What Is Equity Financing and Where Do You Use It?
If you are starting a new business, I am sure you have explored equity financing.
Whether it is a start-up or established business, equity financing is crucial.
It is one of the primary fundraising resources.
Businesses constantly need fund.
It could be either for capex or expanding operations.
This is, in fact, one of the easiest ways to look for additional funds.
The scale and extent of equity financing are quite huge.
From a few thousand to tens of millions, you can raise any amount of money.
Typically equity financing is used to raise seed capital.
So what exactly is equity financing?
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Definition of Equity Financing
Typically, in equity financing, company raise funds through the sale of equity.
In other words, shares of the company are sold to generate funds.
The number of shares that you issue depends on the amount of money you need.
Additionally, the extent of dilution is also a factor.
Depends on who and how you are formulating the fundraising.
Do not mistake; equity financing is not just straightforward share sale.
It also includes other equity investment instruments as well.
So, preferred share sale or convertible preferred stock is also a means of fundraising.
Even warrants classify as tools for equity financing.
So, whenever there is an exchange of equity for money, it is equity financing.
Perhaps the simplest example is initial public offering.
Even a follow-on offer is a representation of this concept.
In all these instances, the company goes public, dilutes stake, raises money.
But equity financing is not based on someone’s will.
Equity Financing Norms
A business or a corporate cannot just decide to go for equity financing suddenly.
There are a series of rules and regulation.
Normally, the central governing body imposes the regulations.
These safeguard the interests of those who are buying these equity shares.
The company has raised its money and can do whatever they wish.
The investor is left with the equity shares.
Now it is important to make these count.
This is where the regulations come handy.
They make sure fake operators cannot just walk away with public money.
Once a company is listed, they are also accountable to the public.
So, information regarding the company’s operation and business model is made public.
This helps the buyers to make an informed call.
They can decide on their own if there is value in buying a specific share.
It is these regulations that help stop unscrupulous equity financing.
Think about the tech bubble in 2000-2002 or 2008 market condition.
The various regulations ensure the protection of the retail investor’s interest.
However, equity financing is often dependent on market conditions.
You will see the renewed interest when markets are trending up.
Conversely, equity financing is not that hot in a ranged trade or declining markets.
Perhaps the biggest advantage is you don’t have to pay back any money.
You sell shares and collect money and can pretty much forget about the whole deal.
On an average, the interest picks up most just after a bout of the market correction.
Investors approach the market with renewed vigor and excitement.
Identifying Sources For Equity Financing
The source you decide for equity financing is a very important factor.
From the amount of money you can raise to the extent of dilution, all depends on it.
Normally if you look at startups, they invest their own funds.
Once they exhaust these means, that’s when equity financing comes to play.
Primarily any source that you decide upon has the money and willing to invest.
Moreover, they also need to have a genuine interest in the business.
This is because they become stakeholders here after all.
The investor will not get any money back.
They need to get the return from equity, and that’s why they need to have a say.
Angel investors are one of the most used sources of equity financing.
Especially, if you are starting a new business, they can offer the best scope.
Normally, they comprise of relatives and friends of the entrepreneur.
Alternatively, it can also be a group of deep-pocketed individuals.
The extent of investment, in this case, is around $500,000.
Most times, the angel investors do not get involved in the day to day business.
This is perhaps the most popular source of equity financing now.
But it is not easy to get funding from them.
They are very particular about whom to provide and how much to provide.
They generally look for strong management teams and sound business concepts.
Venture capitalists are aggressive go-getters by nature.
They never sit back and relax.
Most times venture capitalists take up rather an active role in daily operations.
Their sole motive is maximizing the returns on the investment.
Now, these venture capitalists are serious investors.
Their investment is generally over $1 million and into a private enterprise.
Converting a private business to the public via IPO is one of the most common routes.
These investors are undeniably one of the most ambitious set.
They target an average of 30% plus return on their investment.
Normally, they have huge resource base and can invest up to $500 million.
They are open about investing in a business at any phase.
They are a very active participant in the overall business growth.
Business owners approach them for equity financing capex.
The most usual modus operandi is share sale to public & private investors.
There are some investment banks that run a separate venture capital division.
These concentrate solely on providing equity financing solution to businesses in need.
But most of these initiatives concentrate on financing in the early stage.
This type of equity financing is gaining momentum in recent times.
Normally you will classify these investors as angel investors individually.
Crowdfunding sites undertake the fundraising.
They can comprise of really small investment players.
Creating an online crowdfunding campaign is the first step.
However, you have to verify the legal standing of this arrangement.
In many countries, it is not legal yet.
How Can Small Businesses Get Equity Financing?
In this context, a very important question is how small businesses can get funds.
Compared to large established players, they find raising funds more difficult.
Nor do they have years of proven track record, neither is their a well-accepted product that people are ready to bet on.
More than 75% of the funding for small businesses is from personal sources.
Small businesses often use this as a bait to attract more equity financing.
You have started your own venture and completely convinced about it.
As a result, you are looking for more interested players who are ready to trust you.
In fact, without making your hands dirty, how can you expect others to participate.
Most times investors are keen to see the extent of the business owner’s investment.
Around 25-50% investment normally signals serious players in the market.
It shows they mean business and are here for the long haul.
This is often the best way to convince new investors for equity financing.
In this context, the other key investors are the SBICs.
This stands for small business investment corporations.
These corporations are regulated by the SBA.
It generally comprises of private investors with ready cash.
In fact, the SBICs are mandated to invest in small firms.
The net worth of these is less than $18million and average earnings below $6 million.
Advantages of Equity Financing
The focus then shifts to the pros and cons of equity financing.
First of all, we will handle why you may be interested in equity financing.
Given the different tools available, why would a business select equity financing?
Well, there are many advantages that businesses want to leverage on.
Perhaps the most important one has to be no payback involved.
Once you have sold the equity, the matter is over then and there.
There are no repayment schedules or fund allocation.
Unlike in case of debt financing, you can channelize resources for capex.
If you compare debt and equity financing, the level of risk emerges as a key factor.
Debt products are laden with risk.
However, equity financing is relatively a low-risk offering.
If you compare with a bank loan, the first point is there is no payback.
Investors know that this is a long drawn out process.
They do not expect overnight repayment and instant repayment.
So it helps maintain a more comfortable cash position.
The regular functions of a business need a large amount of cash.
Equity financing helps significantly in this matter.
No Repayment Obligation
Let’s assume you undertake retail financing for a small restaurant.
But it fails to pick up the pace, and eventually you give up.
In case of a bank loan, you had to pay in any case.
It will never take into account whether it is running or not.
But in case of equity financing, you do not have any such obligation.
All those who have bought equity are duty bound to share the profit and loss.
There are several regulations in place to safeguard the equity buyer’s interest.
As a result, there is a very limited scope of the fraud.
Disadvantages of Equity Financing
But like every situation, there are always two sides to a coin.
If equity financing has some advantages, there are some problems too.
Don’t be just too buoyed by the convenience of this tool.
Carefully consider all the disadvantages as well.
Only then you can take a reasonable call on its effectiveness.
You must remember that every situation offers a different challenge.
Only a comprehensive understanding can help take a rational call.
Have to Accommodate Opinion
Buying equities make investors take a stake in your business.
That means you do not enjoy proprietorship on your own content.
The equity investors have a certain degree of right in your business now.
This makes them voice their views and judge you as well.
Though the original concept is yours, other stakeholders can vote against you.
So in many ways, you need to give up absolute ownership.
You can continue to own majority stake, but other stakeholders have brought money.
So, you can never completely ignore them.
Think about Steve Jobs and Apple.
The stakeholders are only interested in running the company efficiently.
They even voted him out of the company when they decided.
Think about a bank loan to a business.
Once the bank has paid the money, they only track the repayment schedule.
But the dynamics are very different in case of equity financing.
The investors often need a very detailed accounting of what is happening.
For every future decision, they need to be taken into confidence.
You have to take a call as a team and cannot just decide on any element unilaterally.
The company is yours, but several other investors have also invested.
So you have to answer everyone’s query and concerns.
Investor queries can often be annoying, and you can also lose time.
A lot of times, you cannot even implement your ideas.
You have to wait for their nod too.
Therefore, be careful about the investors you choose.
Do not just accommodate them because they have money.
Complying with Regulations
Equity financing is very different from a bank loan or debt financing.
It is never as straightforward as applying for a bank loan.
You have to comply with several regulations.
There are government policies and companies policies.
You have to adhere to them all.
Only then, you can complete the financing process.
Additionally, you also need to comply with legal formalities.
In the absence of these, the equity division can be misused.
You can even jeopardize your own stake in the company.
So, proper legal formalities are crucial.
Where Do You Use it?
So, the question is how you can decide if equity financing is right for you?
The solution can be simple.
Ask yourself how soon do you need the financing?
If you need the cash immediately, then equity financing may not be right.
In fact, it can take a long time for the final proceedings to come through.
You have to pitch your plan.
Create a line of interested investors.
Undertake a dialogue with them and then decide on one.
You have to also draw up the legal documents.
You will also need to ensure the all arrangements correctly.
The extent of money you need is also an important consideration.
Debt financing is much better and more convenient for smaller sums.
However, for a larger amount of money say $500,000 or more, equity financing is ideal.
Moreover, the interest cost on such a loan is much higher too.
In many ways then, equity financing reduces cost obligation.
Equity financing is never just about the money.
Along with the funds, equity investors also bring in expertise and drive.
Debt financing is a pure money transaction.
However, equity financing gets you knowledge base and network as well.
So, it&8217;s never just cash in your account.
It is also a huge positive fillip to your overall business.
Often equity financing can provide a lease of fresh life to your business.
Moreover, businesses will have to assess the extent of growth they envisage.
Equity financing makes sense when you are looking for extensive expansion.
It is one of the best ways to garner both money and expertise.
This is one of the most comprehensive means of expansion for sustained growth.
Equity Financing Is a Lot About Sustained Development
For venture capitalists and investors, they are most times looking for growth.
Therefore, it is important to assess the kind of growth you are looking for.
For long-term and widespread growth, equity investors can be the best bet.
The choice of equity partners is also crucial.
If you can zero in on the right person, you can get both value and funds.
Make sure you thoroughly understand the expectations and ability of investors.
Don’t get buoyed by their sheer power.
Always make a realistic assessment of how much value they bring to the table.
That can be a crucial judge of the type of growth they can help you realize.
Though most investors will tell you, they are here for the long haul.
Remember that is only lip service.
Most investors are looking for quick returns and value-based growth via equity financing.