Equity financing - What is equity financing?
Equity financing is a form of business financing through the sale of equity, usually in the form of shares.
Considering receiving financial backing for your new business? Check out our blog on ‘Getting financial backing from a bank or investor’.
Equity financing is one of the two main forms of business financing. The other is debt financing which is when a company borrows money to be paid back at a later date (i.e. a loan).
While equity financing more commonly refers to public company shares, it can also refer to private company financing.
What is equity?
To understand equity financing, you will first need to understand what constitutes as equity.
Equity, also known as shareholders equity in the business world, is the number of assets an investor will own once all debts have been paid.
Equity is any form of asset once all related debts have been paid off. With equity financing, equity is the (part) ownership of the company.
Equity = Assets – Liabilities
How equity financing works
Equity financing is generally used for a short-term need for cash rather than long-term financing. It is also commonly used for startup companies in which several rounds of financing occur during its evolution.
There are a number of different types of equity financing for small businesses. I’ll outline the main types below.
Venture capital firms invest in startups that have a strong potential to grow. In order to receive venture capital, you will need to provide in-depth information regarding your business plan and growth potential.
They are usually only interested in businesses that will grow rapidly in order to receive a large return. Venture capitalists usually spend a lot of time and expertise in helping the business and making decisions.
Angel investors, also known as business angels, aren’t as involved in the operations of the business compared to venture capitalists, but they may provide their input. Angels are usually wealthy individuals who wish to invest a large sum of money, in return for a healthy profit.
Private investment from friends and family
This is an extremely common form of equity financing which involves receiving money from your friends and relatives. It is generally a smaller amount and used for the beginning stages of your business.
Mezzanine financing is a combination of equity financing and debt financing. The lender provides you with the funds you require as a loan. In return, you promise a percentage of your business in case of default.
In other words, if you repay the loan as arranged, then you will keep ownership of the business. However, if you default on the loan, the lender takes part ownership of the business.
Equity financing special considerations
Equity financing is closely regulated by local and national governments. These regulations are aimed at protecting investors from fraudulent companies who may disappear with their money.
Because of this, potential investors are provided with a memorandum or prospectus which clearly outlines the business activities, information on the owners and directors, explanation of how the money will be used, and any further information and financial statements.
Advantages of equity financing
Here are some advantages of equity financing compared to debt financing:
- No loan to repay: With debt financing, you need to repay a loan with interest. With equity financing, there is no loan to repay which can help you put more money into your growing company.
- No credit issues: If you lack credit history, or have a poor credit history, equity financing is more suitable and attainable compared to debt financing.
- Learn and earn: With debt financing, the investors do not participate in the operation of your business. With equity financing, the investors will help build and grow your business. They are usually experienced and knowledgeable people who you may learn something from.
Disadvantages of equity financing
Here are some disadvantages of equity financing compared to debt financing:
- Must share profits: With equity financing, the investor will expect (and deserve) a share of the profits. This may be beneficial due to the experience and growth they bring to your company.
- Share control of the company: With equity financing, investors are buying partial control of the company.
- Potential tension and conflict between shareholders: Occasionally, with shared control of the business, there may be disagreements over the vision and management of the business.