Equity Financing - Is It Right for Your Small Business?
Investors keep you out of debt -- for a price
There are a few different ways to raise funds for your startup. The traditional path is debt financing, which involves taking on a bank loan or private loan. A different approach is to seek equity financing by issuing stock in your company. In essence, this option allows you to sell shares of your company to investors, injecting your business with cash and leaving the investor with the chance to make a high return.
Pros of Equity Financing
Equity financing allows you to cut out the bank as a business partner. Instead of spending cash on loan repayments, you can use the infusion from equity investors to grow your business. Furthermore, equity investors help reduce your personal risk in the business.
In the event your business fails, you would still be required to pay back any bank loans you take or reorganize the debt payment under bankruptcy protection. Equity investors, however, usually don’t have the same rights as debtors; you would not be required to return their original investment in the event your business collapses, for example. Equity investment should be viewed as a long-term solution and a means to inject both cash and experience into your startup.
Cons of Equity Financing
If you’re seeking cash for the short term, offering equity is not the right approach. Investors want their capital to help the company make good investments and position itself for medium- and long-term growth.
If your cash flow hasn’t picked up as you expected, you may want to call a bank instead. Furthermore, you’ll have to cede some control over your company’s operations if you offer stock to investors.
Consider what your long-term strategy is for your business. Shareholders will be looking for a plan to get a return on their investment, and that plan could include merging with another company, selling the company to a larger firm, or conducting a public stock offering which would then allow investors to sell their stock on the open market.
Along with sharing control, you’ll also be sharing the profits. Make sure to run the calculations on any potential equity agreement: You may find that you’re paying a larger percentage of your profits to investors than you would toward a bank loan.
Some sources of equity financing
- Venture capitalists. Venture capital funds are professional investment organizations that invest in growing industries in order to make a profit. VC firms know several of their investment choices may not pan out but are willing to take that risk in return for an occasional windfall. Securing a venture capital firm that specializes in your industry means you’ll be bringing in owners who can offer experienced opinions on running the company but may also seek to exert significant control.
- Angel investors. These are individuals who have a personal stake in seeing a business proposition succeed. Angel investors tend to focus their investments on sectors in which they have a personal interest. The equity arrangement with an angel investor is similar to that of a venture capitalist.
- Initial public offerings. Depending on the nature and stage of development of the company, it may be possible to raise funds by offering shares in the company to the public. This activity is highly regulated and expert advice should be sought prior to embarking on this route.
- Corporate venture capital. This is capital provided by established companies in return for a stake in your business.
A decision to opt for equity financing over debt financing is largely a personal one and in part determined by your appetite for risk.
Setting yourself up for future financing
Depending on how much investment you are looking for at the startup phase, you may want to begin planning ahead for future equity financing. If that’s the case, there are a few things to keep in mind even at this early stage:
- Include some anti-dilution measures in your initial equity offerings. This is to assure first-round investors that their stake in your firm won’t become diluted when you offer more shares later down the road.
- C-Corp or S-Corp? Most large companies are legally set up as C-Corporations. C-Corps are subject to double taxation – the company’s earnings are taxed, and then individual shareholders’ dividends are taxed. Smaller firms can opt to be set up as an S-Corp, where income flows directly to the shareholders and thus only taxed once. S-Corps, however, can not have more than 100 shareholders by law. If you’re looking to take on additional financing, you may want to set your company up as C-Corp from the start. Investors also prefer C-Corps, since they allow preferred stock to be offered, and S-Corps do not.