The need for capital arises at some point during every company's life cycle, whether it is for covering startup costs, paying for an expansion or funding working capital. Business financing options are not the same for each small business; the options depend on the industry, the business's time in operation and the total revenue the business earns each year.
Most small businesses have an opportunity to access capital through debt or equity financing. Both funding options have their distinct advantages and disadvantages. Before determining whether equity financing is the appropriate choice for your business, understand what this funding option entails.
What Is Equity Financing?
Equity financing is the process of raising capital for business operations or startup costs by selling a share of your company to investors. The individuals or firms that invest in equity financing deals own part of the business, and they are entitled to a portion of profits generated by the business over time. Unlike debt financing agreements, equity financing does not involve monthly repayments of loaned funds; instead, investors are repaid through business revenue and are eventually phased out of ownership.
For most small businesses, the most accessible pool of equity investors includes friends and family members. Once a business has a proven record of success, an angel investor may provide a higher amount of financing for a larger share of the company. Typically, angel investors provide funds up to $100,000 and expect returns on their investments over a three- to five-year period. Rapidly growing companies with high projected returns on investment, such as technology startups, may attract the eye of a venture capitalists for higher amounts of equity financing. Venture capitalists only invest in businesses that are likely to pay off substantially through an acquisition or an initial public offering (IPO) in the future.
Benefits of Equity Financing
Equity financing has a number of benefits over debt financing agreements. Small businesses are more likely to operate with a tight cash flow, but they also need available capital. Debt financing provides the access to capital, but it impedes cash flow by requiring monthly repayment. Equity financing deals do not tie a business owner to high payment obligations, allowing the business to use capital as needed, often without restriction.
Equity financing does not require a the business owner or the business to provide a personal guarantee or collateral. Instead, investors who agree to equity financing share the risk of the business failing with the owner. If the business fails, investors are not likely to pursue the business owner for losses, unlike debt financing agreements.
Disadvantages to Equity Financing
Although friends and family may be willing to invest on a small scale, it is not common to obtain a substantial amount of funding through this avenue. Angel investors and venture capitalists can offer much higher amounts of financing, but these outlets are challenging for most small businesses to find, pitch to and secure.
Additionally, equity financing requires a business owner to relinquish a partial share of his company to secure funding. The use of multiple investors can lead to a dilution of equity that results in a loss of control over the organization. For instance, if a business owner needs debt financing down the road, each investor who owns a substantial share (more than 20%) of the company is required to sign off on the loan. Investors may also want to take an active role in the day-to-day operations of the business, leaving the business owner with even less control over his company. Once investors lay claim to more than 49% of the business, it can be incredibly difficult for a business owner to regain control.