Small businesses have tons of financing options. You can get funding through traditional bank loans, online lenders, invoice factoring services, alternative lenders, equipment financing and much more. With so many options, it can sometimes be overwhelming, making it tough to determine which form of financing is right for you and your business.
Before getting into those specific forms of funding, it’s important to be aware that there are two broad categories of financing available to businesses:
- Debt financing
- Equity financing
While debt financing is the most common type among small businesses, equity financing is still a potential option. Read on to find out what equity financing is and whether it makes sense for your business.
What Is Equity Financing?
Equity financing entails selling a stake in your company to investors who, ideally, anticipate receiving a share in the future profits of your business. Thus, with debt financing, your money comes from a lender while, with equity financing, the funding comes from investors and isn’t a loan. When you go this route, you won’t have to repay the money you received in regular installments or pay interest on anything. Rather, when investors fund you through equity financing, they become partial owners in your business who are entitled to a portion of company profits. What’s more, these investors often get a voting stake in company decisions, though this depends on the terms of your financing.
Debt Financing vs. Equity Financing: What’s the Difference?
Another good way of defining equity financing is to clarify what it is not, namely, debt financing. Debt financing is really just a fancy term for what a vast amount of small businesses do for funding: You borrow a fixed sum from a lender to help start or operate your business, which you then pay back with interest. All sizes of business, small to medium to large, utilize debt financing.
Admittedly, equity financing is not nearly as common for small businesses as debt financing. One of the most notable examples of equity financing is to hold an initial public offering (IPO), in which you open your company up to public investors to buy shares of stock in your company, which serves as the funding of your business. Holding an IPO is rarely done by small businesses, nor is it generally recommended, unless you’re already fairly well-established and are poised for major growth. However, there are other ways of equity financing besides IPOs that small businesses can take advantage of. Here’s a look at some of them.
Angel investors are high net-worth individuals who typically have some connection or relationship with the business founder. These individuals are interested in investing in new business ideas and, as a result, are usually willing to take on more risk. Angel investors, though open to risk, do still want to get a return on their investment, so your business needs to have real potential of succeeding in the marketplace. Because they’re willing to take on so much risk, angel investors typically expect big returns once your business takes off. In this way, this form of equity financing can be expensive since the angel investor’s returns will come from your company’s profits.
Where angel investors usually have some kind of connection to the business founder, venture capitalists, or VCs, are experienced, professional private investors who seek out promising startups. Venture capital firms make it their business to identify startups with big potential and invest in them before moving on to the next one. VCs also tend to look for startups that are a bit more mature than those angel investors typically back. Part of the reason for this is VCs are ultimately responsible for obtaining certain returns for their firm or fund. Thus, these investors want scalable businesses with positive cash flow and products or services that are proven out.
A newer version of equity financing that has emerged in recent years is known as equity crowdfunding. This form of equity financing entails a business selling very small shares of the company to a wide pool of investors through the use of crowdfunding platforms. These kind of crowdfunding platforms include Kickstarter, Crowdfunder, Fundable and many more. Running an equity crowdfunding campaign usually requires huge marketing efforts, among other things, to hit the target goal and get funded.
In all cases of equity financing, the way investors get back their investment is through your company’s expected profits. This is unlike debt financing where the lender makes its money back through fixed interval payments regardless of whether your company turns a profit. And this is a key point. If your company ultimately doesn’t work out, with equity financing, the investors lose their investment and you usually don’t owe them anything. With debt financing, if your company tanks, you still owe your lender the money they lent you plus interest.
Pros and Cons of Equity Financing
Whatever financing option you choose to pursue for your business will come with its own set of pros and cons. Equity financing is no different. You’ll need to weigh the pros and cons of each type in terms of you, your business and your business goals. Here’s a look at some of the advantages of equity financing.
Advantages of Equity Financing
Equity financing enables a business owner to spread out the financial risk among a larger group of people. Companies that land equity financing investments will get capital on hand, which they can use to scale up. What’s more, you will not be required to start paying back their investment until your business is profitable. So, if your company is not making a profit, you don’t have to make repayments to your investors. And, if the business fails, none of the investors’ money has to be repaid.
Equity financing can also last beyond just the startup phase. Meaning, investors like VCs or angel investors may provide money to get your business up and running as well as provide ongoing financial assistance. This can be a huge help for businesses, especially as unexpected situations arise or disruptions of cash flow occur.
Disadvantages of Equity Financing
Perhaps the most immediate drawback of equity financing is that, unlike debt financing, it is difficult to come by for most businesses. Instead, equity financing is best suited for startups in high-growth industries, most notably in recent years, the technology sector. Equity financing also requires having a strong personal network because you’ll need to track down angel investors or VCs and make them familiar with your business. To get these types of investors, your business doesn’t just need a well-written business plan but also an innovative idea that has the potential for major growth.
The other main drawback of equity financing concerns control of the business. Since you are selling shares of your company to investors, you must be careful to remain the majority shareholder. If you allow investors to own more than 50% of your business, you’ll lose your majority stake, which carries consequences. It usually entails you have less control over company operations, decision-making and even run the risk of being removed from management if the other shareholders want to change leadership.
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The Bottom Line
Equity financing has some appealing characteristics and some drawbacks, as do all types of business financing. Arguably the biggest advantage of equity financing is that there is no loan and, therefore, no debt and interest that you need to pay back. If you fund your company through equity financing and fail, you are not required to pay back your investors, who ultimately took on the risk when they backed you. With debt financing through a loan, your company will still be on the hook for the money borrowed plus interest unless you file for bankruptcy and, even then, you might still have to repay. Equity financing is tougher to come by for small businesses, but thanks to modern technology, online platforms have made it more accessible through equity crowdfunding.
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