Guide to equity finance
Equity finance involves selling shares in your business in exchange for capital.
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If you're looking to raise business capital, you could either take out a loan or sell business shares in exchange for capital. The latter is called equity finance. It involves selling a share of your business's equity for funding. You can then use this capital for business operations and growth.
What is equity finance?
Equity finance is when you raise capital by selling a part of your business's equity. Your business will receive financing for a number of business operations. In return, your investors will have a stake in your company and a share of your profits.
The alternative to equity finance is debt financing. This is when you take out a loan to fund your business and make regular repayments to pay it off over time.
Equity financing may be helpful if your business is young and does not have sufficient customers or revenue to qualify for debt financing.
How does equity finance work?
Money raised through equity financing can be used for any business expense, activity or expansion. You may need to raise money for a specific purpose, and this can be included in your proposal to investors. But there are usually no limitations or requirements in how you can spend this money. Your investors may, however, provide some advice.
With equity financing, the lender will have a stake in your business. They will be part of your business decisions and will also have a share of your profits.
Depending on the investor, there may be specific features or benefits that come with their investment in your business. Apart from that, equity finance is straightforward: it involves exchanging shares for capital.
How does equity finance compare to debt finance?
While many businesses use a combination of equity and debt financing to fund their operations, there are a number of key differences:
| Equity finance | Debt finance | |
| Repayments | No repayments involved. You don't have to pay back the money you've raised, but you will be sharing your profits either in the short term or the long term. | You have to make regular repayments to the lender, which will include interest charges and ongoing fees. As a result, you'll be paying more than you borrowed. |
| Turnaround time | It will take time to raise finances, and it may involve presenting to multiple investors. | Depending on the type of loan you apply for, you could get funding within a few days. |
| Stake | The investor will have a stake in your business. You will no longer have 100% control or ownership. You will have to take their input into account when making a decision. There may be times when their strategic interest may not overlap with yours. Their expectation of the return on investment and when they expect it may be different from your projections. | The lender does not have a stake in your business whatsoever. Your only obligation is to repay the loan. Your relationship with the lender effectively ends once you repay the loan. |
| Credit score | Your credit score does not play a role in your ability to attract investment. Nor will your credit score be affected, as there are no loan repayments involved. | Your credit score will determine your ability to get a loan. The total cost of the loan may also be influenced by your credit score. Not making repayments on time will eat into your credit score, affecting your ability to get credit in the future. |
| Assets | You give up equity or shares in exchange for investment. You don't lose assets in case your business fails. | You retain your stake in your business, but you risk losing your assets if you default on your loan. |
| Tax benefits | You don't get any tax benefits with equity financing. | Interest paid on debt is seen as a business expense. It is tax-deductible. |
How do I know which option is better for my business?
This will depend entirely on your preferences and priorities. There are a number of factors you will need to consider to help you make this decision:
- What is your company's cash flow? If your net cash flow isn't sufficient to pay down your debt, you may not be able to take out a loan. With equity financing, you may not need high net cash flow at the time of financing.
- Which source of funding is easier for you to access? The age and performance of your company will play a role in your ability to access capital. Many lenders will take the age of your business into account. If you're bootstrapping a startup, you may find it difficult to access a traditional loan given how young your business is. In such a case, equity finance may be your best option. Your business may also not have enough cash flow to justify taking out a loan. Your business credit score will also determine your ability to access debt financing.
- Is it important for you to maintain full control over your business? Generally, with equity financing, even if you have a majority stake, you may have an obligation towards your investors. This is not the case with debt financing, where your only obligation is to repay the loan. The lender will not have any say in how you run your business or its direction.
What are the sources of equity finance?
- Self-funding. This is also called bootstrapping. It's when you put in your own finances into starting and growing the business.
- Family or friends. You could offer a share of your business to family or friends in exchange for funding. This option does come with the risk of affecting your personal relations.
- Angel investors. These are wealthy investors who provide funding in exchange for equity. They can also provide expertise and advice and connect you to the right people.
- Venture capitalists. These are large corporations that invest in startup businesses. The investments are usually large and they will require a large share of your business. They can provide management or industry expertise and will invest if your business has the potential for high growth and profits.
- Stock market. This is also known as an initial public offering (IPO). It involves publicly offering shares to raise funding.
- Government grants. There may be government grants you could apply for. This can help you expand your business, innovate, conduct research etc.
- Crowdfunding. This is when you use the Internet to raise money from a large number of people. They could either invest or donate to fund your product or project. There are websites that provide a platform for crowdfunding. There are different types of crowdfunding. They can be donation-based, reward-based, equity-based or debt-based.
What are the pros and cons of equity finance?
Pros
- Business expertise and contacts. Investors who have more experience than you can provide valuable guidance and assistance. Investors usually have a vested financial interest, so advice will be focussed on advancing your business. They may also provide bigger networks and more opportunities.
- Flexible payback. Investors will want to see a return on their investment, but it won't be in the same rigid time frame as a loan. If things don't go as planned, your assets are also not at risk.
- Lower cost. With equity, there is no added cost of servicing bank loans or paying interest. That money can be used for business activities and expansion.
Cons
- Loss of control. The more equity you give up, the bigger the stake investors have in your business. This means involving other people in decisions. This can make running your business more difficult. If more than 50% of your equity belongs to investors, you lose majority control and possibly management control.
- Sharing profits. Even though the "payback" is expected only once you make a profit, it also means that when there is a profit, it will have to be shared with your investors.
What should I avoid?
- Giving away too much too easily. Determine exactly what you need to grow your business. Receiving too much and giving away too much is not a good idea. You may lose more control over your business by giving away too much. Additionally, by giving away too much now, you will have fewer shares to give away later to raise more money down the line.
- Investments from family and friends. While this may be a good source of seed money, you should think carefully about taking money from family and friends. They may not be the easiest relationships to manage. It may also affect your personal relationship, especially if the business fails.
- Investments from anyone with a conflict of interest. You could have conflicts, including ethical conflicts, from certain investors. Their portfolios might run contrary to your values and interests. It may be important to find investors who align with your values.
- Investors whose strategic interests don't align with yours. Not all investors will be able to give you the strategic guidance you need to grow your business. It's better to seek out industry-specific investors so that you can benefit from the expertise they have in that area.
Frequently Asked Questions
Compare other business loan options
Invoice financing is a type of business loan that is secured by outstanding invoices. It comes with reduced risk, no asset requirements or interest payments.
Image: Shutterstock
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