Equity financing is a form of business funding provided by investors. Small businesses in high-growth markets that have the potential to scale quickly can receive equity financing to help them achieve this growth. In exchange for funding, investors receive an ownership stake in your business and benefit from future business earnings.
What is Equity Financing?
A simple equity financing definition is that it is a method of business financing wherein business owners receive funds in exchange for an equity stake in their business. This may occur through the sale of shares, or a promise of future equity payout by way of a convertible note, or simple agreement for future equity.
How Equity Financing Works
Equity financing is a means of funding a business through the sale of partial ownership of your business, most commonly through the sale of stock in your company. When utilizing equity-backed financing, the business receives funds from an investor in exchange for an ownership stake in the company. Investors may come in the form of angel investors, crowdfunding, or venture capitalists.
Raising equity typically involves identifying potential investors and then giving them a brief presentation. This presentation, referred to as a pitch, is the investor’s first view of your business. It’s crucial that you have a well-rehearsed pitch prepared before approaching investors, as this is how you will convince them to provide funds to support the growth of your company.
When these investors invest in your business, they will receive an equity stake in your business and become partial owners of the company. As your business grows in value, so will the value of the investor’s stake in your company. Some equity financing agreements have defined payouts, usually tied to a specific event, marking when investors can collect their return.
Who Equity Financing is Right For
Some businesses are better suited for equity financing than others. Businesses that are particularly good for equity funding include those that have the potential for high-growth and the ability to scale quickly, and those that need large amounts of funding to obtain their goals for growth. Additionally, due to the amount of time it takes to receive funds, equity financing is a good option for businesses that don’t have immediate financial needs.
Businesses that may benefit from equity funding include:
- High-growth businesses: Equity investors focus investments on businesses that have high-growth potential and will scale quickly. Businesses fitting this description may fair well finding investors.
- Businesses needing a large amount of funding: Angel investors and venture capitalists are often willing to invest substantial amounts of money into businesses. This level of funding can far exceed the amounts that your business may be eligible for through more conventional debt financing sources.
- Businesses whose funding need isn’t urgent: Procuring equity funding can be a time-consuming process and isn’t as simple as completing an application and receiving funding. However, if your business funding need is not time-sensitive, equity financing can typically provide you with larger amounts of funding than debt financing.
If your business is aimed to scale quickly and can attract the attention of investors, equity funding can provide you with many opportunities to grow your business. Not only can investors help fund your business, but they can also serve as valuable advisers to the success of your venture. However, there are some businesses that are not well suited for equity financing, or may prefer more traditional sources of funding.
Who Equity Financing Isn’t Right For
Equity financing can be very beneficial in some cases, but it won’t be the best financing method for every business. Small businesses needing fast funding, may find that equity financing takes too long to obtain. Some business owners are reluctant to release any ownership control in their company, which makes equity funding an undesirable option. Additionally, equity investors seek high growth businesses, so if you intend to keep a small business small, equity financing may not be a good fit.
Equity funding may not be the right choice for:
- Businesses needing a fast source of funding: Raising equity can be a lengthy process, and receiving equity is not guaranteed. Small businesses needing a fast business loan may be better served by other small business financing methods.
- Business owners that do not want to give up control: In most cases equity financing requires business owners to relinquish some control over their company. Those that want to maintain full control of their business may prefer other methods of startup financing.
- Small businesses that intend to stay small: Equity investors are more inclined to invest in high-growth businesses that will scale quickly. If your intent is to keep your business small, equity funding may not be a good fit, and you may want to consider raising money from friends and family.
Some business owners may find that equity may not be the right financing choice for their business and may want to consider alternative funding sources. However, for small business owners that are excited about the opportunities that equity financing creates, it is important to understand the costs that are involved.
Equity Financing Costs
The exact costs of equity funding vary based on your financing agreement with the investors. In general, these costs are made up of future equity payouts to the investors. However, there is the additional cost that comes in the form of lost business control as ownership becomes diluted.
The two primary costs you will experience when utilizing equity funding are:
- Business equity: When raising equity, the initial cost is seen as a percentage of business ownership that you are giving up. This equity stake often entitles the shareholder to fixed dividends. Eventually the ownership percentage will be cashed out as a percentage of the company’s worth.
- Business control: A non-monetary cost of equity is the reduction of your percentage of ownership in the company. However, the sharing of ownership interest also provides your business with the combined business acumen of the investors, which may potentially be as valuable as the funding they invested.
Types of Equity Financing
There are three primary sources of equity financing: angel investors, crowdfunding, and venture capital. Each type of equity funding is slightly different and geared toward businesses with slightly different financial needs. However, each of these sources offer the advantage of not requiring repayment.
The three most common sources of equity funding are:
1. Angel Investors
Angel investors are individual investors who provide funding in exchange for an equity stake (partial ownership) in your business. Because angel investors are fronting their own personal money, they will want to be confident in your ability to succeed as a business owner as well as in the potential success of your business. While your business is still in the startup stage and seeking funding opportunities, you may want to consider seeking out an angel investor.
2. Venture Capital
Venture capital is an equity financing opportunity for funding startups with high growth potential. In exchange for funding, the venture capital firm will require an equity stake in your business. Venture capital is a good option for businesses needing funding of $100,000 to over $25 million in order to scale. To apply, you must find the right venture capital firm, pitch your company, and pass rigorous due diligence.
Many small business startups prefer crowdfunding as a source of equity financing for their business. With crowdfunding, many individuals contribute small amounts of money to collaboratively fund your business. This is often facilitated through a crowdfunding site. Crowdfunding participants are often given something in return for their investment, whether it be equity, promise to repay, or some other reward.
Types of Equity Financing Agreements
Equity financing agreements can take on many different forms, and all have slightly different uses. However, the one thing they have in common is that they represent an agreement between the investors and the business to exchange funds for future ownership equity. Common forms of equity agreements include convertible debt, equity investments, and simple agreements for future equity.
Some of the most common equity financing agreements include:
Convertible debt is repaid to the investor at a future funding or liquidity event. With convertible debt there is a payment (typically 20% of their investment) that the investor can receive in either the form of cash or equity in the company. The liquidity event that makes the debt convertible is dictated in the financing agreement but typically includes either acquisition, subsequent fundraising round, or an initial public offering.
Equity investments by investors are settled with company stock. This equity is paid out when the business reaches a specific, predetermined milestone. Such milestones can include a company being acquired or beginning to trade on a public exchange. At these points in time investors are able to liquidate some of their holdings in the company to realize a profit.
Simple Agreement for Future Equity
A simple agreement for future equity (SAFE) is a form of equity investment entitling investors to shares in the company, typically in the form of preferred stock. These agreements are tied to a future valuation event, such as the next round of equity capital funding, acquisition, or initial public offering.
Equity Financing Examples
While the primary sources of equity funding include financing by means of angel investors, crowdfunding, and venture capital may seem overwhelming, in reality you are likely very familiar with the general way in which this type of financing works. Funding can be raised through the sale of shares, by taking on a partner, or accepting investors—all of which are a form of equity financing.
Some examples of equity financing include:
- Sale of shares: Selling shares of your company allows you to fund the financial needs of your business by selling small pieces of ownership to investors.
- Taking on a partner: Accepting a partner into your business often means giving up partial ownership of the business in return for a financial contribution from the partner.
- Accepting investors: Accepting funding from any form of investor in return for equity stake, or a promise of future equity, is a form of equity.
Equity Financing vs Debt Financing
When you think of business financing, you likely think of debt financing, which is a more traditional form of obtaining funds for your business. Debt financing allows you to borrow funds from a lender and to repay those funds over a defined period of time. This is significantly different from equity funding where funds are invested in the business with the promise of a future return.
Some of the primary differences between debt financing and equity financing are:
- Debt financing requires regularly recurring payments
- Debt financing has a predetermined payoff date
- Equity financing reduces your percentage of business ownership
- Equity financing does not affect your monthly cash flows
Both methods of financing can be beneficial to a business, but deciding which method is right for your business will be based on your specific needs. Businesses needing a large amount of money to grow and scale quickly will likely prefer equity financing. Whereas, businesses needing immediate working capital will likely be better served by debt financing.
Pros & Cons of Equity Financing
As with any form of financing, there are both advantages and disadvantages to using equity financing to fund your business. Benefits of equity financing include that there are no monthly debt payments and you can receive large amounts of funding. Additionally, equity financing investors offer business guidance that isn’t available to many new businesses. However, obtaining equity financing can be a lengthy process, and may require relinquishing some control over your business.
Pros of Equity Financing
Some advantages of equity financing include:
- There are no monthly debt payments: When comparing debt vs equity financing, the primary difference is that debt financing includes regularly-scheduled payments to repay the borrowed funds, while equity does not require regularly recurring payments.
- You can receive large amounts of funding: With equity financing you can receive much larger amounts of funding from investors than you would be eligible to receive through a typical small business loan.
- You can bring valuable experience to your business: Because most forms of equity require that the investors be involved in business decisions, your business can benefit from the business acumen of the investor.
The business acumen that equity investors can share with a company is why a lot of business owners consider equity as a source not just of funding, but also as a strategic partnership that can be leveraged to help the business grow.
Cons of Equity Financing
Some disadvantages of equity financing include:
- You may have to relinquish some control of your company: In exchange for financing, investors often require a seat on your board. This allows for the investors to be part of the decision making process for your business.
- Raising equity can be a lengthy process: It can take a significant amount of time to find potential investors, to present your business as an investment, and to finally obtain funding.
- You have to share profits: In exchange for the funds invested in your company, investors will become partial owners of your company. This means that they will be entitled to a share of your business profits as well.
Frequently Asked Questions (FAQs) (if applicable)
What are the benefits of equity financing?
Some of the benefits of equity financing include that you are able to receive large amounts of funding that do not require a monthly debt payment. Instead, the investors receive an equity stake in your business. Additionally, your business gains the business acumen offered by your investors giving you the advantage of their business experiences.
How do you get equity financing?
To get equity financing you will need to locate an investor willing to invest in your business. These investors are often in the form of crowdfunding sources, angel investors, or venture capital firms. You will present your business to the potential investors who will then decide whether or not to invest in your company.
What does equity financing include?
Equity financing includes the sale of ownership interest in a business in exchange for funds. This may be through the sale of ownership shares, or through financing received from investors in the form of venture capital, angel investment, or crowdfunding. In return for funds, investors receive an equity stake in the business.
Businesses with the potential for high-growth, and with the ability to scale quickly, can benefit from equity financing. Investors are often prepared to invest large amounts of money into businesses they believe will become successful quickly. This is not free money, however, as investors will receive an ownership stake in your business allowing them to profit from the growth of your company.