If you want to start or grow a small business, you often need some kind of financing. There are basically two types of business financing: equity and debt.
When using equity financing, you sell part of your business ownership in exchange for investment money (often called “capital”).
In debt financing, you borrow money. This is usually through a bank loan or access to borrowed money from other sources, such as small business lines of credit or credit cards.
So which one is right for you? In this article, we’ll focus on equity financing options and whether equity financing is the best choice for your business.
Equity financing is the process of raising capital through the sale of shares.If you’re a small business owner without cash on hand, you may exchange shares of ownership in your business for cash.
Benefits of Equity Financing
Equity financing as a whole offers multiple benefits. The primary benefit of equity financing is that you avoid debt, and thus the necessity of debt repayment on a business loan every month.
A costly monthly payment is potentially a risk to cash flow and can even cause your business to capsize if you run short of cash (and therefore the ability to repay your lenders). This can be especially true for very new or very small businesses, or those that have seasonal swings in sales and cash flow.
Debt can also constrain your ability to grow or expand to new locations or new products. The money that might have been used for growth goes to debt payments instead.
Sheerly because equity financing requires networking and pitching your business, another advantage of equity financing is connecting with people or groups who can offer expertise, advice, and mentorship. Debt financing only connects you with financial institutions. Partners and investors often seek out opportunities in which they can offer both financing and advice to small businesses, with the goal of helping them be successful — and thus returning handsomely to those partners and investors!
Finally, using equity financing can also provide you with more flexibility than debt financing. With debt financing, you will need to provide evidence of your creditworthiness, including your credit score. You may have to collateralize a personal asset such as your house as security against a loan. While potential equity investors will also be concerned with your creditworthiness, they will be more concerned with the business and its prospects for success.
Downsides of Equity Financing
That said, equity financing has its drawbacks. It’s important to understand them so you can determine which type of financing is right for you.
The first downside is the potential loss of control over your company. Remember, in exchange for equity funding, you must give some of your business ownership to the investor, as though you had a co-founder. People making equity investments own part of your company. These investors are then likely to want a say in the direction or the running of the company.
In short, you may no longer be the sole decision-maker. Plus, you may not only have to share profit, but share decisions that lead to profit. Equity investors may prefer certain products, locations, or decisions over others because they view them as more profitable — and that view may not be the same as yours.
The second downside is the sharing of profit. Equity investors will expect a profit from their investment. And once they have ownership in the business, that goes beyond paying them back for their initial investment. They’ll receive part of the profits until they sell their ownership in the business.
An entrepreneur needs to know what they need, period. Then they need to find an investor who can build off whatever their weaknesses are, whether that’s through money, strategic partnerships, or knowledge.Daymond John, Investor & CEO of FUBU
What Equity Investors Look For
Potential investors don’t give their money to just any aspiring business owner. You’ll have to show them that you’re a capable businessperson and that your business idea has serious potential.
First, you’ll have to provide information about your company. Equity investors will require a business plan. A business plan includes information about the company: its mission statement, a clear description of the product or service, an overview of the leadership team, employees, and location, and financial information such as balance sheets, income statements, and cash flow. They will likely also ask for growth plans and a market analysis that examines your company in relation to its competitors.
Your business plan should clearly state the value proposition of your company, the resources it uses, and how it adds value for its customer base.
Potential equity investors use this information to assess whether their infusion or cash or other assets will pay off for them. Remember, by investing money in a potentially unproven business, they are taking a risk. A wise potential investor will do everything they can to minimize that risk. All will want a return on investment (ROI) they consider reasonable. Some may want a stake in the business beyond the financial, such as a chance to run the business together with you. Some equity investors may examine your company to see if it can become public at some point, and issue shares, or be sold at a profit.
Tip: If you’re giving equity in your company in exchange for cash, you’ll need to decide on the business structure of your equity investment. Examples include a general partner or a limited liability company (LLC).
For help figuring out how fast you’ll “burn” through your cash reserves, you can try a burn calculator. You’ll also want to do a post-money and pre-money valuation to determine how much your small business is worth now and later. When it comes to determining how much equity to give up in your company, this handy tool will help guide you.
Is Equity Financing Right for Me?
There are four things to consider when determining if equity financing is right for you:
Business Idea Potential
As with most business ideas, quality is more important than novelty. It’s more important that you can execute your business idea better than your competitors. Nonetheless, your business idea still needs to be quite exceptional — either exceptionally profitable or exceptionally beneficial to society. Unless your investor is family, this is not usually the financing method for your average restaurant or beauty salon.
Comfort with Networking
Many, if not most, equity investors are private, wealthy individuals. They are unlikely to publicly advertise themselves. This means that finding these people requires networking, mingling, and presenting your business idea in public. A lot.
If that doesn’t sound like your cup of tea, you need a cofounder that can network.
Comfort Talking Numbers
Investors of all kinds tend to focus on the financial situation of your potential business first, and for good reason. If you’re not comfortable talking about finance and finances before your business growth has accelerated, you probably won’t be comfortable when the finances become even more convoluted.
Confidence talking numbers also shows confidence and certainty. Your financials — and your presentation of them — should be air-tight.
Personal Savings or Eligibility for Debt
What is your personal financial situation like? If you have personal savings, it’s often worth scaling slower and using your personal funds to bootstrap the business. Retaining complete ownership and decision-making power over your business is immeasurably valuable.
You’re Right for Equity Financing if…
- you don’t qualify for loans or another form of debt financing
- you expect debt payments to significantly limit your business’s ability to grow
- you don’t have the personal funds or personal savings to bootstrap
- you understand the financial details of your business intimately
- you’re a confident speaker or can become one.
Types of Equity Financing
Now that we’ve given you an overview of what equity financing is and its major pros and cons, let’s look at three major types of equity financing: 1) partnerships, 2) angel investors and 3) venture capital investors.
In a partnership, you bring in one or more individuals as partners. They provide you with money in exchange for becoming a partner in the business.
Partnerships are a type of business structure that is far more flexible and relatively simple to set up than other types such as S or C Corporations. You will need a partnership agreement in writing, specifying roles, responsibilities, and percentage of the business each partnership owns in exchange for their contribution. If you ever want to bring in new partners or replace the original, the written agreement should specify how this will be done. It generally mandates that all partners approve the change.
You should consult lawyers and other business advisors if you plan to set up a partnership, to make sure you have set it up in accordance with federal laws and regulations, and those of your state.
In addition to funding, a partnership has multiple advantages. It can be an opportunity to bring in people to help you run the business, to provide needed expertise and education, and to manage and share business risk. In a partnership, all partners share in liability risk for the business.
The drawbacks to a partnership are the same as other equity financing alternatives: you must share the control and profits of the business. In addition, if you want to change or remove some partners the process can be complex and time-consuming, as all partners must generally agree to any changes of personnel, significant duties, and percentage control.
In a limited partnership, there are multiple partners but generally only one managing partner. The others are passive investors with no responsibilities for running the business and no liability for the business.
All types of partnerships can be combined with other funding methods to provide maximum funding. Rollovers as Business Startups (ROBS), for example, in which investors use retirement funds such as 401(k)s to fund the business, can productively be combined with a partnership structure. Each partner could utilize ROBS to contribute funding, as long as they have a minimum of $50,000 in a qualified retirement account.
Friends and Family
Equity funding through friends and family is one of the most common methods of financing a small business, whether it’s a loan to be repaid, a gift with no repayment terms, or an investment with equity in your business. Everyone’s situation differs, so it’s up to you and your friends and family to see if family funding is an option for you.
The critical item to remember when arranging to receive money from friends and family is that you write down everything about your plan, so all parties are clear. You want to save yourself from damaging these important relationships with future confusion. Plus, if these are close friends or family that you will see often, you should be prepared to discuss your business decisions with them every time you see them. If that’s going to be hard for you, then skip this funding method.
Asking for money is a tricky subject, of course, but prepare the same as if you were seeking financial assistance from someone you didn’t know. Have your business plan set, your resume updated (to show your successes and experience), and an idea of what you are looking for as far as the amount of money you’re seeking.
The second equity financing option is working with an angel investor. Angel investors are wealthy individuals that act as private investors. Angel investors work with new companies in the early stages, providing seed capital. Many angel investors are high net worth individuals with a specific interest in a sector or in growing your success as a business owner. Friends and family who want to invest in your company can also be angel investors.
There is no hard or fast limit on how much capital an angel investor can provide your company, but it’s generally agreed to be less than a venture capitalist; many cap their contributions at $25,000 to $150,000. Angel investors generally use their own capital as the investment capital, so the capping of investment is one of the ways in which they manage the risk involved in the initial stages of a small business. Statistically, a high percentage of fledging companies fail in the five first years.
Angel investors generally seek an ROI of at least 10 percent. Some may be looking for higher rates of return, depending on their risk profit, funds, sector, and assessment of your business.
How do you find an angel investor? You might start by asking family or friends with deep pockets and an interest in business. Websites such as AngelList and Fundable can also be helpful sources, as well as your community networks.
Venture Capital Investors
Venture capital investors provide equity of $1 million or more in exchange for an ownership stake in your company. Although the term “venture capital” has been very associated with Silicon Valley startup companies in recent decades, typically venture capital investors come in typically a bit later than the startup stage. They look for companies who have established some success (or at the very least, have a minimum viable product), and can be expected to scale up successfully. The focus is usually whether the fledgling company can return a good profit to the venture capitalist investors.
Venture capital investors are usually firms dedicated to venture capital activities rather than individuals. They actively pool money for the purpose of investing in promising businesses.
Venture capitalists look for a substantial ROI: like angel investors, they seek to profit to counterbalance the risk of investing in small businesses early on. To that end, they may actively seek management of the firm so that they can maximize its profit potential. Many venture capitalists may want advisory positions, such as representation on your company’s Board of Directors. They may also want your company to target its efforts toward an initial public offering (IPO) of shares, which can result in substantial investor rewards.
Venture capitalists can be found by searching websites such as MicroVenture and Crunchbase and looking up venture capital firms on LinkedIn.
Note: If your company is successful, venture capitalists will hope to sell their shares back to you or through an initial public offering (IPO) to the public.
5 Steps to Get Started with Equity Financing
- Create a top-notch team. Investors want to know that the people behind the business have strong ideas, passion, and keen business sense. Experience and credibility will also propel you in the game.
- Build a better business plan. You wouldn’t invest in a business that had no written plan, so don’t expect anyone else to do the same for yours. And don’t be hasty when putting this together. It should be well-written and well-thought-out. Check out our How to Write a Winning Business Plan ebook for a place to start.
- Recognize the true value. Ensure you’ve matched the monetary investment you’re asking for with the appropriate value of the business. If this equation is off, the angel investor won’t be interested.
- Embody trust and integrity. Similar to the first item on the list, trustworthiness and integrity are two traits you want to portray during this process. You can’t build a relationship – even in business – without trust.
- Realize the risk. This means you should respect the concerns of the interested angel investor. Of course, be positive, but also realistic.
The process with angel investors may be lengthy and include many meetings and extra-large cups of coffee, but the results could be well worth it. Google and Facebook both used angel investors — and look at them now!
Other Forms of Capital that Could be Right for You
If you have a good credit score and strong personal credit history, you may not need to face the hustle that comes with equity financing. Instead, a loan from a credit union or other banking institution could be right for you. There are many loan programs designed to support small businesses, including equipment loans or Small Business Administration loans. If you need a relatively small amount of capital, a business credit card might be right for you.
Receive a Tailored List of Financing Options Today
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