Equity financing is a tactic businesses often use to raise funds, especially in the case of startups that are in need of cash or businesses who are looking to expand but don't have the capital to do so.
There are a few things small business owners should know about equity financing before seeking to secure it.
What Is Equity Financing?
Equity financing is a common way for businesses to raise capital by selling shares in the business. This differs from debt financing, where the business secures a loan from a financial institution. Equity financing is typically used as seed money for business startups or as additional capital for established businesses wanting to expand.
A business normally obtains this type of financing by selling shares of the business in the form of common stock, which means that the company must be incorporated first. Typically, each share represents a single unit of ownership of the company. For example, if the company has issued 1000 shares of common stock and Owner A has 500 shares, then Owner A owns 50% of the company. Ownership in a business is diluted whenever additional shares are issued.
Benefits for Investors
In addition to voting rights, shareholders benefit from share ownership in the form of dividends and (hopefully) eventually selling the shares at a profit. Given the high level of risk in providing equity financing to small businesses, equity investors expect a very high rate of return.
Larger enterprises often have multiple classes of equity shares (each with a different price per share) to appeal to investors who have different financial objectives. For example, a company may issue:
- A class shares (voting rights and a dividend)
- B class shares (no voting rights and no dividend)
- Preferred shares (dividends but no voting rights, as well as a higher claim on assets than regular shareholders of the company is dissolved)
Share issues are often structured so that a single owner or group of owners have control of the company. For example, Facebook Class B shares have more voting rights than Class A shares, and since Mark Zuckerberg has a large percentage of the Class B shares he retains voting control.
Sources of Equity Financing
New business owners typically invest their own funds into their businesses. These funds often are gleaned from inheritance, savings, or even the sale of personal assets, which then serves as equity financing for the business.
Outside sources of equity financing include:
- Angel investors: These are usually wealthy family or friends of the business owner(s) who provide financial backing for small businesses. Typically, the amount invested is less than $500,000, the terms are favorable, and the investor does not get involved in the management of the business.
- Venture capitalists: These are professional investors who provide funding to select businesses. They are very choosy about investing only in businesses that are well managed and have a strong competitive advantage in their particular industry. Venture capitalists normally insist on taking an active role in managing the companies they invest in and are strictly interested in maximizing the return on their investment. Amounts invested are generally greater than $1 million. Venture capitalists typically invest in a private business with the goal of eventually transforming it into a public company by offering shares on a securities exchange via an Initial Public Offering (IPO). IPOs can generate huge profits for venture capitalists—Facebook's IPO in 2012 was one of the biggest IPOs in history, raising over $16 billion in equity.
- Crowdfunding: The process involves using large groups of angel investors to contribute funding to smaller businesses in amounts as small as $1,000. Fundraising is conducted online by starting a crowdfunding "campaign" via one of the crowdfunding sites such as Crowdfunder or AngelList in the United States and Kickstarter or Indiegogo in Canada.
Equity Financing for Small Business
Obtaining equity financing is more difficult for startups than for established businesses needing funds to expand. Wells Fargo found that 77% of small business startup funding comes from the personal savings of the owners. In either case, having a solid business plan in place is a must for attracting investors.
Making a personal investment that serves as equity financing in a business is often necessary to attract other investors and/or lenders. If you, as the small business owner, are not prepared to put any of your personal funds into the business, what does that say to anyone else who might be thinking of investing in the business—or that you're asking for a business loan? Investors and lenders like to see an equity financing contribution of 25% to 50% from the owner.
Disadvantages of Equity Financing
Aside from dilution of shares, equity financing has other drawbacks:
- Potential loss of control: Investors may wish to be involved in management decisions, which can lead to conflict if there are disagreements in how the business is run.
- It's a time-consuming process: You will need to provide detailed business plans and forecasts that clearly demonstrate to potential shareholders that their investment in your business will be secure and profitable. You will also have to devote time to meeting with and updating shareholders on an ongoing basis.