Equity financing and how it compares to other funding options
Equity financing is a common strategy for funding a new or growing business. Investors provide funds in return for equity in your business through shares or part-ownership. Whether you access private equity funding, work with an angel investor, or reach out to a venture capital firm, equity financing is an effective way to raise essential capital. Of course, as with any business decision, it's important to understand the trade-offs.
This guide looks at how equity financing works, the pros and cons, and how it compares to other finance options.
What is equity financing?
Equity financing is business finance that exchanges a stake in your business for cash. Unlike a business loan, the funds you receive through equity finance don't need to be paid back. However, with part-ownership in the business, most investors expect to have some control over business strategy.
How does equity financing work?
Equity financing involves an agreement between your business and a would-be investor. If you need to raise capital to establish or expand your business, you can sell a portion of it to an investor for a set price. They provide the cash — and sometimes the expertise or advice — to help you achieve your goals. Depending on the terms of the equity agreement and your business goals, the investor may not see a return on their investment until your business is sold or goes public.
What are types of equity financing?
The four main types of equity funding are individual or private investment, venture capital, crowdfunding and initial public offerings (IPOs). Here's how each method works:
A private investor, sometimes called an angel investor, is an individual who invests directly in your company. They're usually successful business owners, entrepreneurs keen to develop new ideas, or wealthy people looking for a new way to invest their money. Angel investors with business experience can add value, offering advice and support along with funding.
Angel investors usually contribute to start-ups and early-stage businesses. Often, they'll want a position in your business as well as shares or part-ownership. This reflects their early involvement and the fact that their investment isn't secured against tangible assets. They're a good option for start-ups and early-stage businesses, but they generally can't offer as much funding as a venture capital firm or other forms of financing.
Venture capital (VC) focuses on growth-phase businesses with innovative ideas and good long-term potential. Unlike private investment, venture capital is usually managed through a firm, although the actual funds can come from individual investors, banks and other financial institutions. Sometimes, VC comes with technical or management support from investors to give your business a better chance of success.
To get a venture capital investment, you should pitch your business to a VC firm, explaining your vision, highlighting growth projections, and showing them how investing in your business will pay off.
A relatively recent funding strategy, crowdfunding involves many ordinary people contributing small amounts of money to a new or prospective business utilising an online platform.
This type of finance is often used to fund an exciting new product or service that captures people's imagination. Your business sets a funding goal on a crowdfunding site, along with a description or outline of your idea, and individuals can donate through the site. Most crowdfunding efforts don't give investors a return in shares or company ownership, but some include a donation incentive — for example, investors might be the first to receive a new product when your business goes live.
Initial public offering (IPO)
An initial public offering (IPO) raises capital by selling stock in your private business to the public using the stock market. When you decide to make an IPO, you offer shares on the stock market, which are bought by private investors or members of the public. The money raised goes back into your business. You can only launch an IPO if your company has a high valuation and is stable enough to meet ASX or NZX reporting requirements.
While an IPO can be a way to make a significant chunk of cash, it's also a huge decision for your business. Changing your business from a privately owned company to a public entity means you must meet more complex compliances. Tax requirements are different — you'll need to file tax returns every year, and your directors and shareholders have to supply their details to the ASIC in Australia or the Companies Office in New Zealand. Regulations for publicly listed companies are stricter than for privately held, and you're also accountable to your shareholders, putting more performance pressure on your business.
On the plus side, an IPO is a way for previous private investors to get a return on their investments – they may be among the first to receive shares. It can also be easier to get funding or sell the business when you're ready, as your company is legally a separate entity.
Example of equity financing
Equity financing can happen in several ways — here's one example:
Jane runs a successful garden centre and wants to open two new locations. She needs to raise capital to fund rental costs, staffing, materials and fit-out. Jane decides to seek equity funding from a private investment firm and gives 15% ownership in the company in exchange for $500,000. The investor provides the cash, receives a part-share in the business and a voice in future business decisions.
Advantages of equity financing
The advantages of equity financing include:
Unlike debt financing, equity financing doesn't need to be paid back. Because there's no loan, you've no loan fees and no interest to pay, reducing the financial impact on your business.
Working with experienced investors and successful entrepreneurs can be invaluable when you're a new business owner, giving you insight, support and industry connections as you grow.
Improved financial health
A burst of funding can improve your company's financial standing by lowering your debt-to-equity ratio. When you take on loans, your ratio of debt to equity — the amount you owe compared to the value of the business — rises, which appears on your general ledger. On the other hand, equity funding is a positive, increasing your assets compared to your debt.
Accessible to all
Equity finance can be a good option for small start-ups who wouldn’t qualify for a conventional business loan.
Disadvantages of equity financing
The disadvantages of equity financing include:
Loss of equity
The main downside is handing over a percentage of your business to an outside investor. If you're not prepared to hand over ownership, equity funding probably isn't for you.
Giving up control
Equity financing may involve giving investors leadership roles and decision-making power in your business. This can be a positive for some people, but you need a good fit between your values and those of your investor.
In the long term, equity funding usually costs you more than loans. This is because the cost of equity rises with the value of your business, while debt has a set cost. For example, if an investor received 10% of your company in return for funding, it might be worth $500,000 at the time but rise to $2 million over the next few years as the value of your business increases. The equity held by your investor increases from $50,000 to $200,000 in that time. Interest and fees on a $500,000 loan, is a more clearly defined cost that doesn't increase with the value of your business.
Difficulty finding an investor
Depending on your situation, it can be more difficult to find an equity investor than a lender.
Equity financing vs venture capital
Individual investors and venture capital are often mixed up, as they're both forms of equity financing used by start-ups and other businesses.
Here's a look at the key differences between the two:
Individual equity investor
Smaller businesses that need capital
Small to medium investment in one or two businesses
Venture capital investment
New businesses with potential for rapid growth
May target specific sectors like tech, biotech, clean energy or financial services
Smaller investments in multiple companies
Equity financing FAQs
What are the risks associated with equity financing?
The risks include losing control or ownership of your business and coping with increased pressure from investors as you grow your business. Investors may be motivated by their return on investment rather than your goals for your company.
Why is equity financing expensive?
Equity financing tends to be more expensive because there’s more risk (and upside) for the investor. While you don’t make loan repayments or pay interest, the value of the shares or percentage of your successful business could end up far higher than the cost of a business loan.
Can you use equity financing and debt financing together?
Yes, many companies use both debt and equity financing. Equity financing often funds growth and development, while debt financing is used to purchase equipment and other assets.
Does equity financing require collateral?
No, equity financing doesn’t usually require collateral.
Secure your financial future with MYOB
For new business owners, securing finance can be one of the most challenging parts of getting started. Do you work with investors, take out loans, crowdfund or try to secure venture capital funding?
Whatever your approach to capital growth and business finance, you must have good financial processes in place. Investors and banks alike will want to see that your cash flow and financial record-keeping are up to scratch before they sink money into your business. That's where MYOB comes in. Our cloud-based accounting software, with a full suite of accounting and analytics tools, is designed to make life simpler for SMEs.
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