7 Types of Equity Financing for Small Business

Avoid Loans and Other Debt by Financing With Equity

Small business finance includes both debt financing and equity financing. Several methods exist to garner both types of financing for your business. Some business owners take out bank loans, use credit cards, or use loans from family and friends. Those methods are a form of small business finance called debt financing. Other businesses turn to organizations or individuals that specialize in funding startups or growing businesses. This is called equity financing.

Equity financing is using other people's money to finance businesses. Those people are the company's investors.

Equity financing is a method of small business finance that consists of gathering funds from investors to finance your business. Equity financing involves raising money by offering portions of your company, called shares, to investors. When a business owner uses equity financing, they are selling part of their ownership interest in their business. 

Here are seven types of equity financing for start-up or growing companies.

Initial Public Offering

An initial public offering (IPO) takes place when a company that has decided to "go public" offers up initial shares on a publicly-traded market such as the New York Stock Exchange. "Going public" is the term used to describe transitioning to a publicly-traded company.

This type of funding requires developing the offering in compliance with the guidelines established by the Securities and Exchange Commission (SEC). 

The SEC requires that the IPO be registered and approved. If approved, the SEC gives the business a listing date. The listing date is when the shares will become available on the market they are going to be traded on.

Once this is done (or even before), the firm needs to start working to ensure investors are aware of and become interested in, the shares. This is accomplished by publishing a prospectus and beginning a campaign to attract investors. 

Going public is usually reserved for small businesses that are regional or national in nature.

Small Business Investment Companies

The Small Business Administration (SBA) licenses and regulates a program called Small Business Investment Companies (SBIC) that provides venture capital financing to small businesses. Venture capital firms pool investors' money in order to invest in start-up, possibly high-risk business firms. These investors may be wealthy individuals, private pension funds, investment companies, and others.

Venture capital financing is a competitive method of funding since a venture capital firm may have any number of firms and projects competing for money at a given point in time.

The underwriting requirements are considered to be less stringent than those for an IPO. This makes it an attractive opportunity for smaller businesses without the need for an extensive IPO process.

Angel Investors for Equity Financing

Angel investors are investors with a significant amount of money who provide financing for startups. They are wealthy individuals or groups who are looking for a high return on their investments and are very discerning about the businesses in which they invest.

Some angel investor groups actively seek early-stage companies in which to invest and they provide technical and operational knowledge to startup ventures. These angel investors may provide the second round of funding for growing companies after the initial start-up funding.

Angel investors become shareholders in the small business. They receive a piece of the action in return not only for their money but for their knowledge in helping a small business get off the ground or grow. 

Mezzanine Financing

Mezzanine financing is a combined form of financing that utilizes both debt and equity. It's called mezzanine financing because intermediate-sized businesses are usually interested in this type of financing. The financing has an intermediate risk level and lies between lower-risk debt and higher-risk equity financing. The lender makes a loan and, if all goes well, the company pays the loan back under negotiated terms.

With mezzanine capital, the lender can set terms such as financial performance requirements for funding the company. Examples of terms could be a high operating cash flow ratio (ability to pay off current debts) or a high shareholder equity ratio (value for shareholders after debts are paid).

One benefit for borrowers is that mezzanine capital can present more value than a traditional lender would be comfortable granting. Another is that since mezzanine debt is a hybrid form of equity and debt, it is considered by accountants to be equity on the balance sheet. It can bridge the gap between the point at which a company no longer qualifies for start-up debt financing and the point where venture capitalists would be interested in financing the firm.

This gives borrowers a lower debt-to-equity ratio, which in turn can attract investors because a low debt-to-equity ratio is usually an indication of less risk. 

Venture Capital

Venture capital firms provide funding in exchange for ownership, or shares, of your business. Venture capitalists are looking for high rates of return when they invest their money in a start-up small business. They usually have many competing businesses from which to choose.

Unlike angel investors, venture capital firms don't use personal funds for investing in startups. These firms consist of a group of professional investors who pool money to invest in start-ups or growing firms. Venture capital firms may also want a seat on your board of directors.

Some venture capitalists see a board seat as a form of managing an investment. Many venture capital firms have transitioned to a mentoring approach to assist with investment growth.

If you are considering venture capitalists, look for firms that are interested in your firm's line of business and helping it prosper.

Royalty Financing

Royalty financing, or revenue-based financing, is an equity investment in future sales of a product. Royalty financing differs from angel investors and venture capitalists because you have to be making sales before approval. 

Investors will expect to begin receiving payments immediately as a result of the agreements made with the lender. Royalty financers provide upfront cash for business expenses in return for a percentage of the revenue received from the product.

Equity Crowdfunding

Equity crowdfunding is selling shares of your company to the crowd as opposed to using a platform where you pre-sale your product to the crowd. The owners of a privately-held business raise money through selling a portion of their ownership interest, or equity, to investors in the crowd in this way.

There is less than half the number of publicly-traded companies there were in the 1990s. Through equity crowdfunding, companies can remain private but raise funds from the public.

Article Sources

  1. Small Business Administration. "Financing Options for Small Businesses," pg. 3-14. Accessed June 14, 2020.

  2. Harvard Business Review. "Mezzanine Money for Smaller Businesses." Accessed June 14, 2020.

  3. Small Business Administration. "Fund Your Business." Accessed June 14, 2020.