Equity finance
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Equity financing is one of the driving forces in some of the most consequential businesses of our time – think Google, Facebook and the like. The idea is that by selling shares in their company, business owners can raise the money they need to take their enterprise through the next stage of growth, while investors could reap a healthy return.
This method can be beneficial for all types of businesses, from start-ups through to more established companies, since there’s no interest to repay and the founders can focus on growth.
In this guide, we’re going to get stuck into the detail – uncovering how it all works, the different types of equity finance as well as weighing up the benefits and pitfalls. It’s important to note that any form of finance has inherent risks. If you’re concerned about your options in any way, you should seek independent legal or financial advice.
What is equity financing?
Equity financing involves raising capital by selling shares in your business. When you do this, investors receive a share of the company, along with voting rights and a portion of the profits and losses, in return for their funds. This method can be particularly beneficial for businesses with high-risk, high-reward investment needs, as it means you can split the risk among shareholders, all of whom have a vested interest in the company's success.
Equity financing is often used by:
- Start-Ups: These businesses need capital to get up and running. Equity financing provides the necessary funds to develop products, enter the market, and start generating revenue.
- Established Businesses: Companies looking to fund their next stage of growth and expansion, such as scaling operations, entering new markets, or launching new products, often turn to equity financing.
By using equity financing, businesses can secure the capital needed for ambitious growth plans while aligning investor interests with their success. This approach not only provides a healthy injection of funds but also brings valuable expertise and networks from investors, contributing to the company's overall growth and sustainability.
How does equity financing work?
While equity financing typically comes from angel investors or venture capitalists, it can also be funding from family, friends or the public.
In return for becoming shareholders, investors can provide the funds you need to take your business to its next level. Some investors will be more involved in decisions made within the company.
It’s possible to go through several rounds of equity financing. But remember anyone who owns more than half of the shares becomes a controlling shareholder – no matter who started the business.
Example of equity finance:
William has started a new business. Up until now he has invested £100,000 of his own money, so he owns all the shares of the company.
While the start–up is showing a lot of promise, it’s in need of capital to grow. William finds an outside investor – his friend Helen – to supply the funds he needs. Helen agrees to pay £40,000 for 40% of the business' shares. This means that the company has now raised a total of £140,000 in capital, and William has a 60% stake of his business.
Types of equity financing
If you’re wondering how to raise equity financing, then you need to get to know the different types. Here are some of the options:
Business angels
Angel investors are often wealthy individuals who tend to have some entrepreneurial experience themselves. They use their personal funds to help businesses in need of capital. They may also bring their knowledge, expertise and business contacts to the table.
Angel investors can even be found close to home, with many businesses turning to family members, close friends and professional contacts.
Venture capital
Venture capitalists are employed by venture capital firms to invest other people’s money into businesses. They tend to invest larger amounts than business angels, but take on fewer investments.
Venture capital firms may also be looking for a seat on your board of directors.
Initial public offering (IPO)
An IPO is when a business sells shares of its stock to the general public for the first time. This is also referred to as “going public”, as it marks the transition from a privately-held company to becoming a public company.
Mezzanine financing
Mezzanine finance is a type of equity finance, but is also a type of debt finance. It blurs the lines between the two, making its own hybrid version of financing.
Mezzanine financing is where a business secures a loan, but the lender is able to convert this to an equity share after a set time frame. In plain English, it’s a loan which can be paid back if all goes well, but if it can’t be repaid then the lender can recover their costs by securing shares in the business. In some instances, it can even be agreed that some of the money will always need to be paid back as equity.
This method can be seen as more favourable than other equity finance options, as it offers a way to get the funds you need without giving up large shares in your business – if all goes well – allowing you to maintain as much control as possible, for longer.
Family and friends
Angel investors can even be found close to home, with many businesses turning to family members, close friends and professional contacts in order to get their enterprise started.
Private equity
This form of investment is similar to venture capital. Both types of equity financing pool others’ money into companies in the hope of a positive return, however private equity investors tend to choose more mature and established companies. They’re also more likely to purchase a larger share of the company, such as 50-100%, and look to improve its profitability.
Corporate venture capital
Large corporates will often invest in smaller firms as part of a wider strategy, which could result in funding for your business in exchange for equity.
Equity crowdfunding
This type of equity financing looks to raise a large number of smaller investments to generate capital. It can be done via specific crowdfunding platforms that give businesses the opportunity to pitch their product or service to catch investors’ attention.
Family offices
Wealthy families with significant amounts of money will sometimes invest in smaller businesses in order to generate more income. By contributing cash in exchange for equity, they hope to see their investment grow as the business does.
Government schemes
National schemes such as the Seed Enterprise Investment Scheme (SEIS) and the Enterprise Investment Scheme (EIS) encourage investors to put capital into new and growing companies by offering tax reliefs to those who invest.
Why should I choose equity financing over another form of business finance?
Business owners may choose Equity Financing over other forms of business finance for a variety of reasons.
- Equity financing provides substantial amounts of capital that do not need to be repaid, making it a good option for large-scale projects or start-ups that lack operational history.
- It does not involve any interest payments, reducing the financial burden on the business.
- It offers investors a share in the company's profits and the potential for significant returns, making it an attractive investment opportunity.
- It can provide businesses with strategic partners. Investors often bring a wealth of experience, valuable industry contacts, and business acumen that can contribute to the company’s growth and success.
Which businesses suit equity finance best?
Equity financing tends to be most suitable for younger businesses or start ups. That’s because at this stage it tends to have the most benefit for all involved. Cash flow tends to be tighter when you’re first starting out, so an injection of capital within the first few years can go a long way.
For the investor, a small percentage of a business during its infancy may well be worth a lot more once it matures. They’ll tend to choose businesses with high-growth potential that can multiply their investment as quickly as possible, and may expect hard work and perseverance in order to do so.
What are the Stages of Equity Financing?
Include:
- Seed funding, Series A, B, C, etc.
- Characteristics and goals of each stage
- How businesses evolve through these stages
Debt and equity finance FAQs
In business, we sometimes have to turn to external help to get the funds we need. Generally speaking, financing options can be split into two camps: equity and debt.
As we now know, equity finance is all about raising the money you need by selling shares in your business. Debt finance is as you’d expect – borrowing money which needs to be repaid, along with interest.
They’re fundamentally different ways to get hold of capital, so it’s important to grasp their respective features and benefits so you can make the right choices for your business. Let’s dive into some of the details.
What is the difference between debt financing and equity financing?
Both debt financing and equity financing are ways to help inject funds into business. The biggest difference between the two is what you have to give the lender.
Equity finance
With equity finance you need to be willing to give up some ownership of your business. In return for their money, the investor will become a shareholder. This means there isn’t a commitment to pay back what was originally invested, but it does give the investor a level of control.
Debt finance
Debt finance acts more like a household loan. A sum of money is released to you, within the arrangement of it being paid back under certain conditions, such as monthly with additional interest. This way, you don’t dilute your ownership of the business and instead pay back more than you borrow.
Weighing up which to choose is dependent on your current situation. Not everyone will be eligible for a loan, and therefore may have limited access to debt financing. Take start–ups for example, who have yet to prove that they are profitable – they may be seen as too risky for lenders, but could have better luck with equity finance if investors are more willing to take on the risk.
Advantages of equity financing
- There’s no commitment to pay back a set amount, and there’s no interest.
- Investors can bring you more than just money. Some are able to offer their own experience and skills, and may be able to help with business decisions.
- Investors may provide further funding as the business continues to grow.
Disadvantages of equity financing
- Finding the right investors and raising the finance you need takes a lot of time and energy.
- You’ll need to be willing to give up some control over your own business – as a shareholder, an investor may want to have a say in key decisions, and they might not always be on the same page as you.
- Selling a cut of your business will also affect your share of the profits. Although it’s worth bearing in mind that your reduced share could become worth a lot more if the investment leads to your business becoming a success.
- You'll need to keep any shareholders up to speed with how the business is doing, which can be time-consuming.
Is equity financing right for me?
With so many options available when looking at business finance, it pays to think ahead about what’s right for you. Equity finance can look enticing, and be useful if your cash flow situation doesn’t permit big loan repayments. However, this opportunity will almost definitely result in a reduction of control.
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