Equity financing is one of the most common ways for businesses to raise capital. It’s an attractive alternative to taking a loan. Here, in this guide, we take a look at how equity financing works, the different types, and help you decide whether you should opt for it or not.
What is equity financing?
Equity financing offers investors ownership in a business, in return for the cash they invest in it. The company provides a percentage of its ownership to the investor in exchange for the capital invested.
In equity financing, investors take a risk. If the business doesn’t perform well, they are likely to lose their investment. Equity financing is different from regular loans, where the business repays the creditor/lender based on the terms of the loan agreement. In equity financing, the business owner does not repay the money but offers ownership in the business based on the amount invested.
How does it work?
Equity financing is one of the most common ways for businesses to raise capital by selling shares in the company. Generally, equity financing is used in two ways:
To raise capital (seed money) for business start-ups
As an additional capital for an established business, that is looking to expand
Before a company can apply for equity financing, it has to be incorporated. Once a company is incorporated, it can begin selling shares. Generally, each share represents a single unit of ownership. To give an example, let's state that a company has 1000 shares of the common stock. If an individual A has 500 shares of the company, then he/she owns 50% of the company. Now, let's assume that the company issues 200 additional shares. Now, individual A's ownership is diluted as it falls to 41.66%.
Besides voting rights in board meetings, shareholders (in this case, equity financing investors) benefit from the dividends distributed by the company. They also can sell the shares at a profit.
Unlike debt financing, where the lender is assured of the amount he lends, equity financing does not offer any guarantees. Since there is a high level of risk involved, investors expect a high rate of return.
Very often, bigger companies have multiple classes of shares to appeal to different investors. These shares have different prices and benefits. Here is an example of various levels of shares:
Share class A – voting rights and dividends
Share class B – no voting rights and no dividends
Preferred shares – no voting rights and only dividends
Generally, preferred shareholders have a higher claim on assets, compared to regular shareholders when the company is dissolved. To give an example, holders of share class A have higher benefits compared to holders of share class B.
Additional Reading: Types of Equity Financing
Is equity financing the right option for your business?
Businesses from different industries and different sizes can benefit from equity financing. Unlike debt financing, you don't have to pay your equity financiers with regular payments. Instead, your equity financing investors are looking to capture profits from your business due to special events like business expansion, new product launches or public offerings.
If you are unsure whether equity financing is the right choice for your business, make sure to consider the following:
Your company has the potential to scale profits quickly, with the help of the investor's capital.
You are ready to include the investor as part of your business decisions in the future.
You look at the investor more than a means to attain capital. The investor can help you guide your company in the future.
Check out the pros and cons of equity financing to decide if it’s the right choice for you.
Advantages of Equity Financing
No regular repayments – It's one of the significant benefits of equity financing. You don't have to repay the loan to your investors as regular monthly payments. Instead, you have to share the profits with the investor on a percentage basis.
Get expert guidance – Very often, equity investors (especially angel investors) offer you expert advice and guidance to help your business grow. It’s like bringing on-board a consultant to help channel your business in the right direction.
Easy to find investors – You can also bring friends and family members as equity financing investors. This way, you can quickly find investors without having to demonstrate your business plan to several third-party lenders.
Disadvantages of Equity Financing
It can ruin relationships – If you receive capital from friends and family, but are unable to provide them with a return on their investment, it can create tension in your relationships.
Finding the right equity investor is a challenge – An equity investor has a close working relationship with your business. The role of an equity investor is not complete with lending the capital. Hence, finding the right investor who matches the wavelength of your business can, at times, be a huge challenge.
You lose ownership of a part of your business – When you find an equity investor, you give up a part of the ownership of your business. Essentially, you lose exclusive control over the decisions of your business.
Raise Capital with Equity Financing
Equity financing is an excellent alternative to debt financing, provided you have the right type of investor. Understand the benefits and working of equity financing and partner with the right equity investor to boost your capital and expand your business.