Table of Contents
Introduction
Equity financing is popular for start-ups and small businesses looking to raise capital. This type of funding involves selling a portion of company ownership shares in exchange for money, services, or other assets. Equity financing can provide entrepreneurs with the capital they need to expand and grow their business ventures while allowing them to retain a majority stake in their companies.
Equity financing can offer several benefits over traditional loan options, such as increased flexibility and potential tax benefits, and allows entrepreneurs to leverage their existing personal resources. However, equity financing also has several downsides, such as the possibility of diluting current ownership stakes, losing control, a difficulty raising future funds, and increased scrutiny from investors due to their partial ownership stake in the company.
Thus start-ups and small businesses need to evaluate all aspects of tradeoffs associated with equity financing before going forward with this approach as part of their capital-raising strategy. This guide will provide an overview of what equity financing is and its advantages/disadvantages so that entrepreneurs can make an informed decision about whether it’s the correct type of funding for them:
- Advantages of equity financing:
- Increased flexibility
- Potential tax benefits
- Leverage existing personal resources
- Disadvantages of equity financing:
- Possibility of diluting current ownership stakes
- Loss of control
- Difficulty raising future funds
- Increased scrutiny from investors due to their partial ownership stake in the company
Types of Equity Financing
Equity financing is great for start-ups and small businesses looking to raise capital. Companies can use several types of equity financing, such as angel investors, venture capital, and crowdfunding.
In this article, we’ll look at the different types of equity financing that start-ups and small businesses can take advantage of:
- Angel investors
- Venture capital
- Crowdfunding
Angel Investors
Angel investors are private individuals willing to invest their capital in a business, typically in exchange for equity. These high-net-worth individuals typically have experience as entrepreneurs, executives, or venture capitalists. They tend to provide more than just capital – angel investors usually form a network that a small business can call upon for mentorship, experience, and guidance.
Angel investors often search for the potential of high returns on their investment down the line; some materials note that angel investors are looking for expected returns greater than 10–20x their initial investment over five to seven years.
Angel networks may invest anywhere from $50,000 up to $2 million or more – larger investments may come from a combination of multiple angel investor groups with different backgrounds. Generally speaking, angel investing will provide entrepreneurs with financial resources and industry connections without the extensive requirements of seeking venture capital investments or public offerings.
However, it is essential to note that if your company expands quickly through an influx of investor funding and you sell it too quickly after receiving it, you may be subject to ‘exit’ tax provisions associated with an ‘unqualified stock disposition’ under US law.
Venture Capital
Venture capital is a type of private equity financing that many start-ups and small businesses use to fund their operations. It is a form of risk capital provided to start-ups and small enterprises deemed too risky for more traditional lenders. In exchange for the capital, venture capitalists typically receive ownership of part of the company and an active role in helping the company ensure its long-term success.
Venture capitalists seek out companies that they believe have potential, and they provide equity financing in exchange for a large ROI (return on investment) or equity stake in the business.
Venture capitalist firms are typically made up of experienced investors who specialize in finding early-stage projects and start-ups with great potential for high returns. They conduct extensive due diligence on each opportunity before investing and typically invest in only a handful of promising ventures per year. The amount invested can range from a few hundred thousand dollars to millions, depending on factors such as funding type, existing cash flow, and expected growth. If a venture succeeds, the investor can reap significant benefits over time; however, if it fails, they lose their entire investment.
Crowdfunding
Crowdfunding is a process by which numerous people, usually internet users, make small investments in a business or project. It is one of the most modern forms of equity financing and has grown in popularity significantly over the last decade. It is an efficient way to gauge investor interest and give entrepreneurs a platform to leverage early-seed capital from multiple sources quickly.
Crowdfunding works by entrepreneurs proposing an idea on various crowdfunding portals such as Kickstarter, Indiegogo, Patreon, or GofundMe. The proposals often feature rewards for investors who assist at different levels of investment. In other cases, individuals can invest directly in the businesses without expecting payback. Common online destinations for crowdfunding are social media sites like Twitter and LinkedIn, as well as blogging platforms like Medium and Reddit. Depending on the platform used, start-ups may receive either debt or equity financing from this process.
Once entrepreneurs decide to go with crowdfunding, they must create an appealing pitch deck featuring details such as:
- their business plan and what sets it apart from its competition;
- an overview of how much money they intend to raise;
- their goals and objectives;
- market survey results;
- their desired timeline;
- financial forecasts;
- objectives for their campaign launch;
- calculated risk assessment report;
- projected outcomes;
- legal documents.
Depending upon success, these documents will often adjust during successive fundraising rounds, with strategic adjustments made over time until sufficient capital is secured.
Initial Public Offering (IPO)
An Initial Public Offering (IPO) is when a company publicly offers its shares of stock in exchange for cash. This process provides the company with capital that it can then use to grow and expand. The sale of shares to the public also provides more liquidity to the business as its stock can now be traded on the open market.
The IPO process requires a lot of preparation, including filing an S-1 registration statement with the US Securities and Exchange Commission (SEC). The S-1 registration statement details the company’s finances, management team, growth prospects, risks, etc. Once it is registered with the SEC and passes its criteria, then companies can move forward with their IPO.
The primary benefit of an IPO lies with individual investors who can purchase stock in a promising start-up or established business by taking part in this process. It does, however, also help existing shareholders liquidate their stake for a greater return since prior investment rounds have generally provided investors with favorable returns due to their access to private information not available on public markets.
An IPO also allows companies to raise capital while preserving control of operations by keeping current owners in control by retaining voting rights over important matters such as executive compensation and choosing board members. Finally, an IPO is often viewed as an opportunity to generate more exposure and increase brand awareness since mainstream media outlets would cover any related news and discuss it online, further expanding its brand recognition among potential customers and partners.
Benefits of Equity Financing
Equity financing is a great option for start-ups and small businesses looking to access capital in exchange for a share of the company’s future profits. Not only does equity financing offer the potential for rapid growth, but it also can help the company to access a larger consumer market.
Let’s dive into some of the other advantages of equity financing:
Access to Capital
Equity financing is generally considered a beneficial form of capital for start-ups and small businesses. It gives entrepreneurs access to working capital that might not be available through loan or debt financing. It can also help them expand operations by adding new clients, resources, and equipment, hiring staff, and purchasing inventory.
Equity financing offers several advantages to small business owners, including:
- Access to additional capital: Equity investors typically provide their own money in exchange for stock in the company. This injection of funds can be used to finance operations or to help launch new products or services. As an added benefit, equity investments don’t have to be paid back like loans do because the investors become part owners of the company; they share in its risks and rewards.
- No debt obligations: Equity financing does not involve paying additional debts that must be repaid with interest. Instead, fundraising is done from outside sources in exchange for a stake in the company’s future success–eliminating any future payment obligations for the business owner.
- Expansion without dilution: With equity financing, businesses can attract new investors without surrendering ownership control. It allows companies to raise funds but maintain majority ownership and control over decision-making.
Access to Expertise
When you bring on equity investors, you are essentially getting a team of people with experience and expertise that can help your start-up or small business grow. They will have a vested interest in ensuring your success, as they will own shares in the company. These investors understand the market and can use their insights to guide decision-making. They also provide more credibility within the community and with potential partners, customers, and investors. In addition, equity investments offer access to these resources at a lower cost than other forms of financing.
In addition to bringing knowledge to your organization, equity investing may provide opportunities for tangible partnerships or collaborations with other businesses related to new markets or technologies that could ultimately lead to long-term success. A larger pool of expertise and resources could create new opportunities for growth and expansion for start-ups in areas such as:
- Marketing and sales
- Product development
- Operations
- Technology systems
- Networking contacts
Just by engaging with equity financing partners.
Potential for Long-Term Growth
For entrepreneurs and small business owners seeking a long-term commitment from investors, equity financing provides an attractive choice. Equity financing involves issuing shares of the business to investors in exchange for their capital contribution. Although equity financing comes with its own risks, it also has several benefits to early-stage firms, such as access to permanent capital. Additionally, companies that go down the path of equity financing avoid taking on debt which can be expensive and stifle growth if not managed carefully.
The long-term potential associated with equity financing is arguably its most significant benefit. Because investors who remain committed to the company when they receive stocks are often motivated to help the company grow — which can benefit both parties. For entrepreneurs and business owners, when the company performs well, it will likely result in increased valuations and potentially more enormous profits if investors sell or hold onto stocks. This type of long-term support could provide financial stability over time as well as prove helpful in building relationships between parties that have made investments in your business’s future success.
Downsides of Equity Financing
Equity financing involves giving up a portion of your company ownership to investors in exchange for capital. While this can provide more resources for business development and long-term growth, it also has disadvantages. This guide will discuss the downsides of equity financing for start-ups and small businesses.
Loss of Control
Equity financing has many advantages. However, it is essential to be aware of the potential drawbacks. One significant downside of equity financing is the potential for losing control over your business or start-up.
When you accept equity investments, they typically come with specific stipulations in which the investor will want a say in decisions. It can range from having a representative on your board of directors or an advisory role in decision-making. However, regardless of the amount of control granted, it can dramatically reduce your influence and remove some sense of autonomy you would otherwise enjoy when running a business or start-up without outside input.
Suppose these limitations are unacceptable to you as an entrepreneur or business leader. In that case, this form of financing may not be suitable for you, and it’s wise to look into other methods, such as debt financing. However, understanding all the pros and cons associated with each type of financing is important before settling on one option for your company’s future growth and sustainability.
Dilution of Ownership
One downside of equity financing is the dilution of ownership, in which the business owners’ stake in the company decreases as they bring on additional shareholders. As dilution occurs, founders and other investors have less control over businesses’ decisions and direction because they have fewer votes on key decisions. Additionally, the new shares may be worth relatively less than the original investors’ shares because their value is divided by more outstanding shares.
Another downside to equity financing includes loss of management control. Each new investor comes with an additional input layer about how a business should run its operations. It can prove problematic if an outside investor wants to influence how the company handles its day-to-day activities or has different opinions from other shareholders about major decisions, such as increasing staffing levels or hiring new leadership. Moreover, majority shareholders—those who hold more than 50 percent of a company’s assets — have even more control over day-to-day operations and strategic decision-making because they can outvote minority shareholders who disagree with them or propose different solutions to operational issues.
Risk of Overvaluation
When raising capital through equity, it is crucial to ensure that the amount of equity distributed accurately reflects the company’s true underlying value. For example, given the current growth stage, suppose the equity is overvalued. In that case, there can be significant problematic implications in that it may limit access to debt and costlier forms of capital down the road. In addition, being overvalued can cause major issues if investors decide to liquidate their investment or if an acquisition is not conducted at a predatory rate resulting in unfair distributions.
In addition, equity financing can create a conflict for entrepreneurs. Funding might increase the value of a company leading to subsequent dilution of ownership based on over-valuation (i.e., diluted earnings per share for founders). Entrepreneurs must weigh this risk alongside other potential risks, such as:
- accruing expensive deficits if wrong decisions are made, leading to a decrease in value
- or even bankruptcy.
Conclusion
In conclusion, owning part of a company can be an excellent way for start-ups or small businesses to access needed capital. Equity funding incentivizes investors to invest in a business and fund its growth, as the potential for return on investment is more significant than in other forms of financing. Choosing the right type of equity financing for a business depends on the company’s needs and goals and how much risk it is willing to take on.
Different types of equity investments include:
- Equity crowdfunding
- Private investment from venture capitalists and angel investors
- Angel investor networks
- Incubators and accelerators
- Private placements
- IPOs
Each type has pros and cons that must be weighed carefully by entrepreneurs and potential investors. In addition, prospective investors should research business plans thoroughly to determine if investments are sound before investing any capital. Ultimately, equity financing can be an excellent way for start-ups or small businesses to raise the funds they need to grow their business—no matter what stage of development they’re in.
Frequently Asked Questions
1. What is equity financing?
Equity financing is a method for start-ups and small businesses in which investors provide capital in exchange for a share of ownership in the company.
2. How does equity financing differ from other funding methods?
Equity financing differs from other funding methods, such as debt financing, because the money investors provide does not need to be repaid. Instead, investors receive a share of ownership in the company and potentially a return on their investment.
3. What are the benefits of equity financing?
Equity financing can provide start-ups and small businesses with access to significant capital without accumulating debt. Investors may also offer valuable business advice and connections to help the company grow.
4. What are the risks of equity financing?
Equity financing can result in a loss of control for the business owner as investors gain a share of ownership. Additionally, if the company is unsuccessful, investors may not receive a return on their investment, leading to financial losses.
5. How do I find investors for equity financing?
Start-ups and small businesses can find potential investors through networking events, crowdfunding websites, angel investor groups, and venture capital firms.
6. What should I consider before pursuing equity financing?
Before pursuing equity financing, business owners should consider the potential cost of losing control, the benefits and drawbacks of involving investors, and the long-term impact on the company’s financials.
