Equity financingis a tactic businesses often use to raise funds, especially in the case of startups that are in need of cash or businesses who are looking to expand but don't have the capital to do so.
There are a few things small business owners should know about equity financing before seeking to secure it.
What Is Equity Financing?
Equity financing is a common way for businessesto raise capital by selling shares in the business. This differs fromdebt financing, where the businesssecures a loanfrom a financial institution.Equity financing is typically used asseed money for business startupsor as additional capital for established businesses wantingto expand.
A business normally obtains this type of financing by selling shares of the business in the form of common stock, which means that the company must be incorporated first. Typically, each share represents a single unit of ownership of the company. For example, if the company has issued 1000 shares of common stock and Owner A has 500 shares, then Owner A owns 50% of the company. Ownership in a businessis diluted whenever additional shares are issued.
Benefits for Investors
In addition to voting rights, shareholders benefit from share ownership in the form of dividends and (hopefully) eventually selling the shares at a profit. Given the high level of risk in providing equity financing tosmall businesses, equity investors expect a very high rate of return.
Larger enterprises often have multipleclasses of equity shares(each with a different price per share) to appeal to investors who have different financial objectives. For example, a company may issue:
- A class shares (voting rights and a dividend)
- B class shares (no voting rights and no dividend)
- Preferred shares (dividends but no voting rights, as well as a higher claim on assets than regular shareholders of the company is dissolved)
Share issues are often structured so that a single owner or group of owners have control of the company. For example, Facebook Class B shares have more voting rights than Class A shares, and since Mark Zuckerberg has a large percentage of the Class B shares he retains voting control.
Sources of Equity Financing
New business owners typically invest their own funds into their businesses. These funds often are gleaned from inheritance, savings, or even the sale of personal assets, which then serves as equity financing for the business.
Outside sources of equity financing include:
- Angel investors: These are usually wealthy family or friends of the business owner(s) who provide financial backing for small businesses. Typically, the amount invested is less than $500,000, the terms are favorable, and the investor does not get involved in the management of the business.
- Venture capitalists: These are professional investors who provide funding to select businesses. They are very choosy about investing only in businesses that are well managed and have a strong competitive advantage in their particular industry. Venture capitalists normally insist on taking an active role in managing the companies they invest in and are strictly interested in maximizing the return on their investment. Amounts invested are generally greater than $1 million. Venture capitalists typically invest in a private business with the goal of eventually transforming it into a public company by offering shares on a securities exchange via an Initial Public Offering (IPO). IPOs can generate huge profits for venture capitalists—Facebook's IPO in 2012 was one of the biggest IPOs in history, raising over $16 billion in equity.
- Crowdfunding: The process involves using large groups of angel investors to contribute funding to smaller businesses in amounts as small as $1,000. Fundraising is conducted online by starting a crowdfunding "campaign" via one of the crowdfunding sites such as Crowdfunder or AngelList in the United States and Kickstarter or Indiegogo in Canada.
Equity Financing for Small Business
Obtaining equity financing is more difficult for startups than for established businesses needing funds to expand. Wells Fargo found that 77% of small business startup funding comes from the personal savings of the owners. In either case, having a solid business plan in place is a must for attracting investors.
Making a personal investment that serves as equity financing in a business is often necessary to attract other investors and/or lenders. If you, as the small business owner, are not prepared to put any of your personal funds into the business, what does that say to anyone else who might be thinking of investing in the business—or that you're asking for a business loan? Investors and lenders like to see an equity financing contribution of 25% to 50% from the owner.
Disadvantages of Equity Financing
Aside from dilution of shares, equity financing has other drawbacks:
- Potential loss of control: Investors may wish to be involved in management decisions, which can lead to conflict if there are disagreements in how the business is run.
- It's a time-consuming process: You will need to provide detailed business plans and forecasts that clearly demonstrate to potential shareholders that their investment in your business will be secure and profitable. You will also have to devote time to meeting with and updating shareholders on an ongoing basis.
FAQs
When companies sell shares to investors to raise capital, it is called equity financing. The benefit of equity financing to a business is that the money received doesn't have to be repaid. If the company fails, the funds raised aren't returned to shareholders.
What is equity financing in simple words? ›
Definition: Equity finance is a method of raising fresh capital by selling shares of the company to public, institutional investors, or financial institutions. The people who buy shares are referred to as shareholders of the company because they have received ownership interest in the company.
What is an example of equity finance? ›
Equity financing involves selling a portion of a company's equity in return for capital. For example, the owner of Company ABC might need to raise capital to fund business expansion. The owner decides to give up 10% of ownership in the company and sell it to an investor in return for capital.
Where is equity financing obtained from? ›
Equity financing is when you raise money by selling shares in your business, either to your existing shareholders or to a new investor. This doesn't mean you must surrender control of your business, as your investor can take a minority stake.
What credit score is needed to get an equity loan? ›
Many lenders require a minimum credit score of 620 to qualify for a home equity loan. However, to receive good terms, you should aim to have a credit score of 700 or higher.
What disqualifies you from getting a home equity loan? ›
Past Bankruptcy or Foreclosure. Having a bankruptcy or foreclosure on your short- to mid-term credit history will likely make it difficult to qualify for all types of loans, including HELOCs. These marks against your creditworthiness are not permanent, but they also don't vanish overnight.
What is the disadvantage of equity financing? ›
Equity Financing also has some disadvantages as compared to other methods of raising capital, including: The company gives up a portion of ownership. Leaders may be forced to consult with investors when making a decision. Equity typically costs more than debt financing due to higher risk.
Which is cheaper, debt or equity? ›
Since Debt is almost always cheaper than Equity, Debt is almost always the answer. Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders). The risk and potential returns of Debt are both lower.
Why is equity financing expensive? ›
The Cost of Equity is generally higher than the Cost of Debt since equity investors take on more risk when purchasing a company's stock as opposed to a company's bond.
How to choose between debt and equity financing? ›
Key Takeaways
Debt financing could save money but demands collateral and returning the money soon. Equity financing removes payback worries but may reduce your control and ownership. Traditional loans offer better rates compared to expensive merchant cash advances.
Unlike debt financing, where there is an obligation to repay the loan, equity investments are permanent and do not require repayment in the traditional sense. Investors expect to see a return on their investment through profit sharing, but there is no set timeline for repayment.
What is equity in finance for dummies? ›
Equity can be defined as the amount of money the owner of an asset would be paid after selling it and any debts associated with the asset were paid off. For example, if you own a home that's worth $200,000 and you have a mortgage of $50,000, the equity in the home would be worth $150,000.
How can I get equity financing? ›
Equity financing is used when companies need to raise cash. It is accomplished by selling a portion of the equity in a company through shares. Equity financing can come from friends and family, professional investors, or an initial public offering (IPO). Debt financing involves borrowing money.
What is the most common form of equity financing? ›
Here are some common types of equity financing:
- Common Stock. Common stock is the most typical form of equity financing. ...
- Preferred Stock. Preferred stock is another form of equity financing. ...
- Private Equity. ...
- Venture Capital and Angel Investors. ...
- Crowdfunding.
Types of equity financing could come from angel investors, venture capital firms, private individuals, or even from IPO. For startups and brand new businesses angel investors and private individuals tend to be the more common sources of equity.
How are you able to get an equity loan? ›
Lenders have different requirements for home equity loans, but generally, the standards include: Credit score: Mid-600s or higher. Home equity: At least 20 percent of home's value. Employment and income: At least two years of employment history and pay stubs from the past 30 days.
Do banks give equity loans? ›
Can any bank give you a home equity loan? No, not all lenders offer home equity loans — even if they offer mortgages. Some prefer to stick to purchase loans or refinances. Still, many banks, credit unions, mortgage lenders and online-only lenders do offer home equity financing to qualified borrowers.
Are equity loans easy to get? ›
It is fairly easy to get a home equity loan, as long as you meet a lender's eligibility requirements. Credit unions, banks, and online lenders all have different loan requirements for borrowers, including a minimum credit score, a sufficient debt-to-income (DTI) ratio, and home equity of at least 20%.
