Home Finance What is Equity Financing? Types, Benefits, & Drawbacks 

What is Equity Financing? Types, Benefits, & Drawbacks 

by Abru Farzeen
Published: Last Updated on

Launching a new business is thrilling. It’s nothing short of a rollercoaster, from the beginning to creating a go-to-market strategy to the dozen pivots you make before discovering that elusive product-market fit. However, these are not inexpensive items, much like the previously stated amusement ride.

You have to have some cash in the bank at some point, and many entrepreneurs like you begin to consider their financing possibilities.

In this tutorial, we’ll discuss equity finance, one of the most common forms of startup funding.

After reading this article, you will understand equity financing much better and be an authority on the subject, knowing whether or not it makes sense for your firm.

What is Equity Financing?

Selling business shares to raise money is known as equity financing. When investors buy shares, they also purchase ownership rights in the business. The selling of any equity instrument, including ordinary stock, preferred stock, share warrants, etc., is called equity financing.

Equity financing is crucial for new businesses to fund plant assets and early operational costs. Gains for investors come from dividend payments and price increases on their shares.

How Does Equity Financing Work?

The procedure for obtaining equity financing will change based on your company. Your investors and the funding you seek depend on it. Generally speaking, these are the actions you should take. 

Assemble the Paperwork

You’ll need financial records, business plans, and a sense of how much funding you need and how you plan to utilize it before you search for investors. All of these should be included in your company pitch to a possible investor. 

Locate financiers

If you are unfamiliar with investors or already have possible investors in mind, you can use your professional or personal finance network to learn more about your choices. In addition, look for investors online, visit LinkedIn, or visit local networking gatherings. 

Decide on an equity split with your investors. 

Once you’ve located your investors, they may carry out independent company valuations to ascertain the future worth of your enterprise and the desired level of equity for their participation. This agreement will be influenced by variables such as the stage of the firm, the level of risk based on market trends, and the projected return based on financial estimates. For example, venture capitalists may desire up to 40%, while angel investors may ask for 20–25%. 

Utilize money

Once you’ve negotiated a price, the money you get from investors might be put toward working capital, hiring new staff, debt refinancing, or product development. 

Divide earnings

Depending on how much stock they have in your company, your investors will be entitled to a part of your profits whenever they begin to turn a profit. Your investors will receive dividend payments equal to this percentage within a set period. The initial investments are only reimbursed if your firm is profitable. 

Pros and Cons Of Equity Financing 

Advantages 

  • There are no conditions on repayment. In a strict sense, an investor in your business is not “repaid” in the same manner as a lender. Instead, your company’s potential future worth and income serve to repay the initial investment. While loans can be a great way to fund your business, not having monthly or weekly payments can benefit startups or businesses focused on growth. 
  • Advisor accessibility. Most investors have made prior investments and have even operated their own companies, so they may be a valuable resource as you manage the highs and lows of running your company. Moreover, your investors will be financially interested in seeing your company flourish since they have invested money. 
  • More outstanding sums of funding. You may qualify for more significant financing with equity investors than debt financing, especially if you’re a startup private company. In addition, if you need more money along the way, an investor may provide additional injections. 
  • Alternative qualification requirements. Rather than business revenue or personal credit, investors will typically look at things like your business idea’s potential and your character.  

Drawbacks

  • loss of the rightful owner. Your ownership stake in the company will drop whenever you receive an equity investment, which may impact how much of any future earnings and value you get. 
  • A loss of command. Transferring ownership may also include giving up some influence over your company, which might be troublesome if you and your investors need to get along. 
  • Typically, for enterprises with significant growth and potential. Since equity financing is often designed for companies with solid growth potential and rapid expansion, many small firms must fit better. 

Types of Equity Financing

Angel financing 

High-net-worth individuals, typically with accreditation, are known as angel investors, and they use their funds to invest in startups or early-stage operational companies. Angel investors may be found on websites such as AngelList or the Angel Capital Association, but they can also be located within your business network or among personal friends. Angel investors are an excellent choice for pre-revenue businesses or business presentations since they are frequently knowledgeable people who may offer advice in addition to capital. 

Venture capital 

Similar to angel investment, venture capital (VC) is a kind of equity financing where investors are often venture capital firms rather than affluent individuals. Generally speaking, VC can be a little more challenging, and companies often join after angel investors have already made their initial investments. VC could be most appropriate for early-stage, rapidly expanding companies already operating. 

Equity Crowdfunding

A type of equity financing known as equity crowdfunding uses online investor groups comprising accredited and non-accredited investors to finance firms. Through online profiles made by the business owners, crowdfunding platforms enable prospective investors to learn more about firms or business ideas. Some people could feel less pressure to raise money through crowdfunding platforms, which might make equity crowdfunding a viable choice for smaller companies or less seasoned business owners. But, investing online has a higher risk of fraud, so you should choose your site carefully. Furthermore, issuing more shares—no matter how tiny—may dilute ownership and higher expenses than working with a venture capitalist or angel investor.  

Substitutes for Equity Funding

Financing for small businesses.

Small-business lending is a frequent kind of debt financing that is a good substitute for equity financing. Term loans and credit lines are available from banks, credit unions, internet lenders, and nonprofit lenders such as community development financial institutions (CDFIs).  

Grants for small businesses. 

If you don’t need much money and want to avoid taking on debt while maintaining control over your company, you should check into small-business grants. Grants are difficult to locate and often don’t provide significant sums of money, but they might be worthwhile if you need funds you are not required to repay. 

Investing for oneself

If you want to avoid paying interest and keep complete control of your firm, you can do so by using your funds. To be sure this is the best course of action for you, consult a financial expert as you risk losing your money if your business fails. 

Family members and friends.

Funding may be available if you have trustworthy friends or relatives who believe in you and your business. Even while getting funds from a bank or other financial organization may feel more official, you should nonetheless draft a contract outlining the specifics of the loan.  

Debt financing vs equity financing: What Makes a Difference?

There are a few important distinctions to remember when choosing between various funding options. They are listed in the following order:

Compensation

When using debt financing, you have a certain amount of time to repay the loan balance plus interest, typically in monthly installments. Conversely, equity financing has no payback obligations, so you can use your firm budget to set aside extra funds for operational expansion.

Naturally, investors want to see a return on their investment. It is only possible if your company is successful in turning a profit. Because equity financing is more likely to take a cut of your company’s future earnings and value than debt financing, which has a fixed cost per unit, its price is thus more variable.

Possession

Equity investors want to purchase a portion of your company, which lowers your ownership. It isn’t the case with debt financing because you still control the entire company.

Nonetheless, investors could offer priceless assistance through monetary and non-monetary resources, expert advice, and access to their network in return for a smaller ownership stake. It might assist you in growing and improving your company.

 Safety

When you apply for financing, a lender could ask you to pledge an asset—like real estate or equipment—as security for the loan. If you cannot make the loan installments, the lender may take possession of your possessions to recoup the money. They could also want an individual guarantee. But when employing equity financing, there’s no need to put up collateral.

Substitutes for assets in a security context

It is difficult to get debt funding from traditional lenders if you are a start-up without any physical assets or past trade history. In this situation, seeking an equity investor is a good idea, as they often back companies that debt funding providers feel are too risky.

Participation

Equity investors may ask to be added to the company’s board of directors. It suggests that they will be involved in critical strategic choices and have a voice in the company’s general course.

Selecting the proper investor can be beneficial as they may bring with them essential experience and may be able to provide access to their network of business contacts. Conversely, a lender is not a shareholder and does not participate in the company’s management choices. Their sole responsibility is to arrange your financing and guarantee that you have the resources to repay it.

The Procedure for Raising Money

Avoid financing equity if you need money quickly. It might take some time to find the proper investor, and then you have, among many other things, to handle the due diligence process and negotiate the conditions of the agreement.

There’s also a lot of legal work involved. On the other side, debt financing is usually a quicker and easier procedure. Lenders can get you money in a few short weeks or even days.

Finance for Equity

Six Equity Financing Sources to Consider

There are several places to get equity financing, such as:

1. Angel investors in businesses

Wealthy people who invest in high-growth companies in exchange for a stake in the company are known as business angels (BAs). Certain BAs invest independently or in groups. BAs are frequently seasoned business owners who provide financial capital and their abilities, networks, and experience to the organization. Check out the business angels.

2. Investment in venture capital

Another name for venture capital is private equity financing. In exchange for equity, venture capitalists (VCs) want to invest more money than bancassurance (BAs).

The majority of high-growth companies that employ venture financing are those that want to sell or list on a stock exchange. Check out venture capital.

3. Using crowdsourcing

Through crowdfunding, many individuals can invest, lend, or support your concept or business with little financial contribution. Together, these funds will enable you to meet your financial target. Everyone who supports your proposal will often benefit financially or in other ways. Check out crowdsourcing.

4. The EIS, or Enterprise Investment Scheme

A limited company may be able to raise money through the EIS. The program is available to small businesses that engage in specific trades.

Those who invest in these businesses may be eligible for various tax benefits, including:

The cost of the shares is exempt from income tax for the buyer of the shares.

If the gain is reinvested into EIS shares, the capital gains tax (CGT) on the sale of other assets might be postponed.

The HM Revenue & Customs (HMRC) EIS advice outlines the requirements that must be fulfilled for a firm to be considered qualified and for an investor to be eligible for tax relief.

5. An Alternative Financing Platform

Under a new government initiative, the largest banks in the UK will supply three alternative finance providers with the data of any small businesses they have turned down for financing if your company is having trouble obtaining bank financing. These are the following:

  • Finance Xchange
  • Finances Available

6. The financial industry

Another way to raise equity funding is to enter a stock or public market. Companies can generate funds for additional development and access money for expansion by listing on a stock exchange. 

Final Thoughts

Businesses frequently need outside funding to sustain their operations and make investments for future expansion. The optimal debt-to-equity financing ratio is a critical component of every well-thought-out company plan.

Equity funding is available from several sources. Regardless of the source, the most significant benefit of equity financing is that it has no payback obligations and gives businesses additional funds to grow.

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