6 Types of Equity Financing for Small Business

Avoid Loans and Credit Debt By Financing with Equity

There are several ways to raise money for a small business. Many business owners take out bank loans; others borrow from family or friends. In some cases, even credit cards can be a viable way to get started. But if a small company is likely to make a significant profit in a relatively short amount of time with appropriate up-front capital, it might be eligible for equity financing.

Equity is the ownership stake that both the business owner and other investors have in a company. Equity financing involves raising money through investors. When a business owner uses equity financing, they are selling part of their ownership interest in the business firm. Investors are actually buying a share of the company in exchange for a percentage of proceeds. In other words, investors believe the company has potential to make money, and they are expecting a return on their investment.

There are several possible types of equity financing or investment in business firms. Here are the most common.

Financing with Money From Family and Friends

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For business owners who have strong family ties or social networks, it may make sense to ask close contacts for investment funding. This type of funding, while relatively common, can be risky. Before asking for funding, it's important for the business owner to feel comfortable with the idea that a friend or family member might lose money.  More

Small Business Investment Companies

The Small Business Administration (SBA) licenses and regulates a program called Small Business Investment Companies that provide venture capital to small businesses. While SBA funding is very competitive, it can also be a great way to get started. More

Angel Investors as a Source of Equity Financing

Angel investors can provide second-tier financing to businesses. They are wealthy groups or individuals who are looking for a high return on investment and are very picky about the businesses in which they invest. More

Mezzanine Financing

Mezzanine financing is actually a hybrid form of financing that utilizes both debt and equity. The lender makes a loan and, if all goes well, the company simply pays the loan back under negotiated terms. If, however, the company does not succeed, the lender has the right to convert their loan into an ownership or equity interest. This approach protects the lender from the reality that most small businesses do fail. At the same time, it allows the business owner keep ownership of their own business for as long as the business is profitable.

Venture Capital

If you get a venture capitalist interested in your business, you will give up a portion of your ownership and will probably have a representative of the venture capital firm on your Board of Directors. Venture capitalists are looking for high rates of return where they invest their money. Unless your business can offer them a high rate of return, they will probably not be interested. More

Royalty Financing

Royalty financing is an equity investment in future sales of a product. It is a less formal process than angel or venture capital investing. Similar to a loan, it involves a funder providing up-front cash for business expenses; the funder is then paid a "royalty" when profits start to roll in. According to Inc.com:

Royalty financing arrangements offer a number of advantages to small businesses. Compared to equity financing, royalty financing enables entrepreneurs to obtain capital without giving up a significant ownership position in the company to outside investors. The founders of the company are thus able to preserve their equity position, which may help motivate them toward continued success.