- Equity-based financing is another small business funding option wherein a company sells its equity to investors to get funding. Rapidly growing businesses and those lacking excellent credit scores are usually the ones that opt for equity financing.
- In general, equity-based financing is divided into three types: crowdfunding, angel investors, and venture capitalists.
- The advantages of equity financing include no repayment requirement, the possibility of working with leading business leaders, higher funding amounts, no collateral requirement, and no credit requirements.
- Equity-based financing also comes with a number of significant downsides: giving up some control of your business, giving some of that control to investors, and paying expensive legal fees.
If you’re a veteran business owner, you know how tough it is for many businesses to qualify for small business loans, especially from banks. When traditional lenders and conventional business loans are out of a business owner’s reach, equity-based financing can be a viable lifeline.
So, what is equity-based financing? How does it work and where can you get it? In this guide, we’ll walk you through the basics of equity financing to help you gauge whether or not it’s the right fit for your company.
What is Equity-Based Financing?
Equity-based financing, or equity financing, is another way for businesses to raise capital for their business. With this type of financing, the business owners sell a portion of their company’s equity to private investors. In turn, the investors provide the funds in exchange for a portion of the company’s future profits. The investors in equity financing could range from individuals to wealthy business owners and companies.
Equity financing is a viable funding option for startups that can’t qualify for traditional loans from banks or a comprehensive loan option from alternative lenders. This is because it doesn’t require a business to have an extensive credit background or financial history. With the money raised from private investors, business owners can invest in business opportunities and achieve business growth.
How does Equity-Based Financing Work?
Suppose a business is strapped for cash and they need to invest in a business opportunity to grow, like a large customer order or product expansion. The first options they usually think of are banks and alternative lenders. However, to qualify for larger amounts of financing, they would have to demonstrate that their business is financially stable and that they’re creditworthy. This could be a significant roadblock to newer companies, specifically startups, that are most likely lacking a substantial credit and financial history.
With equity financing, businesses won’t have to worry about good or bad credit scores and financials. The arrangement involves selling the company’s stock or share to interested investors. Each share represents a single unit of ownership.
So, if the company issues 1,000 shares (usually in the form of common stock) and you (the business owner) sell 250 shares to an investor, the investors would own 25% of the company.
Even if you have bad credit, investors may still be willing to work with you if they see potential in your business venture. However, know that since you’ll be giving these investors equity, they can participate in the company’s decision-making processes.
Types of Equity-Based Financing
Before moving forward with your application, it’s important to know that there are different types of equity-based financing. The different types are distinguished by source – or who the main investors are.
In general, equity financing is further broken down into three categories: crowdfunding, venture capitalists, and angel investors. We’ve gone ahead and laid out how each source works below.
Crowdfunding is one of the most popular ways of selling equity to potential investors. Initially, you have to visit a crowdfunding platform like Kickstarter and pitch your business idea to thousands of potential investors. If investors see potential in your business, they can then invest in your business through the platform.
Once an investor buys equity in your business, you might have to give them incentives in return. This could be early access to your products or discounts.
The downside of crowdfunding is that you may come up with lower funding than other sources. While angel investors and venture capitalists might be willing to spend hundreds of thousands of dollars on a business, investors in crowdfunding platforms may only invest as much as $25.
Furthermore, crowdfunding platforms can be an all-or-nothing deal. Before selling equity on a platform, you have to set a funding goal. On some platforms, you receive nothing if you are unable to meet your target goal. Be sure to research different platform options so you know the rules for obtaining funding. If the funding is dependent on meeting a goal, avoid setting yours too high.
Crowdfunding may be a viable source if you’re looking to raise lower funding amounts. However, if you’re looking to raise larger amounts of additional capital, it might be worth looking into other sources like venture capitalists and angel investors.
2. Angel investors
Angel investors – also called seed investors, private investors, or business angels – are wealthy individuals who might be willing to invest in businesses that demonstrate a high potential for success. The “angel” can be a friend, family member, or entrepreneur with enough funds to invest in exchange for equity.
As the investors and business owners enter into an agreement, they may opt to disburse the funding as a lump sum or release the funding in increments as the business grows.
Most private investors are usually looking to invest in businesses that are still in their early stages. This way, they can take part in shaping the business as it grows. They may actively participate in business management and advise when the business owner needs to make major business decisions.
3. Venture capitalists
Venture capitalists are just like angel investors, but instead of being an individual, it’s a group of individuals or an entire company working with you. Venture capitalists are usually composed of wealthy investors who have pooled their money to invest in small businesses with a high potential for success.
Moreover, venture capitalists may request a seat on the business’s board of directors. This way, they can manage their investment and assist where necessary. Many venture capitalists take the mentoring approach to ensure that their investment grows.
If you’re considering selling your equity to venture capitalists, you should look to work with those that have extensive experience in your industry. This ensures that they have the expertise to see your business grow and prosper.
What are the Pros and Cons of Equity-Based Financing?
Now that you have an idea of how equity-based financing works, it’s time to explore its pros and cons.
1. No repayment necessary
Unlike other asset-based lending options, there are no repayments necessary in equity financing. Since you’re selling company shares, you’re not taking on any debt, and therefore are not obligated to repay the investors. This is usually a major selling point for startups.
However, it is worth noting that the investors will be entitled to a percentage of the company’s profits, as they now own a part of the company.
2. Chance to work with experienced investors
Equity financing gives you a chance to work with reputable investors with a wide range of business networks and experience. Since they have equity in your business, they might tap into their resources to ensure that the business succeeds.
Not only will they help give your business a fighting chance to expand, but they can also offer mentoring opportunities. They can advise on how to handle a specific business situation or decision, guiding you in the right direction. As they continue to impart wisdom, you’ll also get to hone your business management skills.
3. No other tangible assets required
Unlike traditional loans, equity-based financing won’t require any collateral to secure the funding. That means you won’t have to put a valuable asset on the line and risk losing it. Plus, since no repayments are necessary, you won’t have to worry about defaulting on the loan.
4. Possibly higher amounts of funding
Because they see potential in the business and want it to succeed, investors are more likely to invest large amounts of funding for businesses they work with. This is true, especially if your funding source is a venture capitalist firm. This can benefit startup businesses that need a substantial amount to fund their hiring process or product expansion strategies.
5. Accessible to business owners with credit issues
Unlike banks and other lenders, equity investors aren’t as concerned about your creditworthiness. The major factor they will consider is your business’s viability. As long as your business demonstrates potential, you’re a qualified candidate.
1. You’ll have to give up partial ownership of your business
One of the biggest deal-breakers for some companies is the prospect of losing a certain level of control over the business. As you bring more investors on board, your shares will gradually decrease and become more diluted. Moreover, the investors will also be entitled to a certain percentage of future profits.
2. Investors will have control over your business
Since you’re selling equity for funding, the investors can take part in the decision-making process. Although you’re an owner, you may have to consult the shareholders for every significant decision. This could become a problem if you don’t see eye to eye with some of the investors.
While it’s important to bring in as much money as possible in the shortest possible time, it’s also vital to make sure that the investor you bring in shares the same views as you. It could be worthwhile to evaluate their business experience, management style, and outlook. Know that once you establish a relationship with them, you will be in it for a long time.
3. May only be available for high-potential businesses
Angel investors and venture capitalists are investing a significant amount of money by buying equity from a particular company. Considering that only 10% of the total population of startups survive the first few years, the investors would only want to work with a business they think has a high potential for success. This could include technology-based companies.
4. You’ll have to pay legal fees
Since you’re basically entering into a partnership with your investors – even if they’re family or friends – you need to create equity agreements that protect both parties. The agreement is a legal contract, which is why business attorneys should review it. You’ll want to retain a lawyer, especially if a problem occurs with the partnerships. Legal fees can add up to become quite costly.
The Bottom Line: Is Equity-Based Financing Right for You?
If there’s one thing to note about equity-based financing, it’s the fact that it is not a one-size-fits-all solution to every business’ financial issues. If you’re thinking of securing one for your business but aren’t sure whether it would be the right choice or not, consider asking yourself these questions:
- Are you okay with giving up partial ownership of your business?
- Would you be willing to work with other investors in managing your company?
- Does your business demonstrate a high potential for growth?
- Is a low credit score hindering you from getting approved for traditional funding from banks?
If you answer yes to all the questions above, then equity-based financing might be worth a try.
Before moving forward with your application, always do your research. Do a background check on your investors and see if their outlook and business management styles fit your company’s culture and goals.
In the end, if you decide that equity financing is not for your business, there are other ways to fund your business. Debt-based funding could be one. Again, do your homework and consider your business’s current needs and situation.