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Guide to equity finance
Equity finance involves selling shares in your business in exchange for capital.
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Equity finance involves investors investing a sum of money into your business in exchange for a share in your business’s equity. This money then provides you with capital to use for your business operations to stimulate growth. Investors will, in turn, receive a percentage of shares that give them a vested interest and say in your business.
Individuals may choose equity finance over other forms of financing (such as debt financing) as it provides your business with money without placing it in debt or putting its assets at risk.
How does equity finance work and how can you spend the capital?
Money raised through equity financing can be used for any business expense, activity or expansion. Raising capital might be for a specified purpose in your business plan and this can be included in your proposal to investors, but generally, there are no limitations or requirements in how this money is spent, apart from investors’ advice.
Depending on the investor (being an individual investor, an investment firm, an angel investor or a venture capital firm) there might be specific features or benefits that come with their investment in your business. Other than that, equity finance is quite straightforward, exchanging money for a share in your business.
How does equity finance compare to debt finance?
Debt financing is when you take out a loan that will need to be paid back. Equity financing, in contrast, is where you get cash from an investor in exchange for a share in your business.
Some of the main differences between the two types of financing are:
- Giving away control. With equity, you receive money from an investor in exchange for an interest and control in your business. With debt, you get money that has to be paid back with interest, with no other strings attached.
- No debt or bad credit. Equity finance means you don’t owe anyone any money that has to be paid back with interest; equity cannot affect your credit rating the same as debt does.
- No tax deductions. Usually, the interest paid on debt is seen as a business expense and is tax deductible. These types of tax benefits do not exist with equity financing.
- No risk on assets. Even though someone else will have an interest in the business assets, equity finance does not put any of your business assets at risk, as defaulting on debt repayments could.
The benefits and drawbacks to consider
- Business expertise and contacts. Having investors that are more experienced than you can provide you with valuable guidance and assistance in various business decisions. Investors usually have a vested financial interest so advice will be focussed on advancing your business. Investors provide bigger networks and more opportunities.
- Flexible payback. Naturally, investors will want to see a return on their investment, but it won’t be in the same rigid timeframe as paying back a loan. Plus, if things do not go as planned, your assets are not at risk.
- Lower cost. With equity, there is no added cost of servicing bank loans or debt finance with interest. This allows you to use that money for business activities and expansion.
- Loss of control.The more equity that is exchanged for money, the bigger the stake investors have in your business. This means that there are other people involved in the decision-making and taking count of how the money is spent. This can make running your business more difficult. If more than 50% of your equity belongs to investors, you lose management control, which can easily result in you giving up ownership of your business.
- Sharing profits. Even though the “payback” of this financing is only required once the business shows profit, it also means that once there are profits, it has to be shared with all parties.
The pitfalls of equity finance you should avoid
- Giving away too much too easily. It’s important to balance the amount of money needed with the percentage share of your business you will be giving away. Weigh up the pros and cons carefully before just giving up a big stake in your business. There are other financing options such as debt financing that can be used if necessary.
- Investments from family and friends. Be careful to think that family and friends are easy investors to manage. Accepting money from close circles can affect your personal relationships if the business fails.
FAQs about equity finance
What are the different sources of equity finance?
Sources of equity finance can be family and friends, business angels (wealthy individuals that invest their own money), venture capitalists (professional investors that invest funds in companies with high growth potential) or a public float (issuing securities to the public).
Are there any red tape or administrative difficulties involved?
There can be legal and regulatory requirements that have to be complied with when raising this type of finance, for example, when promoting investments. It is recommended that this be taken into account when considering your specific process of raising capital.
Is obtaining equity finance really that time-consuming and distracting?
Obtaining a loan is usually a quicker way to obtain finance, as it can take time to find the right investor. Raising this type of finance can also take management focus away from core business activities, and management time will have to be taken to provide investors with regular business updates.
The biggest amount of time will probably go into becoming investment ready, that is, preparing the right proposals and gathering all the relevant information for your pitch to investors.
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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