To make money in business, you have to begin with money. It’s one of the inescapable contradictions involved with launching your own business. This barrier to entry into the arena of entrepreneurship implies that lots of ideas that might otherwise alter the world wither around the vine for insufficient funding.
Equity financing — that's, financing in which you sell ownership shares in your business in return for startup capital — is really a funding route available to companies that can demonstrate their possibility of maximum growth.
I’ll have more to say of the kinds of businesses best suited to this road to funding later. For now, let’s explore the different types of equity financing open to businesses, the way they work, and also the kinds of companies that are in position to benefit from each arrangement.
Equity Investment From Friends & Family
Soliciting equity investments from family and friends isn’t an option for those would-be entrepreneurs. Because of the extreme racial and sophistication stratification of generational wealth in this country, this funding route isn't a realistic choice for the majority of entrepreneurs looking to build a business. However, I would be remiss basically didn’t mention this potential source of equity investment for entrepreneurs privileged enough to have wealth in their social networking sites or families.
Friends and family aren’t a perfect supply of equity investment because you’ll be jeopardizing close personal relationships in case your business venture falls in flames. Nonetheless, this really is one of the most common sources of equity financing, therefore if the option is available for you, it’s something to think about. What’s more, individuals your individual networks may be more open than other investors to funding a business without, say, the exponential growth potential of a tech startup.
Of course, while it may be easier to convince your Uncle Earl from the merits of the business plan than it is to convince an angel investor or venture capitalist, you’ll need to be confident with the thought of Uncle Earl owning a slice of your business and having a say in how it operates!
Venture Capital
Venture capitalists really are a hard lot to impress. Popular entertainment (Shark Tank comes to mind) has propagated the look of the hard-hearted VC investor shooting down entrepreneurial dreams left and right. Obviously, you will find exponentially more would-be entrepreneurs than you will find vc's, so VC firms can naturally be ultra-selective when selecting their investments.
Given this highly competitive environment, VC firms possess the luxury of investing only in early-stage companies with the highest potential for rapid growth. These investment firms also have a low tolerance for putting risky bets, so it’s a very narrow slice of the entrepreneurial world that will get substantial VC attention.
Owners of early-stage tech ventures with the potential for supercharged growth are usually the business owners who have probably the most success at attracting VC attention and investment. If this describes both you and your business, it might be worth seeking out a number of that sweet VC cash. Remember that venture capitalists tend to be hands-on in influencing how your business is to become run than, say, private investors. VC firms, when they do invest in a business, tend to invest a great deal — consequently, they acquire more equity in your business compared to other kinds of investors. They may well require that the associated with the firm take a seat on your board of directors.
If you’re building the kind of company that attracts vc's and you accept the trade-offs involved in any VC equity funding arrangement, by all means, pursue this funding avenue!
Angel Investors
Angel investors are dissimilar to venture capitalists in several ways. They tend to make smaller investments in businesses than do VC firms, but, accordingly, they sometimes have a more hands-off approach using the businesses they purchase. Angel investors in many cases are successful entrepreneurs themselves, plus they may be more motivated from your personal qualities than your typical VC outfit.
As angel investors often have a more personal method of the things they invest in than do VC firms, they might be open to funding a wider variety of early-stage businesses than a venture capitalist would. Many angel investors come from outside the tech world, and many of these likewise tend to purchase businesses within their sphere of expertise.
This isn’t to state it’s easy to get an angel investor on board with your new business. However, with respect to the kind of company you’re building, you might find angel investors to become a much more likely source of funding than a VC firm — and with more flexible terms as well.
Mezzanine Financing
Mezzanine financing combines both debt and equity financing. Here’s how it works:
The lender gives you financing. If you payout your loan on the loan, you’ll retain full control over your company, and also the loan is going to be treated like every other loan. However, if your business requires a downturn and you can’t repay the borrowed funds, the lending company may then convert the loan into equity interest, effectively seizing some of the company and establishing a claim that they can any future profits generated from your business.
This kind of arrangement lessens the risk adopted through the lender and, in turn, causes it to be much more likely they'll give loan to a company. Of course, any business taking out a mezzanine loan takes around the risk the lender will take over a area of the business should you can’t meet the repayment terms of the loan. If you are capable of making the payments, however, you’ll keep full ownership of the business.
Small Business Investment Companies (SBIC)
The US federal government, via the Sba (SBA), regulates a course known as the Small company Investment Company (SBIC) program. The SBA describes SBICs thusly:
An SBIC is a privately owned company that’s licensed and regulated through the SBA. SBICs invest in small businesses in the form of debt and equity. The SBA doesn’t invest directly into small businesses, but it provides funding to qualified SBICs with expertise in certain sectors or industries. Those SBICs then use their private funds, along with SBA-guaranteed funding, to invest in smaller businesses.
The SBA website procedes to suggest that SBICs “purchase small businesses through debt, equity, or a combination of both.”
Unfortunately for startups, SBICs typically fund mature companies that have already established their profitability. However, different SBICs have different investment profiles, so it will probably be worth it to check out any SBICs which are currently purchasing your particular field. You will find three universal requirements for just about any business seeking to participate in this program, however.
- At least 51% of the employees and assets should be within the US
- Your business must qualify as a small business according to SBA size standards
- Your business should be in an approved industry (certain industries, for example farming, property, and financing, are not around the approved list)
Equity Crowdfunding
Equity crowdfunding is a new form of equity investing. It had been legalized this year using the passage of the JOBS act to allow everybody the ability to invest in companies conducting equity crowdfunding campaigns. It’s like backing a Kickstarter project, except rather than sending money to some campaign in return for an item or some branded merchandise, you invest in a company in exchange for equity within the company.
Essentially, equity crowdfunding websites put you in touch with a crowd of potential angel investors, only instead of getting a large investment from one angel investor, you’ll receive lots of smaller investments (frequently as low as $20) from armchair investors who liked what they saw inside your online crowdfunding campaign (that's, if your campaign is successful).
Thus far, the equity crowdfunding industry hasn’t taken off in the way those who pushed the passage from the JOBS act had imagined. Nonetheless, many companies have managed to attract investments by doing this, also it presents entrepreneurs with a way to go round the VC companies and the big private investors to appeal straight to the public for investments. If you think your company project has mass appeal, however, you haven’t had the opportunity to secure any VC or angel investor capital, consider an equity crowdfunding campaign.
If you’re interested, take a look at our article how equity crowdfunding is different from “regular” crowdfunding. If you’re wondering which equity crowdfunding sites might suit your business, have a look at our piece detailing seven leading equity crowdfunding sites for entrepreneurs.
Equity Financing VS Debt Financing: Key Differences
In case there's any confusion, let’s differentiate between equity financing and debt financing.
When you take out a small business loan from your bank, or whenever you buy a Playstation 4 using your credit card, that’s debt financing. Your creditor (your bank within the first example, your credit card issuer in the second) doesn’t own or control any part of your business (or your PS4). Rather, you just have to pay back your lender with interest. That’s great if you’re able to pay back what you borrowed — you’ll don't have any further obligations to your creditor! Of course, this arrangement involves you bearing risk. If you’re unable to make your required payments on your debt, your creditor can go to court, have your assets seized, wages garnished, and merely generally help make your life hell.
By contrast, equity financing involves less risk to you (and much more risk towards the investor). If you’re able to secure equity purchase of your company and your business winds up crashing and burning, you don’t have to repay your investors. They go ahead and take loss on the investment, not you. Of course, the flip side of this is that equity financing can cost you in case your clients are successful. That’s since your equity investors is going to be entitled to their portion of your company profits provided they own shares of your company, which may well be the whole life-span of the business (unless you buy them out, that will probably cost you a lot more than the quantity of the first investment).
Is Equity Financing Right For Your Business?
Any comparison of debt and equity financing wouldn’t be complete without noting the straightforward fact that equity financing is harder to acquire than debt financing. The main sources of equity investment — investment capital firms and angel investors — usually look for early-stage companies with explosive growth potential, often tech companies. In case your business enterprise doesn’t have expansive, global ambitions and it is more locally-oriented, you’re more likely to locate success securing debt financing than equity financing.
That’s not saying that a smaller/more local company could never get equity investment. However, you’ll likely have to go to alternative sources of equity investment, for example equity crowdfunding or friends/family.
Let’s conclude brass tacks. Is equity financing best for you and your business?
Equity financing is right for you if:
- Your business has exponential growth potential
- You are an entrepreneur searching for a mentor for guidance (private investors like to mentor)
- You want to avoid entering debt to invest in your business
- You have global ambitions for the company
Debt financing may be better for you if:
- Your business does not yet have a arrange for rapid growth
- You want to retain complete treatments for your organization and all future business profits
- Your company only serves the neighborhood market
- You want to raise investment capital without concerning yourself with federal securities laws and regulations
Final Thoughts
Equity financing isn’t a funding route for each business enterprise. However, if you feel it’s a route worth pursuing to fund your brand-new business, just know that there are multiple ways to seek equity investment.
If you decide that traditional debt financing is the perfect bet for the business, have a look at our full set of business loan reviews! It’s filterable!
