The Ultimate Guide to Equity Financing
One notable way to raise capital for your business is to pursue equity financing. This post will explain how to raise funds using this method. In addition, we’ll provide the potential benefits and downsides that come with it.
Equity Financing Definition:
Equity financing is a popular way for entrepreneurs to raise money without taking on debt. In this form of financing, the business owner sells shares of their company to equity investors in exchange for financial compensation.
It sounds simple enough but obtaining equity financing is a big decision that’ll affect your business forever. Prior to exploring equity investments, its crucial to fully understand the process of obtaining this financing source, and the pros and cons that might affect your business.
How to Obtain Equity Financing:
When it comes to pursuing this type of financing, you may go to one (or more) of several sources. Common types of equity financing include:
- Angel Investors
- Venture Capital Firms
- Family and Friends
- Small Business Investment Companies
The process for obtaining equity financing differs depending on the source. With venture capitalists, you’ll need to show them a business plan that demonstrates a high rate of return for their investment, usually at least 25 percent, but often much more.
You’ll also face similar hurdles with Small Business Investment Companies. However, these companies are backed by the SBA, so their qualification criteria is generally less stringent.
With other sources of equity financing such as crowdfunding, angel investors, and family and friends, obtaining funding may be as simple as convincing people that you have a good idea.
That said, a well-crafted business plan will surely improve your chances of success with these types of investors. Also, regardless of who’s investing, you should have a lawyer draw up contracts to detail the specifics of your equity financing deal.
The Pros and Cons of Equity Financing:
The primary benefit of financing your business with equity is its availability, short-term affordability, and limited downside risk.
Even if it’s impossible for you to obtain debt financing because of a poor credit history, you can still access equity financing. Therefore, the direct, short-term cost of this type of financing is generally lower than debt financing because you don’t pay fees or interest.
Finally, since you pay for equity financing with shares of your business, should the business fail, you don’t have to pay your investors back. Some people prefer this format to business loans, which enables them to borrow money, but they have to pay it back in set terms.
However, equity financing also has downsides which include the potential to lose control of your business, as well as limited upside.
Since equity financing requires that you give up shares of your company, this type of financing can cause you to lose some or all your ownership and management rights. In fact, this is how Steve Jobs was forced out of Apple, the company he built.
In addition to that, by selling your ownership shares, you’re entitled to a smaller share of your company’s profits which limits your upside earnings potential. As a business owner, you want to be cognizant of your earning ability. If participating in an equity investment is going to limit your own financial gain, this might not be your best option for increasing cash flow.
Conclusion: Is Equity Financing Right for Your Business?
For any business that needs a significant amount of capital to get started or grow, equity financing could be a good fit. Of course, as the business owner, you must be comfortable with the terms of your equity financing deal, which can vary considerably. In addition, you should be prepared to work with and potentially cede some control of your business to your investors.
Due to this, just because your business needs money doesn’t necessarily mean that equity financing is the right way to go. However, if you find a good deal offered by investors with whom you can have a successful working relationship, equity financing could benefit your business.
Either way, if you decide to pursue equity financing, consult a lawyer to draw up documents and review all contracts. A lawyer can explain the legal considerations of different deal structures and draft documents that protect you and your investors.
Editor’s Note: This post was updated for accuracy and comprehensiveness in January 2021.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.