Equity financing takes place when a business owner sells a partial stake in the company to an investor. This allows the company to get quick access to cash, and the investor benefits by obtaining shares in a company that could potentially grow.
Keep reading to learn how equity financing works, and how it compares to debt financing.
What Is Equity Financing?
Equity financing is a form of financing in which a business owner trades a percentage of the business for a specific amount of money. For example, a business owner might offer 2% of their company in exchange for $20,000. This form of financing enables a business to receive the capital it needs without taking on additional debt.
- Alternate name: Equity funding
In theory, anyone can attract investors. However, in reality, the main sources of equity financing for many small businesses are family and friends.
How Does Equity Financing Work?
New or small businesses that don't have substantial revenue or assets may find it difficult to get a loan, or they prefer to avoid debt, so they turn to equity funding instead. Equity financing can come from family, friends, or employees. It can also come from professional investors known as venture capitalists.
No matter who the potential investor is, the process of closing an equity finance deal will vary from investor to investor. It's entirely up to the business owner and investor to strike a deal that feels fair to both of them. For public companies, this is a highly regulated process in which shares are offered on a public exchange. For small companies, the process can be more informal—though it should still include some sort of contractual agreement.
When seeking money for a retail business, an entrepreneur should consider the company's debt-to-equity ratio. That is the relation between dollars borrowed and dollars invested in the business. The more money owners have invested in their business, the easier it is to attract financing.
Pros and Cons of Equity Financing
Few strings attached
Expands your network
Gives up some ownership
Accounting and reporting become more important
Must deal with investor personalities and opinions
- Less risk: Equity financing is much less risky than a bank loan. Even if the business goes under and you lose all of the investor's money, you won't face any negative repercussions—at least not as a result of your equity financing. Investors can't expect any money from you and, since it isn't debt, it won't show up on your credit report.
- Few strings attached: Money received through equity financing is largely yours to use as you see fit. The money doesn't have to be repaid, and while investors would prefer to see the business thrive, there's no legal obligation for your business to do well. It bolsters your cash position without committing yourself to monthly payments.
- Expands your network: Since equity financing adds investors to your company, these investors may introduce you to a wider network of people that you could potentially tap for more help.
- Gives up some ownership: By obtaining equity financing, you are giving up some level of ownership. Even though you will likely remain the majority shareholder (depending on your situation), you are giving away some control and profit.
- Accounting and reporting become more important: Reporting is more critical when you have investors, and that makes it more time-consuming, as well. Investors need regular, reliable accounting of how their money is doing. Unlike a lender, which only cares about whether you're making loan payments, investors will want detailed insight into your business operations and financials.
- Must deal with investor personalities, opinions: Investors can be bothersome. They may disagree with the way you're running the business. These disagreements aren't simply fodder for personal issues—investors usually have voting shares. That means they can vote against your ideas at shareholder meetings.
Equity Financing vs. Debt Financing
|Equity Financing vs. Debt Financing|
|Equity Financing||Debt Financing|
|The person providing financing is known as an investor||The person providing financing is known as a lender|
|Repay in the form of shared profits||Repay in the form of regular loan payments|
|Relationship ongoing unless investor decides to sell their shares||Relationship ends when loan is repaid|
|Investor may become involved in the business||Lender never concerns itself with business operations|
Generally speaking, a company that needs cash has two options: equity financing or debt financing. Both strategies give companies a cash injection fairly quickly, but there are major differences between the two strategies. These differences largely boil down to this idea: equity gives up freedom in exchange for cheaper funding, while debt pays a higher cost in exchange for greater freedom.
Those who provide equity funding—the investors—have certain expectations about businesses they invest in. They want to carefully track how the business is doing, and they may want to influence decisions that the business makes.
Lenders—those who provide debt financing—have no such expectations. They only expect to receive loan payments. They don't care whether the business is doing well or not, they just want the monthly loan payment. Once you've finished repaying the loan, the lender ends the relationship and you no longer have any obligations related to debt financing (unless you want to take out another loan).
- Equity financing is when a business trades partial ownership for funding.
- Those who provide equity funding become investors who share in the profits and can vote at shareholder meetings.
- The opposite of equity financing is debt financing, which is when a business acquires funding by taking out a loan.