue to repay the loans. Equity financing is often sought out by startups that have high growth goals—their business models and teams will be scrutinized by angel investors and venture capitalists who are seeking a high return for their investment over a period of a few years.
Equity financing is one of the major ways that companies can raise money. It’s the selling of shares to investors in return for funding. From individual private investors to venture capital and initial public offerings, equity financing can take many forms. Though the funds do not have to be repaid, there are drawbacks to equity financing: expectations from investors for returns within a few years, loss of control and autonomy in decision-making, and sharing of profits with investors who now own part of the company. Companies typically use a mixture of equity financing and debt financing to fund their growth and operations.