Equity Financing Definition
When you want to run a firm, you need to make sure that you have enough funds to finance your business operations. You may have bills to pay or investments to prepare for the growth of your business. To raise capital, you can sell shares to your company to interested investors in exchange for cash. This process is otherwise known as equity financing. By doing so, the investors will hold part ownership of the company.
There are many sources from which you can get equity financing. It could be from friends, family, investors, financial institutions, or even through an initial public offering (IPO). One of the most valued methods of raising capital is through Venture Capital (VC).
VC financing is a way for you to collect money from individuals with a high net worth who are interested in diverse investment opportunities. These venture capitalists may opt to sell their stake to other retail or institutional investors once you decide to make it available to the public. Remember that you can only do so when you grow large enough to attract other investors.
In the future, if you need additional capital, you also have the option to go for secondary equity financings, such as right offerings or public offerings.
Equity Financing vs. Debt Financing
Other than equity financing, you can raise capital through debt financing. Many companies all over the globe usually use a combination of both methods. However, the most significant advantage of equity financing over debt financing is that there is no repayment schedule that you need to follow. Also, it can raise additional working capital, which is vital to the growth and development of your business.
Choosing one or the other, or even a combination of both, does not depend on what you want. You need to consider what is most accessible to you, depending on the industry that you are in. You also have to review your cash flow and think about how important it is for the principal owners to hold maximum control over the firm.
Debt financing is quite different from equity financing. With the former, you will have to pay back the exact amount of money that you borrowed plus the interest that the lender has calculated. However, you will still have complete control over your company. All you are required to do is repay the total amount, and your relationship with the financer is over.
It is also tax-deductible, and it will be easy for you to forecast your expenses since your payments would be constant and will never fluctuate.
You must think long and hard about it before acquiring any debt. It will be extremely challenging for you to make your payments regularly if your business does not end up succeeding the way you thought it would. Also, if your company does not receive much profit, you may end up inhibiting your business from growing because of the debt that you are continually paying for.
Sources of Equity Financing
Usually, new business owners invest their own money into their firms. They may have received these funds as inheritance, savings, or even through selling their assets. This is still considered as equity financing.
Placing your own funds into your business is also essential in attracting other investors. It would be a sign of commitment and would show others that you are willing to bet all you have to the success of your firm. If you are not ready to invest in your own company, investors will take it as though you are not confident in your business.
There are several other sources of equity financing, such as:
We typically recommend that up to the $500,000 level, owners try to raise the money on their own. Also known as bootstrapping. We have some suggestions on how to do that.
Family and Friends
Typically a high net worth individual who may be attached relationally to an entrepreneur’s family, friends, network of wealthy individuals, or groups of people that provide you financial support to start your small business. The amount that they invest would likely be less than $500,000, and they will not have any control or role in the management of your firm.
These are professional investors that carefully select the businesses they invest in. They consider the upside potential of the company. The usual amount that venture capitalists invest in is more than $1 million. Their goal is to help a business grow large enough to be acquired or possibly go public and offer an Initial Public Offering (IPO).
This involves gathering several angel investors to contribute funds in small amounts, even as low as $1,000. You can do this online by creating a “campaign” on any of the crowdfunding sites that you can find on the internet. This is only legal in some jurisdictions, so make sure that you research before using this method for equity financing.
These are wealthy people that can provide funding during the early stages of your business. They are sometimes called seed investors, business angels, or private investors. Their goal is to help you and your business go through the very first steps of the process.
They can either give you a large amount of money at once or provide you with funds little by little as the business grows. There are different reasons as to why angel investors choose to invest in your company. First is, of course, the financial incentive that they will receive. Another is their chance to provide small business owners and beginner entrepreneurs with valuable knowledge and information regarding the business world. Sometimes, they aren’t even after your money but instead sees this chance to provide mentorship.
Venture Capital Firms
They are similar to angel investors. However, instead of only an individual providing you with funds, it is an entire firm.
Generally, these capitalists search for companies that have high potential and are in their early stages. There are different rounds that you will have to go through to receive your venture capital. Your chance of moving through each series depends on the growth of your business. You will start at Series A, then go to B, C, and finally IPO.
For each round, you will receive additional VC firm’s funds for a new exchange of equity.
If you choose this method, you will have to pitch your business idea through any of the crowdfunding sites online, such as Kickstarter or IndieGoGo. The visitors of the website that like your plan, can then invest small amounts of money to help you receive your desired funding. In exchange for the funds, you can provide them early access to your products and discounts on their purchases.
Advantages and Disadvantages of Equity Financing
No interest nor and required repayments involved
Since you are selling ownership of your company to investors in exchange for cash, you are not required to pay anything back to the funder. Thus, there is no extra financial burden on your side.
Loss of control
Some investors will insist on taking on an active role in managing your company. They may have conflicting ideas, which will lead to disagreements between you and the investors. However, since they have ownership, they will have a say on the decisions the company makes.
Before you can raise capital through equity financing, you will have to make detailed business plans and financial forecasts to show to investors or your potential shareholders. You need to make sure that your presentation will prove to them that their investments would be worth it, as it is both profitable and secure. Other than that, you need to allocate a large portion of your time to participate in meetings to update your shareholders regularly.
Differences between Angel Investors and Venture Capital Firms
Both types of investors serve the same purpose for your company, which is to provide you with the funds to start your business and keep it up and running. However, there are a few things that they differ in.
Amount of Capital & Equity – VCs typically invest a massive amount ($500k – $2M+) of capital compared to angel investors. However, in exchange for the funds, they will also take more equity.
Active Role – You can expect that venture capitalists will take on a much more active role in the management of your company to ensure that they will get a return on their investment
Focus on Growth – Although angel investors want to see your business grow, VCs are much more enthusiastic about it. Their goal is to build your company up until it is large enough to become a public company. Once you reach the IPO, venture capitalists will gain so much from your company.
Selectivity – Venture capitalists are much more selective than angel investors. They will need to hear detailed presentations of your business plan since they only want to invest in companies that have the actual potential to expand.