To make your business profitable, you need to raise money. Irrespective of whether you’re looking to start your venture or expand an existing business, capital is a fundamental requirement for all small businesses.
Raising capital for small businesses is a challenging task. Most business owners opt for the standard route of bank loans, which is expensive as well as challenging to obtain. A growing tribe of small business owners is opting for other specialized funding like equity financing. Here, in this guide, we take a look at the six popular types of equity financing available to small business owners and help you decide if that's the right option for you.
Before we get into the classification, here’s a quick introduction on,
What is equity financing?
Equity financing is a method of raising funds for your business from investors. In return for the capital provided by the investor(s), you offer them ownership of your business, in the form of shares.
To phrase it in simple terms, when you avail equity funding for your business, you are selling part of the ownership of your business.
Popular Types of Equity Financing for Small Businesses
Several types of equity funding are available to startups, small enterprises, and other mid-sized growing businesses. They are:
Initial Public Offering
Shortly known as IPO, it occurs when a business decides to “go public." Going public is the process when you make your company's shares available to all. Before the IPO, your shares are available only to specific groups of people, with whom you distribute it. After an IPO, the shares of your company are publicly traded on markets like NSE (National Stock Exchange) or the BSE (Bombay Stock Exchange).
If you wish to raise funds for your business with an IPO, you have to comply with the guidelines of SEBI (Securities and Exchange Board of India). SEBI is the regulator of the domestic market in India.
Once SEBI registers and approves your IPO, it provides you with a listing date. It's the date on which the shares of your business will become available. Once the shares are available, investors can purchase it, which, in turn, raises the capital of your business.
Handy Tips: For a successful IPO, your business has to work on creating awareness about the event. Publish a prospectus, generate publicity for the campaign on social media, etc. to attract investors.
Angel investors are individuals or groups of investors with a significant amount of assets. They usually invest in startups and have strict rules about the businesses they invest in. The majority of angel investors choose early-stage companies for investing in and provide operational and technical knowledge to the companies they invest in.
It's a type of financing that combines both debt and equity. In mezzanine financing, the lender provides a loan. If the company is profitable, the borrower repays the loan under pre-negotiated terms.
Here's how it works: The lender offers a business with a loan. As long as the business repays the loan, it's treated like regular business debt. You can retain full control over the company. However, if the business takes a downturn and is unable to repay the loan, the lender steps in and converts the loan into equity. It means the lender can take control over a portion of the company, claiming any future profits.
Mezzanine funding reduces the risk taken by the lender, thereby, they are more likely to lend to businesses. In mezzanine funding, the lender usually lays the terms for funding eligibility based on the financial performance of the business. Some of the common eligibility terms include:
Ability to pay off current debts based on high cash flow ratio
High shareholder equity
One of the biggest benefits of mezzanine funding for businesses is that it offers more value to borrowers than traditional loans. Also, since it's a combination of debt cum equity, it's considered as equity on the balance sheet. Hence, it reduces the debt to equity ratio of the borrower, thereby helping to attract other investors.
Venture Capitalist firms offer funding for small businesses and startups in exchange for ownership (a percentage of shares) of the company. Generally, venture capitalists look for high returns when they invest in a business.
The primary difference between venture capitalists and angel investors is that the latter uses personal funds for investing. Venture capital firms, on the other hand, have a dedicated fund to invest in startups. Also, VC firms may ask for a seat on the Board of Directors while investing in your business.
Instead of a board seat, most VC firms today take a mentoring approach assisting the operations of the business, they are investing in.
Handy Tip: If you are considering venture capital to grow your business, look for VC firms that are suited to the nature of your business. Since VC firms play an active part in the running of the business, firms that have prior experience in your niche/industry is an added advantage.
Also known as revenue-based financing, it's a type of equity funding where the investor gets a share of the future sales of the product. One significant difference between royalty financing and other types of equity financing is that to qualify for royalty financing, you'll have to generate profits from sales.
In this type of financing, investors expect to receive payments immediately after the investment. It provides upfront cash for business expenses, and in return, claims a percentage of the revenue.
Equity Funding from Friends and Family
As the name implies, in this type of funding, your business borrows capital from friends and family. It may not be the right option for all, as you need to have a social network with enough wealth to invest.
The biggest drawback of this funding choice is that it can jeopardize personal relationships if your business venture fails to turn profitable. The benefit of this method is that it’s easy to convince your friends and family of the merits of your business, thereby getting them to invest in your venture.
Is equity financing the right choice for your business?
There's no single answer that fits all. Equity financing is generally difficult to obtain compared to debt financing. The two popular choices of equity financing – angel investors and venture capital firms – usually invest only in startups that have considerable growth potential. If your small business is more locally-oriented and doesn't have global ambitions, then you are more likely to secure debt financing than equity financing.
You can opt for equity financing if:
Your business has significant growth potential.
You are looking for more than an investor. You wish for a mentor who offers guidance for your business.
You don’t mind giving up a percentage of ownership of the business.
Equity Financing may not work for all
However, if you feel that it’s the right fit for your business, make sure to explore the different types of equity funding available and choose the right one that works for you.