What is Equity Financing?
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.
New or small businesses may find it difficult to get debt financing (get a bank loan) so they turn to equity funding. Equity financing often comes from non-professional investors such as family, friends, or employees. It can also come from professional investors known as venture capitalists.
In a nutshell, equity financing, or equity funding, is trading a percentage of a business for a specific amount of money. This form of financing enables a business to receive the capital needed without taking on additional debt. Outside investors will want to see an owner also investing their own money to show they are willing to share the risks. This is not to say that you being a personal guarantor is the same thing. That is debt you are guaranteeing, not that you have taken on. While it is possible to attract investors, the main source of equity financing is still family and friends.
Let's look at some of the positives of equity financing
- It's much less risky than a bank loan. In essence, you never have to pay the money back, just share in the profits.
- Investors are not looking for quick results A bank wants its money right away. At least payments and interest, that is.
- Helps your cash position. Since you are not making a monthly loan payment, you have more cash to use in the daily activities of the business.
- Since you are using investors, you may tap into a network of people to help.
- Probably the best one, if your retail store fails, you do not have to pay this money back. A bank does not care if the store is open or closed; they want their money. While this last one is not a favorite of your investors, it is a truth about the differences between equity financing and debt financing.
But it's not all good with equity financing. Here are some of the negatives:
- You now have "opinions" you have to deal with. With a bank loan, they never get to tell you what to do with the business. But with equity investors, they get a vote and often times they vote against your ideas.
- You are giving up ownership. Even though you're still the majority shareholder, you are giving away some control and even some profit each year as you now have to split the proceeds.
- Reporting is more critical and time consuming. Investors need a regular accounting of how their money is doing. Unlike a bank who only cares if the payments don't show up or you ask for more money, investors will want detailed looks into your business at all times.
- Investors can be bothersome. One of the business I owned had some equity investors in it. While it was great to not have to take on debt, I would constantly get calls from the investors asking question after question eating up a lot of my time. Even worse, was when they thought they had the next big idea and i had to hear it.
If you decide to go the equity financing route, the most important tip is to choose your investors wisely. Read the negatives above and make sure you are choosing the right partner. I have had way too many "silent" investors in my retail business through the year who were pretty vocal. Make sure you know their tolerance and expectations of returns clearly before starting. It will save you lots of hassle. The biggest lesson I learned is that while investors would say they were not looking for immediate results, they always did - and they wanted their money back much quicker than what we had agreed upon or discussed.
This can add tension to you and your relationship with them and that's why you want to be very clear up front about expectations.