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What is Equity Financing: Benefits and Sources of Equity Financing

By Jemima Faith

It’s about time for that startup idea to be put into action. But wait, where are you going to get the required starting funds?  Getting a small business up and running has never been that difficult as now. It takes not just a good idea, but also a good fund.

With most big banks still skeptical about lending money or financing new startups, loan approval rates still below 21.6 %, getting a loan has been just as difficult as getting a camel through the eye of a needle. In fact, the rejection rate is still 78.4%.

With the unstable financial climate, concentrating our resources in just one business may prove more risky compare to getting another source of income to back up our current source of finance. This may mean giving off some of your shares (possibly selling it on the stock exchange market) to pursue a startup dream.

If you happened to be among the unfortunate majority whose small business loan application has been turned down by a bank, odds are you’ll be facing the challenge of raising money from loans. And since new businesses need capital to get it up and to grow, it’s important to explore alternative funding options to give your small business the best chance to succeed. Thus, it’s time to think of equity financing, as the best (and sometimes only) means to raise the much needed funds to start realizing your dreams.

However, this article is drafted to answer questions like what is equity financing? and also provide information on the benefits of equity financing, public and private equity financing, sources of equity financing among others.

 

What is Equity Financing?

In oreder to provide a clear answer to the question, what is equity financing; we may have to start by considering principles underlying this financing strategy.

Equity financing can be defined as the process of raising capital through the sale of shares in a business. Generally, it refers to the exchange of an ownership interest in an enterprise in order to raise funds for business purposes. Equity financing covers a wide range of activities in scope and scale, from a few thousand dollars raised by an entrepreneur from family and friends, to large initial public offerings (IPOs) that run into billions of household names such as Facebook and Google. While the term is typically associated with financings by public companies listed on an exchange such as the NASDAQ and the NYSE, it includes financings by private companies as well. Equity financing is different from debt financing, which is funds borrowed by a business.

Equity financing is an increasingly popular funding option in today’s business sector. This is because it involves not just the sale of common equity, but the sale of other equity instruments such as convertible preferred stock, preferred stock, and equity units that include common shares and warrants.

The scale and size of equity investments vary and are dependent on the startup stage and business’ industry. Early-stage businesses might raise a few thousand dollars from friends and family, while more-established businesses could solicit multimillion-dollar investments from the giant venture capital enterprise.

As a startup grows and evolves into a successful company, it will require several rounds of equity financing. Since startups typically required different types of investors at various levels or stages of its evolution, it may also utilize different equity instruments for its financing needs.

Also, finding and pitching investors requires a large investment of time (commitment), patience and effort, as you might get rejected a number of times before the right investor comes along. On top of that, investors also run the risk of losing control of their own business if they relinquish or give out too much ownership (shares). In order to maintain control of your company, therefore, make sure you retain at least 51% ownership.

Statistics have shown that, investors get the attraction for equity financings varies significantly depending on the state of the equity markets in particular and the financial markets in general. While a torrent of financings may indicate excessive optimism and a looming market top, a steady pace of equity financings is seen as a sign of investor confidence. The pace of equity financings typically would drop off sharply after a sustained market correction because of investor risk-aversion during this period.

The equity-financing process is governed by regulation imposed by a local or national securities authority in most states or jurisdictions. Such regulations are primarily designed to protect the investing public from fraudsters and unscrupulous operators who may take advantage of unsuspecting investors, raise funds and disappear with the financing proceeds. All equity financing process is therefore accompanied by an offering prospectus or memorandum, which contains information that should help the investor make an informed decision about the merits of the financing. Such information consists of the company's activities, risk factors, financial statements, use of financing proceeds, details on its officers and directors.

New businesses on the other hand may have difficulty receiving approval without historical earnings such as financial statement to support their loan application. To solve this concern, lenders may ask you to personally guarantee a loan, such as providing collateral, which usually leaves you on the hook even if your business fails.

Furthermore, the truth here is that lenders don’t actually care about you or your business. Their concern is the full loan repayment and interest, and you are of course expected to repay your loans within a fixed period of time.

 

How Equity Finance Works

In order to run and grow your company, you will be facing at one point, the need for additional funds. This fund may be obtained in one of two ways: equity or debt. Equity financing is the sales of the company's share or giving a portion of the ownership of the company to investors in exchange for fund. The amount of shares be sold in an equity financing depends on how much the investor agreed to invest in the business and what that investment is worth at the time of the financing. For instance, an entrepreneur who invests $800,000 in the startup of a company will initially own all of the stock of the company.  

As the company grows and the need for additional capital arises, the entrepreneur may seek an outside investor, such as a venture capitalist or an angel investor, two main sources of early stage equity financing.  Let us consider the scenario where the investor is willing to invest $200,000 and settled for a share price of $1.00 (assuming that the original $800,000 invested is still worth $800,000), then the total capital in the company will be raised to $1,000,000. This gives the entrepreneur an 80% control over the shares of the company, having sold 20% of the shares of the company to the investor through an equity financing. 

 

When Is Equity Financing the Best Option?

Equity financing may be regarded as the best financing option for entrepreneurs:

  • Whose credit worthiness can’t secure them a loan
  • Who are more of an independent solo operator, you might be better off with a loan and not have to share decision-making and control.
  • Would prefer sharing ownership/equity having than to repay a bank loan
  • Who are comfortable sharing decision making with equity partners
  • Who are confident that the business could generate a healthy profit. You might better go for a loan, instead of sharing your profits.

 

Equity financing has some distinct benefits compared to typical small business loans. Generally, investments are not expected to be repaid by monthly payment instalments, which makes it a safer funding option than loans and frees up much-needed cash flow for young businesses. Also, investors with prior industry experience can serve as advisors that provide invaluable guidance.

If you are just starting up, or if you experienced a decline in sales, loan payments will noticeably, negatively affect your limited cash flow. Any cash flow, especially in the early stages of the business, should be devoted to keeping your business afloat. Contrary to this, any extra expenditure such as loan payments may be just the factor that gradually sinks your voyage. Other benefits include the following:

 

Benefits of Equity Financing

Fewer burdens: Generally, equity financing is not regarded as a loan; therefore, there is no loan to repay. This offers relief in several ways.

The business doesn’t have to make a monthly loan payment. This is particularly important if the business doesn’t initially generate enough profit. It also allows you to channel more money into running and growing the business.

Credit issues gone: Entrepreneurs who lack credit worthiness that can enable them borrow money with their credit card, either as a lack of a financial track record or a poor credit history, equity financing can be the preferable or more suitable than debt financing.

Learn, gain from partners: When it comes to equity financing, you might form partnerships with more experienced or knowledgeable individuals. Some might be well connected. If so, your business could benefit from their business network and their knowledge.

 

Disadvantages

Share profit: Your investors will also share in decision and dividend made by the business. However, it could be a worthwhile trade-off if you are benefiting from the value they bring as financial backers and/or their business network and experience.

Loss of control: This is the heavy price to pay for equity financing and all of its potential benefits.  You will have to share control of the business and if you don’t trad carefully, you may loss total control in the hands of your investors.

Potential conflict: Sharing ownership and having to work with others could lead to some tension and even conflict, especially as different investors may have different goals, management style, and ways of running the business. This is an issue to consider carefully.

 

Sources of Equity Financing

There are a good number of different sources of equity financing available to entrepreneurs and the type of investor you’ll normally attract depends on the size of your business, stage and industry. Some investors might seek a more-established business with proven track records while other investors are strictly interested in early-stage businesses, when the possible return on investment (ROI) but also when the risk is the highest.

Below is a quick review of some of the different types of investors and when they’ll best apply to your business:

  • Family and Friends: These are generally and often the first set of people you turn to, at the early stages of your business. The investment size is usually small, but this capital is essential to getting your business up and running.
  • Angel investors: These are high-net-worth individuals who are attracted to invest in the early stages of the business. They typically have experience in your industry and can always provide valuable advice and guidance. 
  • Private equity: These are separate funds that only invest in proven businesses with substantial ROI. Private-equity companies can also purchase a company outright.
  • Strategic investors: These are businesses or individuals that have a vested interest in the success of your business. For instance, a coffee shop might have a bean roaster as a strategic investor.
  • Venture capital: This typically is a separate fund that invests only in businesses with high potential to succeed. They can provide a substantial amount of investment, but will demand a large ownership stake.

 

Crowndfunding: This is generally an online source of funding where businesses are able to raise a small amount of capital from a large group of people.

Typically, people who “donate” don’t receive an ownership (share) interest in the venture but do receive a small reward, like as a sample of the product being funded. Thousands of entrepreneurs have successfully used this funding option to fund their startups. 

However, crowdfunding isn’t the best funding option for every business. It’s meant to purposely to test, gather feedback on early-stage ventures, validate and promote products to determine whether they are worth large-scale investment. If you are certain about your startup idea with some market potential, equity financing might be a better route than crowdfunding.

Crowdfunding is primarily used to fund businesses with physical products rather than internet-based or technology ventures. The capital raised via crowdfunding is typically used to fulfill product orders, and not to hire and grow operations.

Furthermore, equity financing is investor-centric, whereas crowdfunding is customer-centric. If you want to grow operations by selling an ownership stake to investors, equity financing is your best suited option but if you’re seeking market validation for an early-stage physical product, then look to crowdfunding as your best option.

 

Small Business Investment Corporations (SBICs): SBICs are private investors that receive $3 to $4 in SBA-guaranteed loans for every dollar they invest and are licensed and regulated by the SBA. Under the SBA law, SBICs must invest exclusively in small businesses. A business with an average after-tax earnings (over the past two years) of less than $6 million and has a net worth less than $18 million. They're also restricted in the amount of private equity capital for each funding. Because SBICs are licensed and regulated by a government agency distinguishes them from other private venture capital enterprises. Furthermore, they're not significantly different from those firms.

Specialized Small Business Investment Companies (SSBICs): These are privately capitalized investment agencies licensed and regulated by the SBA. They are designed to aid minority-owned enterprises and women, as well as businesses in economically or socially disadvantaged areas, by providing equity funds from public and private capital. SSBICs just as SBICs are restricted in the amount of their private funding.

Before approaching any venture capital company or investor, make sure you have done enough study, research and find out if their investment preferences match your interest. The best way to contact venture capitalists is through an introduction from a banker, attorney, another business owner or other professional who knows you and the venture capitalist well enough to approach them with the proposition.

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