Unlike debt financing which entails borrowing from a lender and then paying back the money usually with interest, equity financing is a whole different ball game. Equity financing involves selling shares of your business to various investors. Is this right for your company? That really depends—in this article, we will look at the process of equity financing to help determine whether or not it's something you want to consider.
You first need to understand what equity is. Let's say your business had to liquidate. Upon doing so, the amount given back to a shareholder minus liabilities is considered their equity in the company.
In equity financing, the business owner, as noted, sell shares in the company in an effort to raise the capital needed to sustain the business. There is of course risk involved with this, particularly on the investor's part. The only way they get their money back and what's more make money is if the business makes money or ultimately is sold.
Keep in mind, the investor also will have a say in company decisions—depending on how it's spelled out and their subsequent voting rights, they will have a say for example during board meetings.
In equity financing, there are generally two types of stock options: common and preferred. With the common stock, investors have a claim on earnings and/or dividends and they also hold voting rights. With preferred stock, however, they do not get any voting rights. They do though have priority over other shareholders in the event of liquidation for example. Depending on what type of business structure you have, you can determine which type of stock you issue.
Best Candidates For Equity Financing
Not all businesses should go this route. Among the best candidates for equity financing are those looking for a large amount of growth, those considering an initial public offering, businesses that cannot get debt financing for whatever reason, and those who simply don't want to be held to monthly payments to obtain funding.
There are 4 Common Types of Equity Financing
Of course, there are a variety of versions of this type of financing, but the four most common include:
Angel Investors - These are investors who see potential in business early on and thus help it get going. Anyone from a relative, to a retired venture capitalist, could qualify as an angel investor. They either provide the capital all in one shot or can allocate funds to the company as it experiences growth. They usually want to help in terms of not only the financial aspects of the business but also as far as giving guidance, helping with business processes and any other area in which they may have expertise.
Venture Capital - These people are similar to angel investors in that they work with you to get the business up and running. They are committed to increasing the value of your small business as this is why they decided to invest in the first place. They realized in your vision, the potential for major growth. In deciding to work with a venture capitalist you really do need to take the time to see who might be the best fit. And also, you need to decide how much stock you're willing to give in exchange for capital. The money here is usually distributed as the company continues to grow.
Friends / Family - If you're perhaps looking to start a bit smaller in terms of procuring capital you might approach friends and/or family members. They already know you, they trust you hopefully, and they may be a more realistic choice depending on your business and goals. You do however always want to treat the relationship as a professional one. There are a few precautions you should take when working with a friend or family member. For one, it is a good idea to get an attorney involved. They can help more clearly define the relationship and this way if something does arise, an attorney will be familiar with the situation and be able to help resolve the conflict.
Also, make sure the expectations are clear. For instance, do they want a return on their investment within five years? Are they okay waiting longer? Relationships dissolve when everyone is on a different page.
Then there is the question of voting…Will they get a say? Or are they fine in a silent position of support only? Make this clear from the get-go.
Crowdfunding - A relatively new phenomenon, crowdfunding has become a very popular way for companies to raise money. With the likes of Kickstarter and Indiegogo, you can pitch your idea to the masses. Anyone who is intrigued and does want to help can do so by contributing to your campaign. In return, they generally get a gift, discounts, early bird specials, what have you.
Your message though has to be compelling. Tons of companies are essentially competing on these platforms for money. Your idea has to be a standout, it has to be among the very best. Keep in mind, if you cannot reach your predetermined goal, you do not get the funding.
Pros and Cons
Pros
- More Capital Flexibility - You're not making a monthly payment which frees up capital to devote to the business. In the early stage especially, this can be crucial to your sustainability.
- Credit Less of an Issue - Lots of times small businesses can't get a loan because of credit issues—here it's less of an issue. An investor may want a credit check, but more importantly, they're focused on the value and potential value of the company itself.
- Learn From Partners - With the likes of angel investors and venture capitalists they probably do have expertise in some business area. Access to this type of information is certainly valuable.
Cons
- Sharing the Rewards - Remember, investors do need to get paid. If you start making profits, you will most likely have to share. Thus, your portion of the money being made will be smaller.
- Giving up Control - Because many investors do have a say, you are giving away some of the control you'd otherwise have. You could even be outvoted when it comes to major company decisions.
So you really do need to weigh those pros and cons. Going the equity financing route is a big commitment to make no doubt about it. But then again, it can certainly be a huge infusion of cash into a company that is struggling.
At First Union, we love helping small businesses. If you are in need of funding or have questions, call today!