Raising capital for small business can come in many shapes and sizes. What works for one business may not work for another, which is why there is debt and equity financing.
Debt financing involves borrowing a sum from a lender that has to be paid back with interest, while equity financing is exchanging shares in your company for access to capital. Financing your business through an equity investment can provide terrific benefits in the form of expert advice and continued guidance.
In the next few paragraphs, we’ll learn more about what equity financing is, how it benefits you and potential investors, who should use it, the different types of financing, the pros and cons of equity financing and whether it’s right for you.
What Is Equity Financing?
Before defining equity financing, let’s start with equity. If a business were to be liquidated for whatever reason, the amount of money returned to a shareholder, minus any liabilities, would be representative of their equity.
In equity financing, business owners raise funds by selling their own shares of the organization. By selling a portion of their stake in the business, they gain access to capital to address immediate needs.
The Upside for Equity Financing Investors
Equity financing investors assume a great deal of risk; their only means of generating a return on investment is if the company either makes a consistent profit or if the business is sold.
Beyond gaining ownership as a shareholder of the business and the dividends from those shares, an equity investor also has a hand in making decisions concerning the future of your business. While they may not have the same voting rights as others (depending on their equity stake), they still have a say during
Typically, there are two types of stock that can be sold: common stock and preferred stock. When stock is being discussed publicly, the conversation usually is referencing common stock. Common stock provides investors voting rights as well as a claim on the business’s earnings or dividends. Companies like common stock since it allows them to issue different classes of shares to potential shareholders. For example, shareholders with Class A shares are more likely to have voting rights and higher dividends than Class B stock, which may come without voting rights.
The other form of equity a company can offer is known as preferred stock. Shareholders with preferred stock have rights to dividends but don’t carry any voting rights. Preferred shareholders hold higher claims on business assets than regular shareholders with common stock, meaning that in the event of liquidation, they hold pay off priority over other shareholders.
How these voting rights are dispersed depends on the type of organization you have. While S-Corporations and LLCs make your business more open to outside investments, a C-Corporation could be the best way to attract the investors you want. While S-Corps are capped at 100 owners, LLCs and C-Corps have no limitations on ownership, meaning they can exceed 100 shareholders.
LLCs and C-Corps are able to offer preferred stock, which pays higher dividends and puts stockholders at the top of the list in a liquidity event. Ultimately, based on your investors, you’re able to customize the kind of stock you issue.
Who Should Use Equity Financing
Any time you investigate raising capital for small businesses you should keep all of your options open. Naturally, there will be types that either won’t interest you or won’t be available for a variety of reasons.
The businesses that are the best candidates for equity financing are those who are:
- Looking to obtain massive growth
- Considering an Initial Public Offering (IPO)
- Unable to secure debt financing based on creditworthiness
- Uninterested in making monthly payments for access to capital
Of course, there are other reasons a business would want to use equity financing over debt-based financing but for our purposes, these are the main scenarios that matter to entrepreneurs.
The 4 Different Types of Equity Financing
Equity investments come in many forms.
Here are four of the most common:
Angel investors are individuals who fund early-stage businesses that show signs of great potential at scale. An “angel” can be a family member, friend, entrepreneur or retired venture capitalist investing their own funds into a business in exchange for equity.
One of the best examples of successful angel investment is when Peter Thiel became the first investor in Facebook in 2004. While they are typically wealthy entrepreneurs themselves, an angel investor is anyone providing your first infusion of capital into your business.
Also known as “private” or “seed” investors, an “angel” is mostly focused on helping a young business establish itself in the market while providing guidance around major business decisions, including product road mapping, hiring, logistics and anything else they may have expertise or experience in. An angel investor can either provide capital all at once or they can strategically disperse funds as dictated by the business’s growth.
Much like angel investors, venture capitalists (VC) are individuals who work collaboratively. One of the biggest advantages they offer is that instead of access to one investor’s expertise and experience, your business has an entire company dedicated to increasing its value.
While VCs will invest in any business they see an opportunity in, they mainly target early-stage businesses with high potential. Businesses exploring venture capital typically have more suitors than you may find with other forms of small business funding. For entrepreneurs looking to raise capital from a venture capital firm, the process is a bit similar to deciding to apply for a small business loan: you decide how much money you’re looking for and then begin shopping around for the best fit. The difference, however, is that you’re not negotiating payment schedules or interest rates, but instead how much equity you’re okay with parting with.
Venture capital is commonly distributed in “rounds”, with each series correlating with the growth stage of your company, beginning, naturally, with Series A. For many venture-backed businesses, the way most investors are repaid is through an IPO or
a large corporate acquisition. Perhaps the most recent example of this is Lyft’s March 2019 IPO, where the company went public. After making it to a Series I funding round, Lyft raised more than 2 billion dollars. They’ll use these funds to repay their investors and strategically invest in the company.
Friends and Family
Angel investors and venture capitalists are typically eager to invest in any business that could generate a significant return for them. However, these investors are usually seeking much larger growth trends and eventual payouts than anything many small businesses may be able to achieve or are, frankly, interested in.
If you’re not looking to be listed on the New York Stock Exchange, approaching your friends and family might be a more realistic place to start for equity financing. Given that your family and friends know and trust you and understand your passion for your business, they can be great sources of capital.
However, before you approach friends and family about the possibility of a potential equity investment, make sure the relationship (both personally and professionally) is treated properly. Even though you’re quite close with these people, there should still be a formal agreement in place that details all of the terms and agreements between your friend or family member and your business. This practice will keep things defined and hopefully prevent any confusion in the relationship.
To help you keep your relationships intact as you move into a business connection, we recommend the following:
Work With an Attorney
Operating within the letter of the law is a wise thing to do for any business dealing. It’s especially important to preserve relationships and clarify any potential confusion. To keep the friend and family theme going, if you have the luxury of having a personal relationship with a lawyer, ask them if they’d be able to work with you to properly draft legal papers for each investor agreement you enter into.
Understand Investor Expectations
It’s easy for relationships between family and friends to become strained when money is involved. Aside from having things detailed in writing, an easy way to address this is to ask and understand what your investors expect from this investment. For example, while your grandmother may be happy to invest money into your business without ever thinking or wanting a return, your college roommate is hoping to see a major profit in 6 years. Open communication is key to keeping everyone on the same page.
Lost in Translation
One thing neither you or those closest to you want to experience is an argument about intent. The best way to prevent disagreements is to mutually agree to language in your investor agreement. If, for example, you receive from a family member who later passes away, how will their equity stake be handled? It may not be a comfortable conversation but it’s crucial to be hashed out during the establishment of the relationship.
Vote or No Vote
By taking equity financing for your small business, you’ll naturally be opening yourself up to investors who will want to have their say. However, you’re only obligated to take their opinions into consideration, legally, if they have voting rights. If your friends and family are simply interested in supporting you or hoping for a return on their own investment without getting their hands dirty, offering Class B common stock is likely to be the best solution for everyone.
The basic premise of crowdfunding through sites like Kickstarter and Indiegogo is that they allow you to pitch your business’s idea, product or mission to individuals from your community, country or even across the world. Those interested are able to contribute small amounts of money to your goal, which often provides them exclusive access to merchandise, personal keepsakes and, usually, whatever it is your business is producing.
Crowdfunding platforms are a very social and democratic way of raising money for your business. It’s essentially a, “best idea wins” scenario that also allows you to promote your mission or product. The downside to crowdfunding platforms is that they are an “all or nothing” outcome. What this means is that if you’re unable to reach your goal, even only by a few dollars, you won’t receive anything.
With the right message and product, crowdfunding can be a ton of fun and wildly successful. Just be wary of setting your funding goals too high.
The Pros and Cons of Equity Financing
With all of the information we’ve learned, it’s good to break down the pros and cons of equity financing directly.
How to Tell If It’s Right for You
As you’ve gone through this blog, you should find yourself asking two questions: Do I want to have other owners in the business? Would having their advice and knowledge be worth a portion of my profits?
Before you agree to any investor relationship, review this checklist to determine if equity financing is best for you:
- Would you rather pay back a lending company over a period of time or share your profits until the relationship has ended?
- Are you comfortable sharing decision making with equity partners?
- Is your credit score below 520?
If you found yourself answering “no” to questions 2 and 3, a traditional term loan might be the best option for you. Instead of giving up a piece of your equity in order to buy inventory or expand your business, you would more than likely find a greater benefit in using debt financing over an equity investment. Regardless of your business’s unique qualifications, there are plenty of financing options available if you decide to go that route.
Of course, equity financing is still the best decision for many businesses to make. If your business has its sights set on big things, having the counsel and expertise of an investor who’s been there before will help guide you through the twists and turns of entrepreneurship, hopefully leading you to the greenest and most fruitful outcomes.