Types Of Equity Financing For Businesses
To make money in business, you must first start with money. It’s one of the inescapable contradictions involved in launching your own business. This barrier to entry into the realm of entrepreneurship means that plenty of ideas that might otherwise change the world wither on the vine for lack of funding.
Equity financing — that is, financing in which you sell ownership shares in your business in exchange for startup capital — is a funding route available to businesses that can demonstrate their potential for a high rate of growth.
I’ll have more to say about the types of businesses best suited to this path to funding later. For now, let’s delve into the various types of equity financing available to businesses, how they work, and the kinds of companies that stand to benefit from each arrangement.
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Equity Investment From Friends & Family
Soliciting equity investments from friends and family isn’t an option for all would-be entrepreneurs. Given the extreme racial and class stratification of generational wealth in this country, this funding route is not a realistic option for the majority of entrepreneurs looking to build a business. However, I would be remiss if I didn’t mention this potential source of equity investment for entrepreneurs privileged enough to have wealth in their social networks or families.
Friends and family aren’t an ideal source of equity investment because you’ll be jeopardizing close personal relationships in the event your business venture goes down in flames. Nonetheless, this is one of the more common sources of equity financing, so if the option is available to you, it’s something to consider. What’s more, people in your personal 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 of the merits of your business plan than it is to convince an angel investor or venture capitalist, you’ll have to be comfortable with the idea of Uncle Earl owning a chunk of your business and having a say in how it operates!
Venture capitalists are a hard lot to impress. Popular entertainment (Shark Tank comes to mind) has propagated the image of the hard-hearted VC investor shooting down entrepreneurial dreams left and right. Of course, there are exponentially more would-be entrepreneurs than there are venture capitalists, so VC firms can naturally be ultra-selective when choosing their investments.
Given this highly competitive environment, VC firms have 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 placing risky bets, so it’s a very narrow slice of the entrepreneurial world that gets substantial VC attention.
Owners of early-stage tech ventures with the potential for supercharged growth tend to be the business owners who have the most success at attracting VC attention and investment. If this describes you and your business, it may be worth seeking out some of that sweet VC cash. Keep in mind that venture capitalists tend to be more hands-on in influencing how your business is to be run than, say, angel investors. VC firms, when they do invest in a business, tend to invest a lot — consequently, they acquire more equity in your business than do other types of investors. They may well require that a representative of the firm sit on your board of directors.
If you’re building the kind of company that appeals to venture capitalists and you accept the trade-offs involved in any VC equity funding arrangement, by all means, pursue this funding avenue!
Angel investors are distinct from venture capitalists in several ways. They tend to make smaller investments in businesses than do VC firms, but, accordingly, they typically take a more hands-off approach with the businesses they invest in. Angel investors are often successful entrepreneurs themselves, and they may be more motivated by your personal qualities than your typical VC outfit.
As angel investors often take a more personal approach to what they invest in than do VC firms, they may 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 them likewise tend to invest in businesses within their sphere of expertise.
This isn’t to say it’s easy to get an angel investor on board with your new business. However, depending on the kind of business you’re building, you may find angel investors to be a more likely source of funding than a VC firm — and with more flexible terms to boot.
Mezzanine financing combines both debt and equity financing. Here’s how it works:
The lender provides you with a loan. So long as you make your payments on the loan, you’ll retain full control over your business, and the loan will be treated like any other loan. However, if your business takes a downturn and you can’t repay the loan, the lender can then convert the loan into equity interest, effectively seizing a portion of your company and establishing a claim to any future profits generated by your business.
This type of arrangement lessens the risk taken on by the lender and, in turn, makes it more likely they will lend to a business. Of course, any business taking out a mezzanine loan is taking on the risk that the lender will take over a portion of the business if you can’t meet the repayment terms of the loan. If you are able to make the payments, however, you’ll keep full ownership of your business.
Small Business Investment Companies (SBIC)
The US federal government, via the Small Business Administration (SBA), regulates a program called the Small Business Investment Company (SBIC) program. The SBA describes SBICs thusly:
An SBIC is a privately owned company that’s licensed and regulated by 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 does provide 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 small businesses.
The SBA website goes on to state that SBICs “invest in small businesses through debt, equity, or a combination of both.”
Unfortunately for startups, SBICs typically fund mature businesses that have already established their profitability. However, different SBICs have different investment profiles, so it may be worth it to look into any SBICs that are currently investing in your particular field. There are three universal requirements for any business seeking to participate in this program, however.
- At least 51% of your employees and assets must be within the US
- Your business must qualify as a small business according to SBA size standards
- Your business must be in an approved industry (certain industries, such as farming, real estate, and financing, are not on the approved list)
Equity crowdfunding is a new form of equity investing. It was legalized in 2012 with 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 instead of sending money to a campaign in exchange for a product or some branded merchandise, you invest in a company in exchange for equity in the company.
Essentially, equity crowdfunding websites put you in touch with a crowd of potential angel investors, only instead of receiving a large investment from one angel investor, you’ll receive lots of much smaller investments (often as low as $20) from armchair investors who liked what they saw in your online crowdfunding campaign (that is, if your campaign is successful).
Thus far, the equity crowdfunding industry hasn’t taken off in the way those who pushed the passage of the JOBS act had imagined. Nonetheless, many companies have managed to attract investments this way, and it presents entrepreneurs with a way to go around the VC companies and the big angel investors to appeal directly to the public for investments. If you think your business project has mass appeal, but you haven’t been able to secure any VC or angel investor capital, consider an equity crowdfunding campaign.
If you’re interested, check out our article on how equity crowdfunding differs 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 is any confusion, let’s differentiate between equity financing and debt financing.
When you take out a small business loan from your bank, or when you buy a Playstation 4 using your credit card, that’s debt financing. Your creditor (your bank in 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 simply have to pay back your lender with interest. That’s great if you’re able to pay back what you borrowed — you’ll have no 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 just generally make your life hell.
By contrast, equity financing involves less risk to you (and more risk to the investor). If you’re able to secure equity investment in your business and your business ends up crashing and burning, you don’t have to repay your investors. They take the loss on the investment, not you. Of course, the flip side of this is that equity financing will cost you if your business is successful. That’s because your equity investors will be entitled to their portion of your business profits for as long as they own shares of your company, which may well be the entire life-span of your business (unless you buy them out, which will almost certainly cost you more than the amount of the initial investment).
Is Equity Financing Right For Your Business?
Any comparison of debt and equity financing wouldn’t be complete without noting the simple fact that equity financing is harder to obtain than debt financing. The primary sources of equity investment — venture capital firms and angel investors — usually look for early-stage companies with explosive growth potential, often tech companies. If your business venture doesn’t have expansive, global ambitions and is more locally-oriented, you’re much more likely to find success securing debt financing than equity financing.
That’s not to say that a smaller/more local business could never get equity investment. However, you’ll likely have to turn to alternative sources of equity investment, such as equity crowdfunding or friends/family.
Let’s get down to brass tacks. Is equity financing right for you and your business?
Equity financing is right for you if:
- Your business has exponential growth potential
- You are an entrepreneur looking for a mentor for guidance (angel investors like to mentor)
- You want to avoid going into debt to finance your business
- You have global ambitions for your company
Debt financing may be better for you if:
- Your business does not yet have a plan for rapid growth
- You want to retain complete control over your company and all future business profits
- Your company only serves the local market
- You want to raise capital without concerning yourself with federal securities laws and regulations
Equity financing isn’t a funding route for every business venture. However, if you think it’s a route worth pursuing to fund your new business, just know that there are multiple ways to seek equity investment.
If you decide that traditional debt financing is a better bet for your business, have a look at our full set of business loan reviews! It’s filterable!