Equity financing allows business owners to raise funds by selling shares to private or public investors. Equity financing is usually mentioned in contrast to debt financing, which involves taking out a business loan that must be paid back.
There are several types of equity financing, and the best type for you depends on your business and financial status. While there are many good reasons to choose equity financing, it’s not always the best option. Let’s review how equity financing works to help you decide if it’s right for your business.
Definition and Examples of Equity Financing
Equity financing involves selling a portion of your business to raise funds. Some companies sell shares of their stock, while others sell portions of their business to friends, family members, or private investors.
For example, a startup may be able to operate on a shoestring during the research and development phase of developing its app. But once the app is ready for launch, the company will need advertising, tech support, customer service reps, and more. To raise funds for the launch, the company could take out a business loan, a form of debt financing. In this case, the company would have to provide collateral—something of value that could be repossessed by the bank if the company defaults on the loan—and start paying back the loan with interest almost immediately.
But if the product and business plan are strong, the founders may instead be able to attract equity financing from investors who are willing to put their money into the company in exchange for partial ownership.
Equity financing does not require collateral or repayment, because the funders are essentially buying a percentage of the business.
Types of Equity Financing
There are multiple types of equity financing, and all of them involve selling a portion of your business to raise funds.
- Angel investing: Angel investors are typically the first outside investors to invest in a new startup. They’re taking a chance on a business that has yet to establish itself, often in exchange for a larger share of equity.
- Crowdfunding: You might decide to raise funds for a new business through an online crowdfunding platform, such as Kickstarter. Potential investors read about your business and may invest at varying levels. It may be possible to offer products and services in exchange for investment instead of partial ownership of your business, especially if you are making or doing something particularly exciting or interesting.
- Venture capital funding: Venture capitalists, or VCs, are professional investors who carefully select businesses that are likely to make a great deal of money in a relatively short time. Once they decide to invest, they may put a great deal of money into a company. In exchange, they often own a large portion of the business and have a significant presence on the board.
- Initial public offerings: An initial public offering (IPO) occurs when a large corporation begins to sell shares through the stock market to individual investors. IPOs are only available to well-established corporations. In many cases, founders and venture capitalists leave the company once an IPO has been offered.
How Equity Financing Works
Equity financing can work in different ways depending on your company’s status, size, and potential earning power.
For example, small startups won’t be able to sell shares on the stock market but may be able to attract private investments from friends and family in exchange for a portion of the business. To convince a friend or family member to put their money behind your business, you will usually need to create a business plan and be able to answer questions about how you intend to make your business profitable.
Startups with major earning potential may be able to attract large investments from professional investment firms that make money by buying into lucrative opportunities. For example, a local restaurant or salon is unlikely to attract venture capital (VC), but a business software concept might interest a VC company. You’ll generally need to be introduced to a VC funding group by someone you know. Once your foot is in the door, you’ll be asked to attend a series of meetings and provide paperwork, including an impressive business plan, to demonstrate your company’s potential.
Accepting VC funding means the venture capital group will own a sizable chunk of your business and will expect to be involved with decisions that impact its direction and potential success.
While it takes time for a business to grow large enough and establish a solid history of success to pursue an IPO, by this point you’ll have the resources to hire professionals to guide you through the process.
Pros and Cons of Equity Financing
You can raise money without risking collateral
You will not need to pay back the money or pay interest on it
You will lose some control of your business
Others will reap some of the rewards of your business’s success
Equity Financing vs. Debt Financing
Many business owners find themselves thinking about equity financing vs. debt financing when it comes to funding a business. The two methods are quite different, so it’s worth taking the time to understand the tradeoffs.
|Equity financing||Debt financing|
|Is not a loan—requires no collateral and no payback||Is a loan—requires both collateral and payback|
|Sells a percentage of your company to another person or entity||Allows you to maintain 100% ownership|
|Can be provided by a friend, family member, venture capitalist, or crowdfund investor, or through an IPO||Can be provided by a bank or some government agencies|
- Equity financing involves selling part of your company to investors in exchange for money.
- Equity financing is one way to raise cash without risking collateral or requiring repayment.
- When you use equity financing, you no longer own 100% of your business.
- Several methods of equity financing are available, depending on the size and type of business.