The concept of equity financing is an avenue through which businesses make use of to raise capital, especially for start-ups that require funds or for businesses that desire to expand but are limited by funds.
This article focuses on what you should know about equity financing and where you can get it.
What Is Equity Financing?
Equity financing is the platform for businesses to raise funds through the process of selling shares in the business. Besides, equity financing is different from debt financing in which case the business gets a loan from a financial institution.
However, equity financing is used as seed money for new businesses or as an additional fund for established organizations looking to expand. So, a business gets this type of funding by selling shares of the organization in the form of stock, which means that the business must first be an incorporated entity. Therefore, every share stands for one unit of ownership of the business.
For instance, if a company has issued 1200 shares of stock and an owner has 600 shares, then it means the holder of the shares owns 50% of the company. However, business ownership becomes diluted when additional shares are released.
What Are The Sources Of Equity Financing?
Owners of new businesses usually put in their funds into the business. This capital comes from the sale of assets, personal savings, or even through inheritance. All these sources serve as equity financing for the start-up.
Other external sources of equity financing are;
Angel investors are people who provide funding at the early-stage of business with great potential. The term “angel” means it can be a friend, entrepreneur, a family member, or a retired venture capitalist who invests their money into businesses for the exchange of equity.
Angel investors assist young businesses to establish themselves in the market while monitoring the decisions like logistics, hiring, or any other thing they are experienced at. Also, they can provide all the needed capital or strategically issue these funds according to the growth of the business. Usually, the investment fund is not up to $500,000.
The venture capitals work collaboratively. It targets businesses with high potential and at the early-stage. They are professional investors that provide capital to selected companies. They invest only in businesses that are well-coordinated and highly competitive in a particular sector.
However, these capitalists insist on being active in the management of the company they invest in thereby maximizing their return on investment (ROI). The amounts invested usually exceed $1 million. Besides, they invest in a private business intending to make it a public company by offering shares on a securities exchange through Initial Public Offer (IPO). IPOs can offer good returns for venture capitalists. In 2012, Facebook IPO was one of the highest ever, realizing above $16 billion in equity.
These are democratic and social platforms where you can raise money for the business. It involves the coming together of angel investors to contribute funds for smaller businesses in the range of $1,000. This is done online by initiating a crowdfunding campaign through sites like AngelList or Crowdfunder in the US, and in Canada, you have Indiegogo or Kickstarter.
Family And Friends
If you don’t aim to get listed on the New York Stock Exchange, speaking with families and friends might be a sure way of raising equity financing. The professional and personal relationship between family and friends must be treated with care.
Terms and agreement of business between family and friends must be documented in a formal agreement which must be well-defined to prevent any confusion in the relationship.
Equity Financing For Start-ups
Raising equity financing for new businesses is more difficult than for established businesses requiring capital for expansion. According to Wells Fargo, 77% of start-ups’ funds for small businesses comes from personal savings. Therefore, a well-defined business plan is needed to attract investors.
So, making use of personal financing as equity financing in a business is required to attract other investors or lenders. So, if you are unwilling to invest your savings into the business, which would send a wrong signal to anyone thinking of investing in the business. Lenders and investors are interested in seeing an equity financing of about 25% to 50% from the business owner.
Demerits Of Equity Financing
It is time-consuming: A well-defined business plan and forecast is needed. This would explain to the potential investors that their investment in the business would be profitable and secured. Also, enough time is required in meeting and updating potential investors on the progress achieved.
Loss of control: Here, potential investors might be willing to be involved in key management decisions which might lead to a clash of interest in the running of the business.
Payment of legal costs: This would come into play even if you are raising funds from family or friends. Also, equity agreement must be checked by attorneys and both investors and the owner should be protected – all these come at some legal cost.
Merits Of Equity Financing
Credit Score is not considered: Equity financing is the better option even if you have bad credit or no credit at all. However, investors may want to find out about your score or credit history – a poor score, therefore, would not stand as a hindrance from working with them.
Working with a valuable partner: It gives the opportunity of having a close working relationship with investors. Oftentimes, these investors have knowledge that can be shared with the business. This kind of relationship is of great value to the business.
Open to flexible capital: This is one of the important things you should know about equity Financing. It gives money that does not have to be repaid over time. This would help to avoid regular payment of a loan, thereby allowing for flexibility when budgeting.
In conclusion, raising funds for small businesses can be accessed in different forms, whatever works for company A may not work for another company, therefore the need for debt and equity financing.