6 Types of Equity Financing for Small Business
Avoid Loans and Credit Debt by Financing With Equity
These days there are several ways to raise money for a small business. Many business owners take out bank loans, while others borrow from family or friends. In some cases, entrepreneurs look to credit cards, peer-to-peer loans or crowdfunding to provide the necessary funds to get started.
Small companies that are likely to make a significant profit in a relatively short amount of time with appropriate up-front capital, are often eligible for equity financing.
Equity represents the ownership stake that both the business owner and other investors have in a company. Equity financing involves raising money through investors. When a business owner uses equity financing, they are selling part of their ownership interest in their business.
Investors are actually buying a share of the company in exchange for a percentage of its future proceeds. In other words, investors believe the company has the potential to make money, and they are expecting a return on their investment at some point in the future.
Several possible types of equity financing or investment exist to help out small, growing companies, such as the following list.
For business owners who have strong family ties or social networks, it may make sense to ask close contacts for investment funding. This type of funding, while relatively common, can be risky, especially because you are putting a relationship at risk if you cannot pay the loan back at some point.
Before asking for funding, it's important for the business owner to feel comfortable with the idea that a friend or family member might lose money.
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. While this type of funding is very competitive, it has looser underwriting requirements than venture capital and can be a great way to get needed funding.
Angel investors can provide second-tier financing to businesses. 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 groups, such as Southern California's Tech Coast Angels, have over 300 investors, actively seek early-stage companies for investment, and also provide technical and operational knowledge to startup ventures.
Mezzanine financing is actually a hybrid form of financing that utilizes both debt and equity. The lender makes a loan and, if all goes well, the company simply pays the loan back under negotiated terms.
If, however, the company does not succeed, the lender has the right to convert their loan into an ownership or equity interest. This approach allows the lender to have a claim to any future profits and protects the lender from the reality that most small businesses do fail. At the same time, it allows the business owner to keep 100 percent ownership of their own business for as long as the business is profitable.
If you get a venture capitalist interested in your business, you will give up a portion of your ownership and will probably have a representative of the venture capital firm on your Board of Directors. Venture capitalists are looking for high rates of return where they invest their money. Unless your business can offer them a high rate of return, they will probably not be interested.
Royalty financing is an equity investment in future sales of a product. It is a less formal process than angel or venture capital investing. Similar to a loan, it involves a funder providing up-front cash for business expenses; the funder is then paid a "royalty" when profits start to roll in, such as a percentage of each sale. According to Inc.com:
Royalty financing arrangements offer a number of advantages to small businesses. Compared to equity financing, royalty financing enables entrepreneurs to obtain capital without giving up a significant ownership position in the company to outside investors. The founders of the company are thus able to preserve their equity position, which may help motivate them toward continued success.