Sometimes you need an influx of cash to launch or grow your business — equity financing is one way to do that. With an equity finance loan, you sell shares of your business in exchange for cash in hand to use for operations or growth. This type of financing can work well for small businesses and startups with little or no credit history or limited time in business.
In this article, we explain where to get equity financing, the pros and cons, and whether or not it could be right for your small business.
Major Sources of Equity Financing
Equity financing doesn’t look like a bank loan or line of credit (or debt financing), and you don’t go to a traditional financial institution, like a bank, to get it. So where do you turn to for equity financing? There are several avenues to explore when looking to raise money from equity financing for your small business.
Private Equity Investors
A private investor, also called an angel investor, has a large net worth and is willing to invest their money into a startup or business after deciding that they like the idea. They can include family members or friends. If you choose the individual investor route, it will likely take many investors to get the amount of working capital you need.
Angel investors often want to play an advisor role to oversee and assist with building and launching a business.
A venture capitalist is a type of equity investor and can be one person or a venture capital firm. They invest equity finance loans from a venture capital fund into businesses. Venture capitalists seek out businesses that have a lot of potential for growth. They have the money and willingness to invest, but may want to take control of your company.
Initial Public Offering (IPO)
Also called “going public,” pursuing an IPO means transforming your company from a private company to a public one. To do this, your business offers public stocks that shareholders can purchase.
However, this method can cost you a lot of time and money, and not everyone is eligible. Your eligibility depends on the industry your business operates in and your annual revenue. On the other hand, an IPO may give you more cash flow than other equity financing options.
Equity crowdfunding is crowdfunding for businesses. With equity crowdfunding, you’re selling future products or services. It can give you a much larger pool of investors than you could find on your own. Some popular platforms that offer equity crowdfunding are AngelList, StartEngine, and Wefunder.
Pros of Equity Financing
There are several positives of choosing equity financing over debt financing for your business needs, like:
- Built-in advisor. Investors often act as advisors to your business. Equity investors can offer their network, their lessons learned, and their expertise for you to learn from. Additionally, they will have skin in the game, so they will want to see your business succeed. Think of every episode of Shark Tank — each business that comes out with a deal also gets an advisor in their Shark.
- You won’t add on debt. Your business won’t take on debt when you use equity financing. Instead of owing on a loan or line of credit, you are selling a share of your company. With debt financing, you also may have to put down collateral — like real estate — to qualify for the loan. If you can’t keep up with your payments, you risk losing the collateral. This isn’t the case with equity financing.
- No monthly payments. You won’t have to make a monthly payment like you would with debt financing, and you won’t have an interest rate on the amount you borrow. The amount you make in payments on loans and other debts doesn’t depend on how well your business is flourishing, so even if you’re still struggling, you owe the same amount in repayment each month. Equity financing allows you to avoid monthly payments altogether.
Cons of Equity Financing
There are also several negative things to consider before choosing equity financing, such as:
- It can cost you down the line. You’re giving away a portion of your company when you turn to equity financing. If your company does well, it can cost you a lot of money because the equity investor owns a share of your future profits.
- You may not keep control of the company. If you give away 50% or more of your business, you are no longer in control. You won’t be able to decide the direction of your business or how it operates going forward.
- Additionally liability. Equity financing can create extra liability when you have investors who own part of your company. Their actions can affect your business.
How Does Equity Financing Work?
The process of equity financing may seem confusing, but we’re here to break it down for you.
If you’re looking for direct investors, you’ll first need to find them. Turn to family, friends, and colleagues, or one of the equity crowdfunding platforms we mentioned above. Otherwise, venture capitalists may be interested in funding you.
Then, potential equity investors would look into your company’s financials and your business plan, and may want to tour your business facilities. Once they’re on board, you’ll come to a mutual agreement on the following:
- The amount of money the investor will put in
- The number of shares the investor will get in the business (or the percentage of the company the investor will own)
- Special requirements from either party
The worth of your business, or its valuation, decides what percentage of ownership the investor gets in your company. It can be challenging for new entrepreneurs or small business owners to get a fair deal. If your business is high risk, you may be asked to offer preferred shares or convertible preferred stock.
Pro tip: Going public may not be the best route for most small businesses because you’ll have to qualify and pay your shareholders dividends, which can really eat into your profits.
4 Reasons to Use Equity Financing
Debt financing is often not an option for many small business owners because traditional lenders may see you as too risky. Your business may lack a substantial enough credit profile or you haven’t been operating for long enough. These are the most common situations that cause small business owners to turn to equity financing.
- When you’re launching a startup or small business
There is a huge learning curve to starting a business. Many potential investors want to work with new businesses from the ground up. They could provide you with enough cash flow to start your business and fund its operations, which could be a leg up when you’re buying equipment or opening an office.
- When your business is risky
Two factors can make a business high risk: the likelihood of success and the potential for illegality. A high-risk business either has a higher potential to fail than some businesses, like a restaurant, or it operates in an industry that’s prone to fraud, like gambling. Sometimes having an excellent credit score and perfect financials isn’t enough to get a loan for a business considered high risk. Equity investing can help you to tap into the money you need.
- When your business has a lot of debt
If you already have several loans and lines of credit, equity financing won’t add to that burden. Equity financing doesn’t count as business debt like loans or credit cards. Instead, raising capital through equity financing is an added resource and your business’s debt is a burden that the company’s board works to fix.
- When you need to enhance your business network
Bringing on investors can also be like bringing on business advisors that can help with your decision-making. If that’s what you need, it can be a huge help. Your investors will have a reason to care about the success of your company as well, because they have put their hard-earned dollars into it. Keep in mind, however, that equity financing isn’t the only way to build business connections.
What To Do Before Seeking an Equity Investment
Before choosing equity financing, research all your options to make sure it’s the right fit for your business. By signing up for a free Nav account, you can browse our lending marketplace with over 160 business funding options from more than 65 different partners. This marketplace can give you a broad idea of the types of financing your business could qualify for — and you may decide to pursue more traditional financing after all.
If you do decide to go after equity financing, first talk to a business attorney. An attorney that specializes in business operations can help you create clear guidelines and rules for each person’s role and responsibilities in the exchange, as well as help you hold onto control of your business after taking on investors.