Equity Financing for Your Business
Equity financing is provided by individual and group investors rather than banks or other financial institutions. Early-stage businesses with potential for growth may want to consider equity financing as an option when looking for funding to expand.
- Equity financing refers to selling a percentage of your business’s future profits in exchange for upfront funding.
- Equity financing is often provided by angel investors or venture capitalists, but friends, family members and colleagues could also invest in your business in exchange for equity.
- Unlike traditional loans, you don’t have to repay the funds you receive from equity investors. Instead, the investors get a percentage of ownership in your company, earning them a share of the profits as your business grows.
What is equity financing?
Equity financing is a way to generate funds for your business through the sale of company shares, including common stock and preferred shares. With equity financing, startups and recently established companies with limited cash can approach wealthy individuals or investment firms to see if they want to back their great ideas.
You can seek equity financing from individual or angel investors, as seen on the popular show “Shark Tank.” You can also raise funds through a crowdfunding platform or with a venture capital firm.
While you don’t have to repay the funds like with small business loans, you do have to give up a percentage of ownership in your company. However, you also gain expert knowledge from your investors when you bring them on board, which can help strengthen your business model.
How does equity financing work?
With equity financing, you sell a portion of ownership in your company for funding. This is often a permanent decision, as unlike a business loan, there’s no set end to the business arrangement. Investors will typically remain partial owners of your business unless you eventually buy them out or sell the company.
If you find angel investors, venture capitalists or other individuals that are willing to invest in your business, you’ll need to make a mutual agreement and formalize it in writing. This begins with a term sheet — a non-binding agreement that outlines the number of shares and total percentage of ownership the investor will receive in return for a set amount of funding.
Once all the terms are set, you’ll finalize the deal with legally binding documents that might include a share subscription agreement, which formalizes the share purchase, and a shareholder’s agreement, which details the rights, responsibilities and obligations of the investor. A business attorney can help you understand the documents you may need. After both parties have signed these agreements, you’ll typically receive funds in a lump sum and pay your investors the agreed upon percentage of your future profits.
Types of equity financing
Individual investors
You can ask your friends, family and colleagues to contribute funds to your business in exchange for a share of equity. Since each individual will likely contribute a small amount, you may need to recruit multiple investors to reach your funding goals.
Individual investors may not have experience in your field or the relevant business skills to help provide support along the way. And, depending on the amount of equity they contribute, some investors might consider themselves partial owners of the business and expect a say — or even equal vote — in business decisions.
Carefully consider — and discuss — exactly what an equity stake would look like before taking on investors. And keep in mind that you could risk straining close relationships if your business doesn’t succeed, especially if they invested a significant amount.
Angel investors
An angel investor is typically someone with a lot of wealth who helps fund startups — as long as they have potential for high returns. Often, angel investors have experience in the same or related fields and can offer guidance and support to ensure your business succeeds.
You can search for angel investors through your professional network or use a platform like AngelList or the Angel Capital Association.
Venture capitalists
Venture capital financing is similar to angel investing, but with funds coming from a firm instead of individuals. Venture capital (VC) investors typically require at least 20% ownership in your company and will have a say in business decisions. But they also act as a strategic advisor, helping connect you to industry experts to take your business to the next level.
While angel investors like to support early startup businesses, VC is generally reserved for businesses that are established but still growing. If your company is too young, a VC firm might worry about its long-term potential.
Equity bridge financing
Bridge financing, or a bridge loan, can be used to cover urgent funding gaps while a company waits to secure long-term financing. If you don’t want to take on debt with high interest rates, you could consider equity bridge financing with a venture capital firm.
With this option, the investment firm provides financing for a specified period in exchange for equity ownership in your business. The timeframe for funding can range from several months to a year, although the firm will keep ownership after the funding period ends.
Venture capital firms may take the risk to help a struggling business if they see a strong potential for growth, as this can indicate a higher return on their investment.
Crowdfunding platforms
Crowdfunding for business involves creating a public fundraising campaign to collect donations from friends, family and the general public. Popular crowdfunding platforms include Fundable, Kickstarter and Indiegogo. EquityNet is another crowdfunding site, though it primarily focuses on connecting you with accredited investors like venture capitalists and angel groups.
While you don’t need to repay the donations you receive, some platforms require you to give something in return, such as discounted rates, VIP access to events or even equity in your business. Additionally, most crowdfunding platforms deduct a small fee for their services and some will only release the funds if you meet your goal.
Initial public offerings (IPOs)
Bigger companies with a solid track record can consider raising capital through initial public offerings (IPOs), which is where you sell company stock to the general public. However, businesses typically need to operate for around eight to 10 years before exploring this option.
Smaller companies wanting to sell stock shares can start by offering over-the-counter (OTC) stocks on the Pink market. This is a trading platform for stocks not listed on the major exchanges. Keep in mind that you usually need some shareholders on board before offering any type of IPO and that it may require extensive paperwork and legal requirements.
If your business needs funds, two popular financing options include debt financing and equity financing.
With debt financing, you borrow a set amount of funds from a bank, credit union or alternative lender. The most common forms of debt financing include small business loans and lines of credit. The lender doesn’t have any stakes in the company. Instead, you simply repay the debt with added interest.
Equity financing, on the other hand, involves selling a portion of your company’s equity in exchange for capital. For example, you could sell 20% of ownership in your business to an investor to help fund a major expense or expansion. The investor will then own 20% of your company and can contribute toward making key business decisions.
There are many advantages to each type of financing, with many companies using a combination of both as they see fit.
Pros and cons of equity financing
Pros
-
No interest charges or repayment terms.
Unlike traditional business loans, you don’t need to repay equity financing with repayment terms or accrued interest. Instead, investors take a share of your company’s profits. -
Access to experienced industry leaders.
Since investors have their own money tied up in your business, they’re typically motivated to do all they can to ensure your business succeeds. -
Higher funding amounts.
While banks and alternative lenders typically have borrowing caps, there’s no set limit to how much you could receive via equity financing. Additionally, your investors may provide additional funds along the way, especially if you continue to show steady growth. -
Flexible qualification requirements.
Some investors will review your credit history, while others may be more interested in your business’s potential for success and growth.
Cons
-
Sharing control with investors.
A company share comes with partial control of the company, which means as shared business owners, your investors have a say in your business’s future decisions. This can be a challenge if you and your investors aren’t on the same page. -
Can be more expensive than borrowing.
If your company hits it big, you could end up giving away a significant portion of your profits. Meanwhile, a traditional business loan has a predetermined interest rate and once the debt is paid off, you’re done. -
Must have a business that shows high growth potential.
Investors are more likely to hand money over to a business that shows signs of steady growth. This means some startups and slowly growing businesses won’t qualify.
How to get equity financing for your business
1. Decide how much you need
Look at your business budget and calculate your most immediate funding needs. If the amount is relatively small, you might find it easier to apply for a small business loan. However, investors could be a better fit if you need a significant amount of money or access to ongoing funding. Just keep in mind that it will take longer to raise funds.
Your investor will want to know how much you need and what you plan to use the funds for, such as building an expansion, upgrading equipment or branching out into a franchise.
2. Gather key metrics and documentation
Before you approach equity investors, you’ll need to prepare by gathering some key metrics, which investors will use to assess your business viability and potential for growth. The specific metrics investors want to see may depend on the business age and industry, but you can generally plan to provide the following:
- Total addressable market (TAM): Also known as the total available market, this quantifies the market opportunity, which can help potential investors understand the overall market demand and potential for growth.
- Revenue targets: If your business makes predictable monthly income, your monthly recurring revenue (MRR) might be the best metric to include, as it can demonstrate consistent results. If your business makes transaction-based income, sales forecasts can help you project future revenue.
- Burn rate: In addition to revenue projections and profit margins, investors want to understand how quickly your business is burning through its cash reserves. This metric tells investors how efficient you are with the funds you already have, and it can indicate how far you have to go to reach your goals.
- Customer acquisition cost (CAC): This explains the amount of money it takes to attract prospects and turn them into paying customers. A lower CAC typically means more efficient growth.
You’ll also need to have your business’s essential paperwork on hand, including financial documents that can prove the metrics and forecasts you’ve provided are accurate. While the required business documents will vary based on the investor or firm, here are some of the documents you might need:
3. Find investors
This is the trickiest step in the process: finding investors who are willing to take a chance on your business. If you don’t have any connections with investors in your personal or professional networks, you could look for potential investors through social media or through a pitch competition.
You can also try using an online platform or directory to find investors. Here are some of your options:
- Angel Capital Association: The ACA is a professional society of angel investors. It maintains a public directory of member organizations, which can point you toward angel groups, marketplace platforms and family offices you can contact to ask about investment capital.
- AngelList: This online platform connects startup founders with angel investors and incubators. It also helps streamline the paperwork process by allowing investors and business owners to sign essential documents directly in an app.
- StartEngine: This equity crowdfunding platform helps you raise capital for your startup business through a network of accredited and non-accredited investors.
- National Venture Capital Association: The NVCA is similar to the ACA, but its members include venture capital partnerships, corporate venture groups and growth equity firms. The NVCA member directory provides a list of VC firms across the country. You can use this list to research individual firms that might be a match for your business. As you’re doing your research, look for firms that have previously invested in companies that are in a similar industry and growth stage as your business.
4. Negotiate the equity split
After finding an individual investor or VC firm, you’ll need to do a business valuation to determine your company’s overall worth. Knowing this can help investors negotiate the estimated price per each equity share. Your company’s time in operation, cash flow projections and general market trends can help influence the equity share.
Most venture capitalists want around 20% to 25% ownership in your company, while angel investors typically want between 20% to 50%, though it can vary quite a bit and is typically up for negotiation. Remember, the equity share lasts forever or until the investing firm sells it back. This means you will hand over that percentage of profits as long as your company continues to operate.
5. Use the funds to grow your business
Once you’ve agreed on an equity price and share amount and formalized all the details in writing, the investor will release the funds to your business checking account. From there, you can use the cash to tackle your company’s most pressing needs, such as hiring new staff, refinancing business debt, purchasing new equipment and more. Keep in mind that investors may want a say in how their money is used.
6. Share the profits
As your business starts turning a profit, you will need to release the agreed-upon percentages to your investors. Payments are usually sent as dividends on a rolling basis. This is something your bookkeeper or accountant can help with — or you can use small business accounting software to do it yourself.
If your startup fails, you typically don’t need to repay the original investments. This is a risk investors take when they sign up to back your business.
When is equity financing a good idea?
Equity financing could be a good fit if your company is already established but needs an extra boost to reach the next level of success. It can also make sense if you have a solid business idea but you lack the credit history to qualify for traditional financing.
Additionally, some equity investors have extensive knowledge in your field and are committed to teaching you business strategies to improve your business model. In this sense, equity financing gets you funding plus a supportive business partner.
However, your business must show potential for growth to appeal to equity investors. If you’re a brand-new startup in a competitive field, you might want to consider alternative funding methods instead.
Alternatives to equity financing
There are many advantages to equity financing, such as helping you get funds during the early stages of your business without incurring debt. That said, it might not be the best fit for your company’s needs. Here are some other types of business financing to consider:
- Business loans: If you’re an established business with good credit and strong revenue, a business loan with a low interest rate might make more sense than equity financing because it allows you to retain full ownership of the company.
- Business grants: There are a variety of small business grants offered by the state and federal government, as well as corporations and nonprofits. Finding the right grant takes time and effort, but this option could be worthwhile if you have a unique business idea and you need less funding to bring it to life.
- Business credit cards: These can be easier to get than business loans and they can help cover everyday expenses. Borrowing limits tend to be lower than other types of business financing, but business credit cards could be used to cover smaller expenses while you’re looking for investors.
- Friends and family: You can also use a family loan to support your business growth. Just make sure that owing money to a friend or family member won’t strain the relationship, especially if your business fails.
- Sell your business: Another option is to sell your business while staying on as an employee, CEO or partial equity owner. You could negotiate your future role or equity share in the company during the sale.
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