Equity Financing 101: Understanding the Basics

by QuickBooks

5 min read

With approval rates at their highest since 2008, there’s a sense of reluctant optimism on the mercurial small business loan front. In fact, lending indexes show that big banks approved more than 21.6% of small business loans in January 2015. The bad news, however, is that the rejection rate is still 78.4%.

If you’re an unfortunate member of the majority, odds are you’ll get rejected for a small business loan. And since new businesses need capital to grow, it’s vital to explore alternative funding options to give your small business the best chance at success. For some businesses, the best (and sometimes only) option is equity financing.

What Is Equity Financing?

Defined as the process of raising money in exchange for ownership shares in a business, equity financing is an increasingly popular funding option.

The size and scale of equity investments vary and are dependent on the business’ industry and startup stage. Early-stage businesses might raise a few thousand dollars from family and friends, while more-established businesses could solicit multimillion-dollar investments from venture capital firms.

Equity financing has some distinct advantages compared to typical small business loans. Generally, investments don’t have to be repaid with monthly payments, which makes it a safer funding option than loans and frees up much-needed cash flow for young businesses. Additionally, investors with prior industry experience can serve as advisors that provide invaluable guidance.

On the other hand, finding and pitching investors requires a large investment of time, effort and patience, as you might get rejected several times before the right investor comes along. On top of that, you also run the risk of losing control of your own business if you relinquish too much ownership. To maintain control of your company, be sure to retain at least 51% ownership.

Can’t I Just Apply for a Loan?

Sure, you can. But there are drawbacks.

New businesses have difficulty receiving approval without historical earnings to support their loan application. To parlay this concern, lenders may ask you to personally guarantee a loan, which leaves you on the hook even if your business fails.

Although idealists refuse to admit it, there’s a high failure rate for new businesses, with some studies estimating that a whopping 80% of businesses fail within their first 18 months of operations. If you don’t buck this troubling trend, your personal assets, such as your personal residence and personal bank accounts, can be used to repay a business loan that you’ve personally guaranteed.

Furthermore, the truth is that lenders don’t care about you or your business. Their foremost concern, perhaps rightfully so, is full loan repayment plus interest, and you must repay your loans within a fixed period of time.

If you just opened up shop, or if your sales decline, loan payments will noticeably throttle your limited cash flow, and any cash flow, especially in early stages, should be devoted to keeping your business afloat. If not, astronomical loan payments may be the iceberg that gradually sinks your voyage.

Who Are Equity Investors?

There are a number of different types of equity investors. The type of investor you’ll attract depends on the industry, stage and size of your business. Some investors are strictly interested in early-stage businesses, when the risk is highest but so is the possible return on investment. Other investors might seek more-established businesses with proven track records.

Here’s a quick primer on the different types of investors and when they’ll apply to your business:

  • Friends and family: They’ll often be the first people you turn to early in your business. The investment size is usually minimal, but this capital is essential to getting your business up and running.
  • Angel investors: These are high-net-worth individuals that have experience in your industry. They’ll invest early in your business and can offer valuable advice and guidance.
  • Venture capital: Venture capital is typically a separate fund that invests in businesses with high potential returns. They can invest a substantial amount of money but will demand a large ownership stake.
  • Private equity: This is a separate fund that only invests in proven businesses with substantial earnings. Private-equity firms can also purchase a company outright.
  • Strategic investors: These are individuals or businesses that have a vested interest in the success of your business. For example, a coffee shop might have a bean roaster as a strategic investor.

What About Crowdfunding?

Crowdfunding is when a project or business raises small amounts of capital from a large group of people—usually on the internet.

Typically, people who “donate” don’t receive an ownership interest in the venture but might receive a small reward, such as a sample of the product being funded. In 2013, sites such as Kickstarter and Indiegogo helped the crowdfunding economy grow to over $5.1 billion, and thousands have used the platforms to get their ventures off the ground.

However, crowdfunding isn’t ideal for every business. Instead, it’s meant to test, promote, validate and gather feedback on early-stage ventures and products to determine whether they are worth large-scale investment. If you have a validated idea with some market traction, equity financing might be a better route than crowdfunding.

Furthermore, crowdfunding is primarily used to fund physical products rather than technology or internet-based ventures. The capital raised through crowdfunding is typically utilized to fulfill product orders, not to hire and grow operations, which is better suited for equity financing.

Additionally, crowdfunding is customer-centric, whereas equity financing is investor-centric. If you’re seeking market validation for an early-stage physical product, crowdfunding might be your best option. If you want to grow operations by selling an ownership stake to investors, look into equity financing.

How Complicated Is the Process?

Landing equity investors can require a lot of time and money. Between preparing the necessary documents and presentations, finding and vetting interested parties, and pitching and onboarding investors, the process can take as little as a few months to as long as a couple years.

Additionally, selling equity in your business will involve securities law. As such, you’ll need to consult a corporate securities lawyer in order to make sure your offering is SEC compliant. As an alternative, there are new equity-funding platforms, such as FlashFunders and AngelList, that connect businesses with lawyers, expand the reach of your offering and, in general, facilitate and expedite the process.

Consider Your Options

Equity financing isn’t ideal for every business. Loans might be the preferred funding route for traditional industries, whereas high-growth tech businesses might be better suited for equity financing. Conduct due diligence for each option to determine the best funding route for your business.

To learn more about the process of finding, pitching and landing equity investors, see our free e-book, The Complete Guide to Equity Financing.

The Complete Guide to Equity Financing

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