What is Equity Financing and How Does it Work? (+ Examples)

Written by Max Freedman | Jul 4, 2022 4:00:00 AM

Businesses require lots of tools, equipment, and people to launch or grow – in other words, lots of money. That’s true both in the long term and the short term. At any time, new business goals or shifting industry and economic conditions can affect your revenue and cash flow. And during rough periods, your revenue might not be enough to cover all your costs. When that happens, many small businesses raise money through equity financing. Learn more about it below.

What is equity financing?

Equity financing is when a small business sells part of its shares in exchange for extra capital. Selling shares in your small business means selling partial ownership of the business. This definition might make you think of shareholders and investors, and it’s true that they’re a part of equity financing. But in reality, the term “equity financing” encompasses so much more.

Methods of equity financing

Each method of equity financing involves selling shares to an interested third party. Among these methods, there are significant differences regarding the entities to which you sell those shares. Each option has its own unique advantages and disadvantages, as explained below.

Private equity investors. You can sell shares of your small business to equity investors, who are private individuals interested in your company. Their interest in what you’re doing typically motivates them to finance your future. These investors are often people with whom you have a prior relationship. That could mean friends or family who just want to see you succeed.
Public stock offerings. You can make an initial public offering (IPO) that allows the public to purchase shares in your small business. Doing so can be better than choosing private equity because public investors can’t assert as much control over your business.
Venture capitalists and angel investors. Equity financing can come from venture capitalists and angel investors who have plenty of money to invest in exchange for a seat at your table. Venture capital firms typically seek companies with high growth potential, whereas a good business idea can sway angel investors. You can get much more money from venture capitalists, though only angel investors will potentially forgive your debt if your business fails.

Examples of equity financing

Just as there are many methods of equity investing, there are many possible investors. A few of the most common ones for growing a business include:

Friends and family. Many small businesses receive equity investing from friends and family as they get started. You typically won’t get a ton of money from the people in your life, but it’s often enough to cover the basics.
Private investors. These investors are individuals you seek out – or who seek you out – to buy shares in your business. The amount of money they can provide often depends on the person.
Initial public offering. The public can also purchase your stock with an IPO. The small amount that each person buys means that you still keep majority control, but catering to the public is often challenging and time-consuming.

How equity financing works

In equity financing, you’ll grant company shares to an investor in return for money. A larger cash infusion into your company will grant the investor more shares and decision-making power. You should be careful on this front. An investor can overtake majority control of your company when they own 50% or more of its shares.

The differences between equity financing and debt financing

Small businesses have two primary options for raising capital: equity financing and debt financing. Where equity involves selling shares in (and control over) your company, debt financing involves borrowing money from larger financial institutions with no controlling shares. Each method can provide a temporary increase in capital, but they also have distinct benefits and drawbacks. You can generally group these pros and cons into the below three groups.

Repayment. Loans are the most common form of debt financing. They can get you lots of cash, but they come with potentially challenging loan repayment obligations. You’ll need to repay everything you borrow alongside additional money due to the interest rate. Equity investments, on the other hand, don’t require regular loan payments. While investors always hope for a return on their investment, they typically don’t collect on it until the company is doing well.
Control. While equity investment doesn’t require regular payments, investors’ shares give them a say in how your company operates. Conversely, loan institutions can at most restrict how you spend the money you borrow. They don’t have a direct say in how your business operates.
Speed. Both debt financing and equity financing can be time-consuming to apply for and obtain. However, applying for a loan is usually more straightforward than finding an investor. For starters, identifying investors can take a lot of time. Then, after that, there are negotiations and legal work to consider.

Why should you consider equity financing?

Equity financing can be helpful if you:

Need short-term cash. Rough times can drain the financial resources you need for your basic expenses such as payroll and inventory. Equity financing can help you get the funds you need to keep your business afloat until you get back to speed.
Need money for long-term growth. Your business can’t continue to grow without the necessary capital to pay for new expenses. The funds you can get from equity financing can help you invest in your business and its future.
Have a poor credit score or high-risk business. Most lending institutions have strict criteria to determine who’s eligible to qualify for a loan. These criteria typically leave high-risk businesses and entrepreneurs with low credit scores without many options. Investors are more likely to fund the riskier companies and borrowers that banks might not consider.
Need to manage your debt. The capital you get from equity financing isn’t counted as business debt on your balance sheet. Your equity financing arrangement assumes that your business will do so well that the investor automatically makes back their money over time. You’ll get more funding without taking out more debt, so you can more easily manage your current debts.
Want to build connections and learn from the experts. Yielding a seat at the table to an expert investor can give you a highly knowledgeable business partner. This person can bring invaluable advice to the table that guides you to success in ways you might never have considered.
No repayments. Equity financing isn’t a loan. That means there’s no need to account for regular repayments when you obtain equity financing. That said, if you obtain funding through venture capitalists and your business fails, you’ll owe them the money they invested. The same is sometimes true of angel investors.

Bottom Line

Equity financing options can be an excellent way to gain funds to grow your business, but they can require planning to use correctly. Finding an investor that’s right for your business is often time-consuming, and it can be undesirable to give up some control over your business. If that sounds like you and your need for funding isn’t going away any time soon, SmartBiz® can help. See if you pre-qualify* now for our debt financing options such as SBA 7(a) loans and bank term loans. The capital you need may be just clicks away.

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