Creating and establishing a business can be costly. Although some business owners cover various startup expenses out of their own pockets, not all entrepeneurs can afford to do that.
And even when they can, ponying up personal savings to fund a startup is unsustainable. That's why anyone with Silicon Valley-style aspirations should be familiar with equity financing. It's the money that the investors and entrepreneurs ask for on each episode of Shark Tank.
If you're wondering how to fund a business, here's what you need to know about equity financing.
What is equity financing?
In equity financing, a business owner raises cash by selling shares — partial ownership — in the business. That allows the owner to raise capital, which can be leveraged to expand the business.
Take note that this is different from debt financing, in which a business owner borrows money from creditors while maintaining total ownership.
Every share that's sold represents a unit of company ownership. For example, if a business issues 2,000 shares of common stock, and the founder of the business holds 1,000 shares, then the founder owns half the business.
Any investors supplying capital for your business will do so in return for shares in the business. In other words, when investors put money into your business, they become shareholders of your company.
In the example, the other 50% of the business is distributed among the investors. The amount of equity, or ownership, given to each investor typically corresponds to the amount of capital the investor has put into the business.
Types of equity investors
There are several types of equity financing investors:
Angel investors: They tend to be wealthy people who invest in promising, early-stage businesses. Just think of Mark Cuban and his castmates on Shark Tank.
Crowdfunding investors: In this type of arrangement, you present your business idea on a crowdfunding platform, such as Kickstarter. Investors who visit the platform can opt to put money into your proposal if they think it’s promising.
Venture capital firms: They're similar to angel investors, but on a larger scale. You'll be working with a company that routinely trades capital for business equity.
Advantages and disadvantages of equity financing
What benefits could you receive when using equity financing? Also, are there reasons to avoid equity financing? Here are the advantages and drawbacks you must consider before getting into an equity funding arrangement:
One advantage of using equity financing is that it does not require repayment, which is a big plus if you're the owner of a startup business.
In debt financing, you must repay the creditor — and pay interest. For medium-term loans, you might be required to make monthly payments, and with short-term loans, daily or weekly payments may be expected.
But with equity financing, investors hold equity in your company and will be repaid through your future profits.
Moreover, in equity financing you will gain helpful business advice. Chances are, your equity investors have been in the industry a long time. They may have invested in several earlier ventures, or maybe they started their own companies.
As equity shareholders in your business, they may hold voting power in your organization. That means they can share their knowledge with you, helping put you on the correct path. You can obtain valuable business advisers and partners via equity financing.
And a big advantage of equity financing is that equity investors often put considerable amounts of money into the companies they work with. That can help you invest in your business and hire the right team to be successful.
One of the most significant drawbacks of equity funding is that you will lose some shares of your ownership. Whenever you dispense shares to equity investors, your business ownership gets diluted. Meaning, you'll have to share any profits or income from your company.
Another downside is that equity investors will have some control over your business. Moreover, the investors may insist that your business be examined and appraised — so that they can feel certain they're investing in an enterprise with high potential.
Equity financing can be a brilliant move for most businesses, but make sure you have a complete understanding of how it works.
If all you need is capital and you're not interested in sharing parts of your business or gaining the wisdom that investors can offer, then debt financing may be the better choice for you.
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