If you’re starting a business, and are looking for an alternative to taking out a loan, one option is equity financing — offering investors equity ownership in your business in exchange for their cash.
What Is Equity Financing?
Equity financing, or equity capital financing, is when a business, including a new or small business, exchanges equity, or partial ownership in the business for capital, or an infusion of financing. Equity financing can take the form of shares or a percentage of profits, based on the valuation, or estimated worth of a particular business at a given time. The capital can be used for operational expenses, as well as short or long term business expenses or needs.
Equity capital financing can come in different forms, including from angel investors, venture capital or even family members or friends.
How Equity Financing Works?
Equity financing occurs when a business gives up a percentage of its ownership to an investor (or investors) in exchange for capital.
In equity financing, the investor is taking a risk. It is understood that if the company doesn’t do well, they lose their investment. Friends and family and angel investment typically involve smaller amounts, but can all be considered types of equity investment.
When an equity investor agrees to invest in your company, they invest in exchange for ownership in the business. This financial arrangement is different from debt transactions where lenders/creditors are repaid according to the terms of their agreement.
Reasons to Use Equity Financing
There are a few reasons why a business might want to pursue equity financing, or an equity finance loan:
- A business, particularly a startup or newer or smaller business, may not have the available capital or financing it needs in order to scale, or even to cover one-time expenses as it gets started and equity financing can provide that needed infusion.
- Equity financing can help create value for the entity offering the capital in the longer term should the business succeed, and in the shorter term for the business owner needing immediate funds.
- Equity financing is a particularly useful option for businesses that do not have an established credit history and would therefore be less likely to qualify for a low interest loan.
- The investor is taking a risk on the business when pursuing investing in it via equity financing rather than pointing the business towards a bank or traditional lender for capital.
- Equity financing is also useful if a business is seeking more than just capital, as investors often also offer advisory services and networking capabilities, which can be incredibly valuable for business owners, particularly those just starting out.
Is Equity Financing a Good Option for You?
Businesses from all industries can be good candidates for equity financing, provided they have the potential to grow significantly with the addition of the investor’s capital. Unlike a lender, equity investors aren’t looking for regular payments; rather, they are looking for an event (such as a business sale or public offering) to capture profits, which is one reason tech startups are appealing to an equity investors. Here are a few reasons to consider this type of financing:
- You have a business model with the ability to scale profits quickly with the infusion of capital investment
- You are willing to offer equity in your business to a future investor in return for capital
- You are willing to give the investor a seat at the decision-making table
- You see the advantage of a potentially more experienced voice in helping guide your company
Pros to Equity Financing:
- Unlike traditional bank financing, equity investment is not subject to regular payments. Investors are looking to a future capital event and the opportunity to capture their share in the profits.
- Equity investors (especially angel investors) often offer guidance and advice that can help your business grow.
- It can be easier to secure early investment from friends and family because they know you personally and can quickly get excited about taking part in your success.
Cons to Equity Financing:
- Accepting investment from friends and family can create tense relationships, especially if you are not able to provide a return on their investment.
- Finding the right equity investor can be more time-consuming than applying for a loan, and the process may take longer.
- There may be long-term implications to taking equity investments. If you give up a large piece of equity in your business, you lose exclusive control over future business decisions.
Equity Financing vs. Debt Financing
Equity financing and debt financing are two ways in which businesses can access capital. Equity financing is when a business offers equity, shares or a percentage stake in the company in order to raise funds, often to cover specific anticipated operational or other expenses. Debt financing, in contrast to equity financing, is when a business has already accumulated debt and is seeking to sell it off, generally in the form of bonds or loans from lending institutions. Equity financing is a way to bet on your future, whereas debt financing is a way to right-size the past.
Ways to Choose Between Debt and Equity Financing
Debt is cheaper than equity, which makes debt financing the default option for businesses seeking capital. Debt financing does though require repayment with interest, regardless of how well the business may be doing.
Equity financing is a good option for businesses in early stages, particularly if they do not have liquid capital to pay back a traditional loan. Debt financing may be preferable over equity capital financing if a business needs a cash infusion to cover operational expenses and anticipates being able to make on-time payments to repay the loan.
Anticipated business performance is a key factor to consider, as the business will owe more to equity financial capital investors is the business does really well. With debt financing, the total capital repaid is a known amount from the time it is borrowed.
Types of Equity Financing
Angel investors are people who invest personal wealth into specific businesses on an individual basis. Some angel investors work alone, while others operate as part of a network. The term “angels” points to their experience: many angel investors are current or former business leaders that want to contribute to businesses that spark their interest. When they sign on to invest, they are often not only giving money but also guidance and valuable advice.
For these reasons, angel investors are highly sought-after, and many take their time in deciding which companies to invest in.
Venture capitalists are individuals or firms that manage funds set aside to invest in new businesses. Modern VC firms tend to focus on young, high-growth companies—typically tech startups. This type of equity investor differs from friends and family and angel investors in that they are usually only interested in high-value investments (almost always millions of dollars instead of thousands of dollars). When a venture capitalist invests in a high-growth company, the investor expects to either be a member of the company’s management team or sit on its board of directors, thereby taking an active role in the operations of the business.
Friends and Family
Your friends and family can be excellent sources of equity investments because, generally speaking, they trust you and can get excited about your vision and desire to succeed. Before asking your friends and family for an equity investment, it is important to contemplate your relationship with your potential investor. Don’t take shortcuts and try to avoid a formal agreement between your friend or family member. It might be tempting to ignore their advice, but you should treat them like any other equity investor and be aware they may want a voice in how you run your business in the future.
How to Raise Equity Financing?
Equity financing can sound like an informal agreement (especially in the case of friends and family investment), but you can’t approach it that way. Prepare a well-laid-out business plan, and do your homework regarding the valuation of your business and your projections for future earnings.
*Note: You are required to register some early investments with the SEC. There are exceptions to this; it is advisable to talk with a tax attorney for more information.
Here are a few success tips:
Friends and Family
- Consult an attorney that specializes in equity arrangements. While this may sound like a pricey proposition, it’s worth every penny. To save money, you might ask a lawyer who is a family member or friend to help you out. Draw legal papers for each investor agreement, no matter how small the amount.
- Only take funds from people who you know would be fine if they were never repaid. Family and friend relationships can quickly become strained when monies are lost.
- Make sure your agreement is clear. If you receive money from your elderly aunt and she dies, will her equity go to her descendants? Include all of this information in your contract.
- Only agree to investments from people you trust. Equity transactions mean investors will have a say in the workings of your business. Be discerning with whom you bring on as investors.
- Consider offering “non-voting” stock, especially if you are concerned about family members or friends being too pushy in the operations of your business. “Non-voting” stock means an investor will have stock in your company, but not a voice in how you run your business.
- Set clear expectations (i.e. don’t tell your uncle that he will receive 1,000 times his investment back in five years if you aren’t sure that he will).
- Consider offering a convertible note, which is a type of contract agreement that can start off as debt (monies you will be required to pay back), but then can be converted into equity if your business does well or attracts larger amounts of funding later on.
- Think twice before offering large equity percentages.
- Do your homework and only approach angel investors that typically invest in your industry—that way, you’ll avoid wasting both your and their time. And, most investors will appreciate that you’ve done some research before you contact them. Start your search by checking out the following resources: Angel Capital Association, Angel Resource Institute, and Angel Investment Network.
- Be prepared for your meeting with an angel investor. Make sure your presentation is polished, and you can confidently talk about your business idea. Angel investors are pitched all the time; your proposal will only float to the top if you exude confidence and are able to answer all of their questions with little hesitation.
To Sum Up
Equity financing can be a great way to fund your business, provided you have the right type of business. Although it can be an alternative to bootstrapping or debt financing, there’s more to it. The right type of business can benefit from an equity investor. Be sure to consult a qualified attorney before agreeing to any transaction, and treat every investment meeting—even those with your family and friends—professionally.