December 26, 2019 Equity en_US Before you seek investors, learn how they might impact your business. Here's a look at the pros and cons of equity financing and other financing options. Breaking the bank: What is equity financing and how does it work?

Breaking the bank: What is equity financing and how does it work?

By John Shieldsmith December 26, 2019

Since most new businesses need capital to grow, it’s vital to explore all funding options so you can make an informed decision for your business. For some business owners, a sound option may be equity financing.

If you’re a startup or business in need of some quick funding for immediate growth, equity financing can help you in a big way. So, let’s see how it works, where you can find it, and how it differs from crowdfunding and other financing models.

What is equity financing?

Equity financing is the process of raising money in exchange for ownership shares in a business.

The size and scale of equity investments vary and are usually dependent on the industry your business is part of and its startup stage. Early-stage businesses might raise some money from family and friends, while established businesses could solicit multi million-dollar investments from venture capital firms.

In any case, equity financing is typically used as a short-term method for raising capital. Many businesses lack the working capital to get their company off the ground or to launch a new product, making equity financing the best option for them.

Equity financing has multiple components that may be advantageous compared to other financing options for small businesses or startups. Generally, investments don’t have to be repaid with monthly payments and aren’t due until your business is profitable. This can free up much-needed cash flow for young businesses. Additionally, investors with prior industry experience can serve as advisors and may contribute invaluable guidance.

On the other hand, finding and pitching investors can take a large investment of time, effort, and patience, as you might need to make several presentations before an investor match is found. You’ll also need to determine how much of your business you want to offer to equity partners. To maintain control of your company, a good rule of thumb is to ensure you retain at least 51% ownership.

Types of equity financing

There are a number of different types of equity investors. The type of investor you’ll attract usually 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 some of the different types of investors:

  • Friends and family: Often the first people small business entrepreneurs turn to, friends and family make investments that are usually minimal but may be essential to getting your business up and running. Even better, friends and family generally aren’t as worried about their rate of return on the investment.
  • Angel investors: An angel investor is a high-net-worth individual who usually has experience in your industry. They’ll invest early in your business and may offer valuable advice and guidance.
  • Venture capital: Venture capital is typically a separate fund that invests in businesses with high potential returns. Venture capitalists can invest a substantial amount of money but usually require a large ownership stake in exchange. Venture capitalists operate differently from angel investors, so make sure you know how to pitch a venture capitalist before approaching one.
  • Private equity: This is a separate fund that invests in proven businesses. 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.
  • Institutional investors: An institutional investor is a blanket term for any kind of organization or group that pools money from various people or sources to invest or purchase.

No single equity financing source is perfect. Each one has their strengths and weaknesses. Owing Mom a few million dollars can be awkward, while owing money to an institution can leave you panicked. Think about each source carefully before moving forward with your financing plan.

How complicated is the equity financing process?

Landing equity investors can require a significant investment of time and money. Between preparing the necessary documents and presentations, finding and vetting interested parties, and pitching and onboarding investors, the process can be time consuming.

In total, finding an investor can take as little as a few months to as long as a couple years. Factor in companies that go through multiple rounds of equity financing, and you’re easily looking at years, not months. And there are legal considerations you need to take into account.

Securities laws

Selling equity in your business involves securities laws. Whenever you receive an investment, this is legally known as a security. Security laws exist to regulate the entire process of selling equity or a stake in a company.

If and when you get to a point where you’re selling security in your company, you’ll need to be concerned with the following types of security laws:

  • Litigation: In the event of any dispute surrounding equity, a litigation suit will be brought forth. Both parties will need to make their case and lay out what happened.
  • Transactional law: This is a type of business law that involves a lawyer who brokers or oversees the deal between the two parties, the buyer and the seller.
  • Regulatory: There are a number of state and federal regulatory laws that can come into play when selling equity in a business. This process covers those laws, ensuring both parties are playing by the rules that apply to their product or industry.

All of the above cases necessitate a lawyer who specialises in securities, meaning you’ll need to consult a corporate securities lawyer in order to make sure your offering is SEC compliant. Before you rush off and start selling portions of your business, make sure you’re playing by the rules and contact a legal consultant first.

What is crowdfunding?

Crowdfunding is when a project or business raises small amounts of capital that can add up to a big amount from a large group of people — usually online.

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 or an early release of the product when it’s finished. Well-known crowdfunding sites include Kickstarter and GoFundMe, among others.

Crowdfunding is usually used 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 for your business than crowdfunding.

But 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 a good option. If you want to grow operations by selling an ownership stake to investors, you may want to consider equity financing.

Debt financing vs. equity financing

Debt financing is what most think of when they think of traditional financing. Personal loans, mortgages, and student loans are all forms of debt financing for personal use.

With debt financing for businesses, you’re agreeing to borrow a set amount of money with an interest rate attached. So unlike equity financing, you will have to pay back your lender regardless of your business’s success.

These loans often involve a personal guarantee, meaning you guarantee you’ll pay the loan back in the event the business and collateral don’t cover the debt. This puts more of the risk on you, as you could wind up owing money if you have a business that folds, and you could even lose your home or personal belongings.

The big perk of debt financing is that you are still in complete control of your company and aren’t handing over any ownership to another party. Publicly-traded companies often have to answer to those who own many shares of the company, so there’s definitely something to be said for maintaining ownership.

Another perk to debt financing is that the interest you pay can be deducted from your taxes in many cases. This can lower the amount you owe on your taxes, and in some cases, put you in a lower tax bracket.

Interest rates still aren’t something to take lightly. Speak with a financial advisor before agreeing to any debt financing.

Before pursuing equity financing

Equity financing isn’t ideal for every business. Consider your options and speak to a business advisor before doing something as drastic as equity financing. Friends and family can be great channels to ask first, but also keep in mind how awkward Thanksgiving dinner could be if your business falls through after they invest.

There’s almost always money available to finance your business, you just have to look for it. You’ve already taken the first steps toward growing your business by researching your financing options. You can find the right investment path for you and take your business even further.

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