From time to time, business owners need a quick infusion of capital to execute specific operations that can potentially create impressive results in the long run. Such operations may include starting a new line or product, expanding to new geographical locations, or increasing production capacity. Equity financing is one of the major ways companies raise the money they need. The other means is through debt financing.
But in this post, we’re going to explore what equity financing is all about.
What is Equity Financing?
Equity financing is the process of raising capital through the sales of shares of a company. Companies sell shares so they can raise money to cater to short-term needs like paying bills or long-term needs like investing in growth. By selling shares, they lose part of the ownership in their company to investors in exchange for cash.
Let’s consider a simple example. A business owner might offer 5% of their company in exchange for $50,000. This provides cash to the business owner without taking on additional debt.
Sources of Equity Financing
New business owners typically invest their own funds into their businesses. These funds are collected from saving, inheritance, or even sales of personal assets. In a sense, this amount they’ve sacrificed serves as equity financing for the business. But as the business grows, financial requirement begins to skyrocket and business owners typically turn to different sources based on the stage they’re in.
- Angel Investors
These are typically wealthy family, friends, or community members, who can provide financial backing for your enterprise. In return, the gain some ownership in the business. In most cases, angels investors are not active in the day-to-day operations of the business but they can provide advice to the owner. Amount invested is typically less than $500,000.
- Equity Crowdfunding
This involves a large group of angel investors contributing funds to small businesses. Each investor can put amounts as low as $1,000 into the venture. A good way to think about it is when people invest in an early-stage unlisted company (a company that is not on a stock market) in exchange for shares in the company.
- Venture Capitalists
These are professional investors that meticulously select businesses they wish to invest in. They review businesses and determine their competitive edge and likelihood to succeed. The goal of venture capitalists is to invest in businesses that will maximize their return in a short time. Typically, the amount invested is more than $1 million.
- Initial Public Offering (IPO)
An IPO refers to the process of offering shares of a private corporation to the public in a new stock issuance. For venture capitalists, the goal is usually to transform the company they’ve invested in into a public company. IPOs help generate huge profits for venture capitalists and also raise new funds for the business.
Pros of Equity Financing
Here are some of the pros of equity financing:
- Less risk
Equity financing is less risky than debt financing. Even if the business ends in disaster, you don’t have to worry about paying back your investors. Similarly, it won’t show up in your credit report because it isn’t debt. The reward the investors get from investing in you is the equity they receive. If the business succeeds, they stand to benefit greatly.
- Few strings attached
For the most part, you are free to spend the money you receive from investors as you deem fit. Furthermore, there’s no legal obligation for your business to succeed. Not having to make monthly payments (as in debt financing) gives you peace of mind.
- Expands your network
Investors generally bring expertise that you can tap into. They provide advice that can be invaluable. Furthermore, they usually have a wide network of people that can potentially help in the future.
Cons of Equity Financing
Here are some of the drawbacks of equity financing:
- Gives up some ownership
Anytime you obtain equity financing, you have to part with some level of ownership. While you may remain the majority shareholder, you are losing some of your control and profit. In specific scenarios, you may lose your status as a majority shareholder, thereby watering your power in the company you started.
- Interference from Investors
Investors may have conflicting views on the actions you deem to be appropriate for the company. Since investors have voting shares, they can vote against your ideas at shareholder meetings (unless you retain majority control).
- Accounting becomes crucial
Since you’re no longer the sole owner of the business, you become accountable to your investors. You have to adequately report the regular reliable account on how investors money is doing. Creating detailed insights and financials is usually a time-consuming process.
We understand financing anything can be a nuanced maze full of complex legalities. One question can easily turn into four others. We’re here to help. Contact us here today for more information.