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Equity financing trades a percentage of a business’s equity, or ownership, in exchange for funding. Equity financing can come from an individual investor, a firm or even groups of investors.
Unlike traditional debt financing, you don’t repay funding you receive from investors; rather, their investment is repaid by their ownership stake in the growing value of your company. Equity financing is a common type of financing for startup businesses — especially for pre-revenue startups that don’t qualify for traditional loans — and businesses that want to avoid taking out small-business loans.
What is equity in business?
Business equity refers to the amount of ownership in a company or business, usually calculated as a percentage or by number of shares. For smaller private companies, equity is usually reserved for owners, investors and sometimes employees, while larger, publicly traded companies may also sell equity on the stock market.
Business equity is calculated by subtracting a business’s total liabilities from its total assets. For that reason, equity reflects a business’s value and indicates to shareholders the business’s overall financial stability.
» MORE: What is an equity injection?
How does equity financing work?
The process of getting equity financing will vary depending on the type of equity financing you’re looking for, your business and your investors. Generally, you can expect to follow these steps.
Gather documents
Before you start looking for investors, you’ll need documents like a business plan and financial reports, plus an idea of how much capital you need and what you will use it for. These are all things you’ll need to outline to a potential investor in your business pitch.
Find investors
If you don’t know investors or have potential investors in mind already, consider leveraging your personal or professional network to understand your options. You can also use online platforms to search for investors, or even check LinkedIn or attend local networking events.
Negotiate how much equity to give to your investors
Once you’ve found your investors, they may conduct their own business valuation, whereby they determine the potential value of your business to decide how much equity they want for their investment. Factors like business stage, amount of risk based on market trends and expected return based on financial projections will influence this negotiation. Angel investors may request 20-25% for example, while venture capitalists may want up to 40%.
Use funds
Once you’ve negotiated a price, the cash you receive from investors may be used for product development, new hires, debt refinance or working capital.
Share profits
Once your business starts making money, your investors will be entitled to a portion of your profits depending on how much equity they have in your business. This percentage will be paid to your investors in dividends within a predetermined time frame. If your business fails to make money, original investments do not have to be repaid.
» MORE: Debt vs. equity financing
Pros and cons of equity financing
Pros
No repayment terms. Strictly speaking, you don’t “repay” an investor in your company the way you would a lender. Instead, the initial investment is repaid by the prospect of the future value and profits of your business. While loans can be a great way to fund your business, not having monthly or weekly payments can be very beneficial to startups or businesses that are focused on growth.
Access to advisors. Most investors have invested before, and have likely even run their own businesses, which can make them a good resource as you navigate the ups and downs of running your business. Plus, because they have money invested in your business, your investors will have a special interest in helping your business succeed.
Larger funding amounts. You may qualify for larger amounts of financing with equity investors than with debt financing, especially if you’re a startup business. In addition, if you end up needing more money along the way, an investor may provide additional injections.
Alternative qualification requirements. Rather than business revenue or personal credit, investors will typically look at things like your business idea’s potential and your character.
Cons
Loss of ownership. Any time you receive an equity investment, your percentage of ownership in the business will decrease, which can affect your share of any future profits and value.
Loss of control. When you hand over ownership, you may also be handing over some control of your business, which can become problematic if you and your investors don’t see eye to eye.
Usually for high-growth, high-potential businesses. Equity financing is usually tailored for fast-growing businesses with high growth potential, which means many small businesses won’t be the right fit for this type of financing.
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Common types of equity financing
Angel investing
Angel investors are high-net-worth individuals, most often accredited, who invest their own money in startups or early-stage operating businesses. It is possible to find angel investors through platforms like the Angel Capital Association or AngelList, but they can also be personal acquaintances or members of your professional network. Angel investors are a good option for business pitches or pre-revenue startups because they are often experienced individuals who can provide guidance in addition to funding.
Venture capital
Venture capital (VC) is a type of equity financing that’s similar to angel investing, but instead of wealthy individuals, VCs are usually investing on behalf of a venture capital firm. In general, VC can be a little more difficult to qualify for, and firms usually get involved after angel investors have already made initial investments. VC may be best fit for early-stage, high-growth businesses that have started operating already.
Equity crowdfunding
Equity crowdfunding is a form of equity financing that draws on groups of online investors, some accredited and some not, to fund businesses. Crowdfunding platforms allow potential investors to learn about businesses or business pitches through online profiles created by the business owners. Some may find less pressure in raising capital on crowdfunding platforms, which may make equity crowdfunding a good option for less experienced entrepreneurs or smaller businesses. However, online investing poses additional risk of fraud, so you want to be diligent about the platform you use. In addition, issuing more shares, however small, may dilute your ownership and increase costs more than using an angel investor or VC.
Alternatives to equity financing
Small-business loans. Small-business loans are a common type of debt financing, and a fair alternative to equity financing. Loans can be either term loans or lines of credit, and may come from banks, online lenders, credit unions or nonprofit lenders like community development financial institutions (CDFIs).
Small-business grants. If you want to avoid taking on debt and keep control of your business, and you don’t need a ton of funding, consider looking for small-business grants instead. Grants can be tricky to find and usually don’t fund in large amounts, but they can be worth it for funding that you don’t need to pay back.
Self-investing. Tapping into your own savings can be a way to maintain full ownership of your business and avoid paying any interest. However, you risk losing your savings if your business fails, so it’s best to seek the advice of a financial professional to determine whether this option is right for you.
Friends and family. If you have friends or family members you trust and who support you and your business, they may be willing to provide funding. Though this may feel less formal than receiving funding from a bank or other financial institution, you should still create a contract that details the terms of the business loan from your friends or family.
» MORE: How to fund your business idea
