What Is Equity Financing, and How Does It Work?
As a small business owner, you might find you need some extra cash to expand or build your company. There are several financing options available. You’re likely most familiar with debt financing, but equity financing is another option to consider.
With debt financing, you take out a loan and then pay the money back with interest. However, with equity financing, you sell shares of your company to investors in exchange for cash. While you don’t have to make regular installment payments or deal with interest rates, you do give up some control of the company.
Keep reading to find out more about equity financing, how it works, reasons you might want to consider it, and other types of financing options.
What Is Equity Financing?
Equity financing is when a company sells its shares to raise money. The funds can be used for short-term or long-term business needs. The cost of each share will depend on the valuation of the company, and the investors become part owners.
Equity financing isn’t just for big companies. A new business or startup can sell shares to private investors, such as angel investors, a venture capital firm, or even friends and family. In most cases, entrepreneurs need to get equity funding several times, especially during a high-growth period.
Private companies who want to raise a substantial amount of money can also opt for an initial public offering, or IPO. This is a process where a startup or private business will offer shares on the stock market and become a public company. Equity financing refers to funding for both public and private companies.
How Does Equity Financing Work?
When a company wants to sell shares, it makes an agreement with investors for a set amount of money in exchange for a certain number of shares. Those shares represent a percentage of ownership of the company.
The more the investor buys, the higher the stake they have in your company. Investors who own more than 50% of a business will have control of the company. Small business owners who want to maintain control should make sure that they keep over 50% of the company.
When an equity investor owns shares, they get to have a say in certain things. For example, they might serve on the board of directors, insist on being part of planning and operations, or provide insight and connections as needed.
Types of Equity Financing
Depending on which stage you are in your company’s growth, you could have different types of equity financing. Here are some of the most common methods of equity investment.
These investors are usually people you might know, such as friends, family, or colleagues. They usually have less money to invest. so depending on your cash flow needs, you may need other financing options from lenders or more investors. These types of investors may not have any knowledge of the sector or guidance to help contribute to the company.
Angel investors are equity investors who invest in the early stages of a company. They are usually specialized groups of investors or wealthy investors who think that the company has the potential for high returns. Angel investors not only tend to invest a lot of money early on, but they can also serve as mentors and help the company develop and grow with industry connections.
Venture capitalists or firms make investments in companies they think have the potential to rapidly develop and grow and are at a competitive advantage. In many cases, they will want to have a substantial share of the company and be more involved.
After all, they want to protect their investment and make sure the company will succeed. In most cases venture capitalists get involved early and will exit when the company has an IPO, making a lot of money in the process.
With equity crowdfunding, a private company offers shares to a group of people to raise money. Crowdfunding often happens on online platforms, which may charge a percentage for the funds raised.
Unlike with an IPO, your company remains private. The U.S. Securities and Exchange Commission allows companies to raise a maximum of $5 million through crowdfunding platforms in a 12-month period.
Initial Public Offerings
An IPO is usually a stage that more established companies take when they want to raise a lot of money. With an IPO, the company sells its shares to the public. It requires a lot of time, effort, and expenses to complete an IPO and is highly regulated. IPO investors tend to have less control in the company than venture capitalists and angel investors.
Advantages of Equity Financing
Here are the main advantages of using equity financing:
Great for startups: Small businesses that are just starting out are some of the prime candidates for equity financing. This is especially true if you are seeking funding from angel investors or venture capitalists and want to scale up your business.
No set repayment terms: With debt financing, you need to repay your loans no matter your financial situation. With equity financing, investors wait to get their money back until the company is profitable.
Can get extra guidance and resources: Angel investors and venture capitalists usually provide mentorship and guidance to companies. They can also connect companies with connections from experts in their field.
Disadvantages of Equity Financing
Here are the main advantages of using equity financing:
Investors have control: When you sell your shares, you are selling some control of your company. If investors buy more than 50% of the company, then you lose control and don’t have as much of a say in how the company operates.
Difficult to obtain: Getting investors to buy shares of your company requires a lot more work than getting debt financing. You need to have a strong network and a solid business plan to convince investors to give you money.
Have to share profits: While you don’t have a repayment schedule like you do when you take out a loan, you will need to share your profits with your investors. This can make equity financing more expensive in the end than debt financing.
Equity Financing Alternatives
Equity financing doesn’t work for all companies. Here are some other alternatives for small businesses looking for financing:
Alternative lenders: Alternative lenders like Backd offer many financing options with flexible repayment terms and competitive interest rates. At Backd, for example, you can get a working capital advance of up to $2 million to quickly bridge a cash flow gap, stock up on inventory, or invest in new equipment.
Venture debt: Venture debt is a type of bank loan offered by financial institutions and non-banks for early-stage companies. They often have higher interest rates and shorter terms than more conventional loans. In many cases, it can be used in conjunction with equity funding.
Invoice factoring: With invoice factoring, you sell your outstanding invoices to a third party. The factoring company pays you most of the money from the invoices immediately and collects the payment directly from your customers.
Equity Financing Is Just One Way to Get Funding
Equity financing is one way to raise funds. New businesses might be interested in the extra guidance and expertise that early-stage investors bring. It’s also a way to increase cash flow without going into debt and can help you scale up your company quickly, especially if you plan to sell it.
However, it can also mean giving other investors control of your company, including a say in how it’s run. Plus, equity financing may be more expensive than borrowing over the long term, as you will have to share your profits with your investors.
Looking for ways to finance your company and still stay in control? With Backd, you can get a working capital advance of up to $2 million to help with financing your business or a business line of credit of up to $750,000 with unlimited terms.
Apply today, and find out if you qualify in just 24 hours.