Equity Financing: What It Is, How It Works, and Why You Need It
How do you raise money to start your own business? You can borrow it, or you can sell off part of your company to investors. Equity financing, which involves selling shares of your business to investors, can be much easier and less risky than traditional debt financing, especially if you are trying to start a small business or if you don’t have enough collateral to qualify for bank loans. What are the advantages of equity financing? Is it right for everyone? What should you know before pursuing equity financing? Find out here.
What is Equity Financing?
Equity financing is the process of raising money by selling a percentage of your company to investors in exchange for equity. Startups use equity funding to pay for initial business expenses and fund future growth. As opposed to taking on debt financing or a bank loan, which requires repayment with interest, equity financing allows you to keep control of your company while also giving you the capital you need to grow.
How Does Equity Financing Work?
To raise equity financing, you need to find people who are willing to invest in your company. Often this is done through a formal process called an equity crowdfunding campaign. The more popular your idea is and the more well-known you are, the easier it will be to attract investors. Equity financing works by giving your backers ownership of the company. For example, if someone invests $1 million in your company and you earn $2 million that year from operations, then that person would get a 20% return on their investment (or $200K) via the shares allocated to them at the point of investment. Your responsibility as CEO of the company is to make sure that their investment pays off for them every year.
In some cases, startups can offer equity as part of their compensation packages to new hires, especially where they might not be able to offer the highest salary. If all goes according to plan, equity financing can help fuel rapid growth while providing financial returns for everyone involved.
There are three main types of equity funding: venture capital, private equity investments, and government funding.
Who Uses Equity Financing?
Companies of all shapes and sizes use equity financing to raise the funds they need to keep their business running. From startups with new ideas to existing businesses that are looking for expansion capital, there are many reasons why you might want to consider raising equity. Whether you're in the market for growth or stability, it's important to understand how your potential investors can help support your business.
Advantages vs. Disadvantages of Equity Financing
Equity financing provides you with an opportunity to raise capital from investors rather than taking out credit. The advantages include the ability to learn from your investors and their experience and open the door to a network of future investors who can help scale your company in the future.
There are some disadvantages, however. You will have less control over your company (your investors will have a say) and share the profit made with investors. It's also worth noting that a poor relationship with investors can also prevent you from accessing more investors in the future. A final drawback is the cost of finding equity financing- most people do not know where to start or how to find these investors. Raising equity finance can be done through different sources such as banks or other financial institutions, private individual investors or public crowdfunding sites.
Equity Funding vs. Debt Funding
In the simplest terms, equity funding is the process of raising money by selling a portion of your company to investors in exchange for cash. Debt financing is when you borrow money intending to pay it back. The difference between the two is that debt financing gives you an obligation to repay the money while equity funding does not and may include other conditions or perks. For example, equity funding often includes provisions for how much control investors will have over decision-making, while debt financing does not.
Equity financing can be used in different ways but there are a few times when it's most appropriate. Sometimes you'll need to raise money quickly and don't want to incur high-interest rates on debt finance, which might also require repayment after a short time frame. Other times you'll want less responsibility from investors so they can give feedback on decisions without fearing any repercussions from their involvement. Finally, if you're seeking long-term capital as opposed to one-time funds, equity financing could be the way to go because it allows businesses greater access to capital over time through reinvestment dividends.
Where Can I Find an Investor as a Start-up?
Raising capital from investors can be a challenging process, with the business concept, plan and research all being factors of whether or not a person or organisation will want to invest.
You can find investors in a multitude of ways, from asking friends and family to using online fundraising platforms and organising events. Read our article on where to find investors to find out more.
When do I raise money with crowdfunding?
Raising money through crowdfunding is an excellent option if you have a business that has already been created and you have a great idea to help it grow. Forms of crowdfunding include peer-to-peer lending, equity-based, reward-based and donation-based crowdfunding.
When considering equity investors, it's a good idea to set up some goals as to what you want from your investors (other than their funding); for example, do you want someone with expertise in the area of your business or someone exceptionally skilled at scaling? Your investors will have a say in how your company is run, so choosing investors that can offer a wealth of knowledge and experience will benefit you.
What to do once you have raised your first round of funding?
Now you've successfully raised your first round of funding, congratulations! Next, you need to start thinking about issuing equity, how you will manage that process, the KPIs you need to set up to ensure you're delivering on what you have promised and how you will communicate with your investors.
For more information on what comes next, read our guide on managing startup equity.