What is equity financing? | Navigation

Sometimes you need an influx of cash to start or grow your business – equity financing is one way to do that. With an equity financing loan, you sell shares of your business in exchange for cash to use for operations or growth. This type of financing can work well for small businesses and startups with little to no credit history or a limited time in business.

In this article, we explain where to get equity financing, the pros and cons, and whether or not it might be right for your small business.

Main sources of equity financing

Equity financing isn’t like a bank loan or line of credit (or debt financing), and you don’t go to a traditional financial institution, like a bank, to get it. So who do you turn to for equity financing? There are several avenues to explore when looking to raise funds from equity financing for your small business.

Private equity investors

A private investor, also known as an angel investor, has significant net worth and is willing to invest their money in a startup or business after deciding they like the idea. They can include family members or friends. If you choose the individual investor route, it will likely take many investors to get the amount of working capital you need.

Angel investors often want to play an advisory role to oversee and assist in the creation and launch of a business.

Capital risk

A venture capitalist is a type of capital investor and can be a person or a venture capitalist. They invest in companies with equity financing loans from a venture capital fund. Venture capitalists look for companies that have a lot of growth potential. They have the money and the will to invest, but may want to take over your business.

Initial public offering (IPO)

Also known as “going public,” pursuing an IPO means transforming your business from a private company to a public one. To do this, your company offers public shares that shareholders can buy.

However, this method can cost you a lot of time and money, and not everyone is eligible. Your eligibility depends on the industry in which your business operates and your annual income. On the other hand, an IPO can provide you with more cash than other equity financing options.

Crowdfunding

Equity crowdfunding is crowdfunding for businesses. With crowdfunding, you sell future products or services. This can give you a much larger pool of investors than you could find on your own. AngelList, StartEngine, and Wefunder are some of the popular platforms that offer equity crowdfunding.

Benefits of Equity Financing

There are several advantages to choosing equity financing over debt financing for your business needs, such as:

  • Integrated Advisor. Investors often act as advisors to your business. Equity investors can offer their network, lessons learned and expertise for you to learn. Plus, they’ll have skin in the game, so they’ll want to see your business succeed. Think about every episode of Shark Tank – every company that makes a deal also gets an advisor in their Shark.
  • You will not add debts. Your business will not go into debt when you use equity financing. Instead of owing a loan or line of credit, you are selling a share of your business. With debt financing, you may also need to post collateral, such as real estate, to qualify for the loan. If you cannot meet your payments, you risk losing the guarantee. This is not the case with equity financing.
  • No monthly payments. You won’t have to make a monthly payment like you would with debt financing, and you won’t have an interest rate on the amount you borrow. The amount you pay in repayment of loans and other debts does not depend on how well your business is doing, so even if you are still struggling, you owe the same amount in repayment each month. Equity financing allows you to avoid monthly payments altogether.

Disadvantages of Equity Financing

There are also several negative things to consider before choosing equity financing, such as:

  • It can cost you. You are giving away part of your business when you turn to equity financing. If your business is doing well, it can cost you dearly, as the stock investor owns a share of your future profits.
  • You can’t keep control of the company. If you give away 50% or more of your business, you are no longer in control. You will not be able to decide where your business is going or how it will operate in the future.
  • Moreover, the responsibility. Equity financing can create additional liability when you have investors who own part of your business. Their actions can affect your business.

How does equity financing work?

The equity financing process can seem confusing, but we’re here to break it down for you.

If you are looking for direct investors, you have to find them first. Turn to family, friends and colleagues, or one of the crowdfunding platforms we mentioned above. Otherwise, venture capitalists might be interested in funding you.

Next, potential equity investors will review your company’s finances and business plan, and may want to visit your business facilities. Once on board, you will come to a mutual agreement on the following points:

  • The amount of money the investor will invest
  • The number of shares the investor will get in the company (or the percentage of the company the investor will own)
  • Special requirements of either party

The value of your business, or its valuation, determines the percentage of ownership the investor gets in your business. It can be difficult for new entrepreneurs or small business owners to get a fair deal. If your business is high risk, you may be asked to offer preferred stock or convertible preferred stock.

Pro tip: Going public may not be the best path for most small businesses because you’ll have to qualify and pay dividends to your shareholders, which can really eat into your bottom line.

4 reasons to use equity financing

Debt financing is often not an option for many small business owners because traditional lenders may view you as too risky. Your business may not have a strong enough credit profile or you may not have been in business long enough. These are the most common situations that cause small business owners to turn to equity financing.

  1. When you launch a startup or small business

There is a huge learning curve to starting a business. Many potential investors want to work with new businesses from scratch. They could provide you with enough cash to start your business and fund its operations, which could be an advantage when buying equipment or opening an office.

  1. When your business is risky

Two factors can make a business high risk: the likelihood of success and the potential for illegality. A high-risk business either has a higher potential for failure than some businesses, such as a restaurant, or it operates in an industry prone to fraud, such as gambling. Sometimes having a great credit rating and perfect finances isn’t enough to secure a loan for a business considered high risk. Investing in stocks can help you tap into the cash you need.

  1. When your business is heavily indebted

If you already have several loans and lines of credit, equity financing will not increase this burden. Equity financing does not count as commercial debt like loans or credit cards. Instead, raising capital through equity financing is an additional resource, and your company’s debt is a burden that the company’s board is working to resolve.

  1. When you need to improve your business network

Bringing in investors can also be like bringing in business advisors who can help you with your decision making. If that’s what you need, it can be a big help. Your investors will also have a reason to care about the success of your business because they have invested their hard-earned money in it. Keep in mind, however, that equity financing is not the only way to build business relationships.

What to do before looking for a stock investment

Before choosing equity financing, research all of your options to make sure they’re right for your business. By signing up for a free Nav account, you can browse our loan marketplace with over 160 business finance options from over 65 different partners. This market can give you a general idea of ​​the types of financing your business might qualify for – and you may decide to seek out more traditional financing after all.

If you decide to go for equity financing, talk to a business lawyer first. A trading lawyer can help you create clear guidelines and rules for each person’s role and responsibilities on the exchange, as well as help you maintain control of your business after taking on investors.

This article was originally written on April 14, 2022.

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Carol M. Barragan