6 Types of Equity Financing for Small Business

Avoid Loans and Credit Debt by Financing With Equity

Several methods exist to garner financing for your business. Some business owners take out bank loans or credit cards. Other businesses turn to organizations that specialize in funding startups with equity, or use other equity financing methods. 

Equity financing is a method 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. 

Several types of equity financing exist for starting 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 the date 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. 

Small Business Investment Companies

The Small Business Administration (SBA) licenses and regulates a program called Small Business Investment Companies (SBIC) that it has licensed to provide funding to small businesses.

This method is generally well known. As such, it is a competitive method of funding, which can elongate the process of securing small business equity financing.

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

Angel Investors for Equity Financing

Angel investors are usually investors with a significant amount of assets that provide financing for startups. They are wealthy individuals or groups who are looking for a high return on investment and are very stringent about the businesses in which they invest.

Some angel investor groups actively seek early-stage companies for investing in and provide technical and operational knowledge to startup ventures. 

Mezzanine Financing

Mezzanine financing is a combined form of financing that utilizes both debt and equity. The lender makes a loan and, if all goes well, the company pays the loan back under negotiated terms.

In a mezzanine debt, the lender can make terms such as financial performance requirements for funding. This could be a operating high cash flow ratio (ability to pay off current debts), or a high shareholder equity (value for shareholders after debts are paid).

One benefit for borrowers is that a mezzanine loan 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.

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 capitalist firms provide funding in exchange for ownership, or shares, of your business. Venture capitalists are looking for high rates of return where they invest their money.

Unlike angel investors, they don't use personal funds for investing in startups. 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. This is an older approach, as most have have transitioned to a mentoring approach to assist with investment growth.

If you are considering venture capitalists, look for firms or individuals that are interested in helping your business grow.

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 in that generally 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. They provide upfront cash for business expenses in return for a percentage of the revenue.