Starting a business can be expensive—there’s no doubt about it.
And while some entrepreneurs are lucky enough to cover different startup costs with their personal savings, not all new small business owners can afford to do so—or want to do so, for that matter.
When funding your startup on your own dime isn’t in question, you have two general options available: debt financing and equity financing.
Whereas debt financing is, generally speaking, the process of taking on a business loan from a lender to finance your company (and paying that loan back, plus interest), equity financing is a totally different ballgame.
If you don’t know the best way to finance your business, we’re here to help you make this all-important choice. Here’s everything you need to know about using equity financing to grow your startup.
If you’re new to the world of entrepreneurship and small business ownership, then the term “equity financing” might not mean anything to you.
Well, for small business newcomers, here are the absolute basics:
Equity financing is, of course, a way to secure capital for your business. It’s a common way for businesses to raise capital by selling a certain amount of shares in the business during the early stages.
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.
When you take on a new investor for your business, you’ll get the capital to grow your company.
But let’s look at the deal on the investor’s end.
By investing in your business, the investor gets a chunk of ownership—or equity—in the company via their ownership of the business’s shares. That, we’ve covered.
As a shareholder of the business, the investor will benefit from dividends from those shares and (hopefully) the sale of those shares at a profit down the road. Because investing in any small business is risky, equity financiers want a high rate of return on their investment. (We’ll get more into that in a bit.)
They also get voting rights in your business. So 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. (Again, we’ll dig into this in a moment.)
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.
In general, the two types of stock are common stock and preferred stock.
When people talk about stock, they’re usually referring to common stock. Investors with common stock 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 B class shares have no voting rights and no dividend.
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.
Speaking of, who are these investors, anyway?
When we talk about “investors,” we could be talking about either angel investors or venture capital firms.
Here’s what you need to know about each type of equity investor.
Angel investors are wealthy individuals who swoop in to fund early-stage, promising businesses
They can be family, friends, entrepreneurs, or retired venture capitalists, who invest their personal funds in businesses in exchange for equity in those companies.
Angel investors (sometimes called private investors, seed investors, or business angels) are usually focused 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 wealthy individuals) who believe in you and your idea such that they’re willing to put time, effort, and money behind you. They’re putting a bet that they’ll make outsized returns on their investment in your startup.
As a small business owner, your startup is your baby. You care deeply in your business. But why do angel investors care?
Here’s what generally motivates angel investors to invest in your business:
As we mentioned before, an angel investor can really be anyone.
Anyone who has the time, money, and willingness to fund an early-stage business could be one of your angel investors—which means there isn’t really one place you go to find one.
But many small businesses and startups find angel investors through entrepreneurial networks, financial advisors, angel investing networks (groups that aggregate angel investors who invest in similar business models), sites like AngelList, and so on.
Or an angel investor could be a trusted family or friend who believes in you!
Before we get into the second type of common equity financing source—venture capital firms—let’s cover crowdfunding.
Some small businesses raise capital on crowdfunding sites like Kickstarter or IndieGoGo.
With crowdfunding, you pitch your business idea on crowdfunding platforms. Visitors on the site then invest very 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.)
The next equity financier you might come across while you’re raising capital for your business is a venture capital firm.
Venture capital firms are like angel investors, just multiplied.
Instead of just one angel investor working with your business, you’ll have an entire company dedicated to swapping equity for capital.
Venture capital firms typically invest the firm’s funds into high-potential, early-stage businesses. And generally, 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 your growth of your company. You move from a seed round, through series A, B, and C, to finally an IPO in some cases (or offer stocks to the general public in an initial public offering).
Each round you raise of venture capital is a new exchange of equity in exchange for the VC firm’s funding.
While venture capitalists and angel investors essentially serve the same function for small businesses, a few qualities make the two different.
When you take all those differences between the two types of equity financing into account, they all really come down to one thing:
While angel investors invest because they want to turn an idea into a business, venture capital firms invest because they want to turn a startup into a giant.
When you work with an angel investor, odds are you found the investor in a pre-existing entrepreneurial network, through a close colleague or friend, or through a general angel investing network.
And while there’s almost an unlimited number of angel investors you could work with, there are actually only about 200 venture capital firms in the world—and not all of them are firms you want to work with.
Again, your relationship with venture capitalists starts when you’re ready to raise money through rounds, and you’ll only meet with venture capitalists when you’re in the process of raising capital.
If you’re looking for venture capital firms to work with, a good place to start your process is at the National Venture Capital Association—you’ll at least get a sense of the big venture capital players in your industry.
Now that you have the general gist of how equity financing works and the major players, let’s get to the heart of the matter.
Why is using equity financing a good idea? And what are some of the reasons why you’d steer clear of equity financing?
Here are the pros and cons you need to weigh before you get into an equity financing agreement.
If you choose the debt financing route and grow your business with a loan, you’ll have to repay the lender you work with (including interest on top).
Depending on the type of loan you take on, you start repaying the lender with set loan repayments. For short-term loans, this could be daily or weekly payments, and with medium-term loans, this might be monthly payments.
Equity financing, on the other hand, 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.
While repaying financing isn’t necessarily a bad thing, the lack of repayment requirement might be a benefit for startup owners who are trying to hold onto their capital in the beginning.
One of the biggest downsides of equity financing is the prospect of losing more and more ownership in your own 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.
Odds are, your angel investor or venture capital firm has been around the block a few times. They’ve either started their own businesses or have invested in a few successful ventures before.
As an equity shareholder in your business, they might have voting power in your business. This means that they can impart their business wisdom during the tough decisions to help guide you in the right direction.
And in the best cases, you might have found a lifelong business partner and advisor through equity financing. This means valuable business wisdom, connections, and experience to help your business grow as quickly and successfully as possible.
On the other side of things, 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 losing ownership in your business and giving investors decision-making power, you run the risk of losing control of your business.
To avoid a disagreement between you and your investor, be sure that you’re working with a compatible investor before you agree to equity financing.
Take a look at what they’ve done with past businesses, and try to get a sense of their management style. This will hopefully be a long-term relationship, so you want to make sure you and your investor have similar goals and working styles.
When you pursue debt financing, on the other hand, your relationship with your lender is fully over once you’ve paid the loan off. There’s no obligation of management, ownership, or decision-making with a lender relationship.
One benefit 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.
This can be a major benefit for businesses that need to hire different teams and invest in their product to be successful.
Because angel investors and venture capitalists are putting so much money in, they’ll only want to work with the highest-potential startups.
And with the high failure rate of small businesses (50% of all small business 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.
Equity financing can be a smart move for many different businesses. But the decision to do so is one that shouldn’t be taken lightly.
Before you decide to pursue equity financing, make sure you know the ins and outs of the agreement you’re making with the investor. This includes considering 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. Because this can be a complicated negotiation, drafting up an equity financing agreement might be the time to get advice from a lawyer.
You should also consider whether you really want to have other owners in the business. Do you really need the advice and counsel of investors?
It may be that you just need capital to buy inventory, finance a new location, or expand your business. If you just need capital and wouldn’t necessarily benefit from having the advice of investors, it might make more sense to pursue debt financing. In this case, a distinct benefit of using business loans are the variety of types of business loans available.
And finally, before you sign the dotted line on your equity financing agreement, be confident in your growth and financial projections.
These investors will be looking for results, so be sure you’re ready to deliver!