When you’re starting a business, you generally have two options for startup financing. First, you can explore your various debt-based options, such as small business loans, lines of credit, etc. Second, you can look into equity financing—which is completely different.
What is equity in finance? How does it work? Is it right the solution for your business funding needs?
In our comprehensive guide to equity financing, we’ll walk you through everything you need to know to answer those questions—and more.
What Is Equity Financing?
Equity financing is a method of raising funds in which business owners sell shares (i.e. equity) of their company to investors in exchange for capital. In this way, equity financing is completely distinct from debt financing, in which you borrow money from a lender that’s paid back over time, with interest, while maintaining complete ownership of your business.
Equity financing is a particularly common funding method among startups, as well as businesses looking to fund growth or expansion.
How Does Equity Financing Work?
With this equity financing definition in mind, let’s explain a little more about how this type of business financing works.
Once again, equity financing involves securing capital by selling a certain number of shares in your business.
Each share sold (usually in the form of common stock) represents a single unit of ownership of the company. For instance, if the company issues 2,000 shares of common stock and you, the business owner, have 1,000 shares, you own 50% of the business.
Any investors offering capital for your startup will do so in exchange for units of ownership in your business—meaning the rest of the 50% is distributed among your investors. The amount of ownership, or “equity,” the investors give your business usually correlates with how much capital they invested in your business.
When an investor invests in your business (and gets issued a portion of the business’s shares), they become a shareholder of the business.
Benefits for Investors
As a business owner, working with an investor gives you the capital you need to start or grow your company. You might be wondering, however, what are the advantages of equity financing for investors? In short, investors who participate in global equity finance deals gain:
- Dividends: By investing in your business, the investor gets a percentage of ownership—or equity—in the company via their ownership of the business’s shares. As a shareholder of the business, the investor will benefit from dividends from those shares. They may also reap a profit from the sale of those shares down the road. Since investing in any small business is risky, equity financiers want a high rate of return on their investment.
- Voting rights: They also get voting rights in your business. When you hold board meetings to make important decisions for your business, those shareholders (or their representatives) will be there and have a voice in the decisions. Not every shareholder gets the same voting rights in the business—the level of voting rights varies based on the kind of equity shares the investor is issued. Here are the different types of stock you might issue to investors:
- Common stock: If an investor has common stock, they have a claim on the business’s earnings (or dividends) and have voting rights. A company can also issue different classes of common stock to shareholders. For instance, shareholders with A-class shares might have voting rights and dividends, but those with B-class shares have no voting rights and no dividend.
- Preferred stock: Preferred shares, on the other hand, have dividends but no voting rights. Preferred shareholders have a higher claim on the business’s assets than regular shareholders with common stock. This means that, in the event of liquidation, preferred shareholders are paid off before other shareholders
When it comes down to it, you’re able to customize the kind of stock you issue based on your investors.
Sources of Equity Financing
If you’re considering equity financing as a source of funding for your business, it’s important to understand the different types of equity financing. Generally, the different types of equity financing are distinguished based on the source—in other words, where the financing comes from.
Overall, the external sources of equity financing can be broken down into three categories:
Angel investors are wealthy individuals who swoop in to fund early-stage, promising businesses. These individuals invest their personal funds in businesses in exchange for equity in those companies. You might turn to family, friends, entrepreneurs, or retired venture capitalists to find angel investors.
In addition, angel investors (sometimes called private investors, seed investors, or business angels) usually focus on helping a company takes its first steps. They can disburse capital all at once, or they can distribute funds little by little as your business grows.
Essentially, an angel investor is a wealthy individual (or a group of them) who believe in you and your idea. They’re willing to put time, effort, and money behind you. They’re also betting that they’ll make outsized returns on their investment in your startup.
This being said, although financial incentives can be a motivating factor for angel investors, some also fund businesses to take part in another form of entrepreneurship (after having success with their own businesses) or for the opportunity to mentor a new business owner.
Venture Capital Firms
Next, venture capital firms are another common source of equity financing.
Venture capital firms are similar to angel investors, just multiplied. Instead of one angel investor working with your business, you’ll have an entire company dedicated to swapping equity for capital.
Overall, venture capital firms typically invest the firm’s funds into high-potential, early-stage businesses—and typically, venture capital is a more competitive form of small business funding.
As a startup owner trying to raise capital from a venture capital firm, you’ll usually decide how much money you’re looking for and how much equity you’re okay with giving away, and then you’ll shop around. Venture capital is then usually distributed in “rounds”—Series A, Series B, or Series C. The series correlate with the growth of your company. You move from a seed round, through Series A, B, and C, to finally an IPO in some cases.
Each round you raise of venture capital is a new exchange of equity in exchange for the VC firm’s funding.
On the whole, when you work with an angel investor, it’s very likely you found the investor in a pre-existing entrepreneurial network, through a close colleague or friend, or through a general angel investing network. To this point, whereas there’s almost an unlimited number of angel investors you might work with, your venture capital firm options are limited to about 200 venture capital firms that are actually fundraising at any given time.
Consult our comprehensive guide to learn more about the differences between angel investors vs. venture capitalists.
Finally, crowdfunding is a more creative form of equity financing.
With crowdfunding, you pitch your business idea on crowdfunding platforms like Kickstarter or IndieGoGo. Visitors on the site then invest small amounts of money into your business idea to help you reach your funding goal. In exchange, you might give those “investors” early access to your product, discounts, or simply a personalized thank you note.
In a way, the people who invest amounts in your business are like angel investors—just at a much, much smaller scale. Whereas an angel investor could invest up to $500,000 or more in your business, a user on a crowdfunding site might pitch in $25.
Therefore, crowdfunding is often used to reach smaller funding goals, or in conjunction with other types of financing.
Equity Financing: Pros and Cons
Now that you have an understanding of how equity financing works, you might be wondering: How do I know if this type of financing is right for my business?
What are the advantages of equity financing? The disadvantages?
Here are the pros and cons you’ll want to keep in mind as you evaluate whether equity financing can meet your funding needs.
Pros of Equity Financing
- No “repayment” necessary: Compared to debt financing, in which you repay the lender you work with (plus interest) on a daily, weekly, or monthly schedule, equipment financing doesn’t come with any repayment stipulation. Because you’ve offered equity in your business, the equity investor is repaid by the prospect of gaining future profits the business brings in. Repaying financing isn’t necessarily a bad thing. The lack of repayment requirement, however, may benefit startup owners who are trying to hold onto capital in the beginning.
- You’ll receive valuable business advice: It’s very likely that your angel investor or venture capital firm has either started their own businesses or have invested in a few successful ventures before. Therefore, by opting for equity financing, you’ll be able to receive advice, mentorship, connections, and more from your investors to help you as you start and grow your business. In addition, as an equity shareholder in your business, your investors might have voting power in your business. This means that they can impart their wisdom during the tough decisions to help guide you in the right direction.
- Access to large amounts of funding: One advantage of going the equity-financing route is that investors typically invest large amounts of money in businesses they work with. Again, angel investors typically invest less than venture capital firms—but it’s still quite a large amount of money for startup funding. This can be a major benefit for businesses that need to hire different teams and invest in their product to be successful.
Cons of Equity Financing
- You’ll lose a portion of your ownership: One of the biggest disadvantages of equity financing is the prospect of losing total ownership of your business. Every time you bring on a new angel investor or distribute shares to a venture capital firm, the ownership of your business gets more and more diluted. This means that any future profits of your business aren’t totally yours anymore.
- Investors will have some control of your business: Similarly, you might find that you and your equity financing partner don’t see eye-to-eye when it comes to the direction of your business. By giving investors decision-making power, you run the risk of losing control of your business. For this reason, it’s important to evaluate a potential investor—in terms of their past business experience, management style, etc.—before agreeing to enter into an equity finance relationship with them.
- Difficult to obtain for most small businesses: Unfortunately, because angel investors and venture capitalists are investing so much capital, they’ll only want to work with the highest-potential startups. And with the high failure rate of small businesses (50% of all small businesses fail in their first five years of business), investing in a small business might not be the safest bet for investors. In general, angel investors and venture capital firms are more likely to invest in high-growth businesses (like technology-based businesses) than they are in “Main Street” small businesses.
The Bottom Line
At the end of the day, although equity financing can be a smart move for startup or growth financing, it won’t be right for every business.
Therefore, before you decide to pursue this funding route, you’ll want to thoroughly compare debt vs. equity financing in order to determine what will be a better fit for your business.
If you do determine that equity financing is best for you, you’ll want to ensure that you understand exactly the agreement you’re making before working with any investor. You’ll want to consider the length of the relationship, the amount of equity you’re giving away, the types of shares you’re giving, and what voting rights the investor would have.
Ultimately, because equity financing can involve complex negotiations, you’ll likely want to work with a business attorney to help you through the process.