When you buy an equity share of a company, you are buying into the ownership of the business. As an equity investor, you are a partial owner of the company.
The number of shares a corporation is authorised to issue is prescribed in its corporate charter. When a company decides to sell additional shares to new or existing shareholders, this is sometimes referred to as raising equity.
Why it matters
During the early stages of a company’s growth, particularly when the company does not have sufficient revenue, cash flow or assets to act as collateral, equity financing can attract capital from early-stage investors.
For investors, equity financing is an important method of acquiring ownership interests in companies.
Financing with money from family and friends
For business owners who have strong family ties or social networks, it makes sense to ask for investment funding. This type of funding, while relatively common, can be risky.
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.
This is 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 the negotiated terms.
If 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 to keep ownership of their own business for as long as the business is profitable.
If a venture capitalist is interested in your business, you will have to give up a portion of your own share and there will probably be a representative of the venture Capitalist on your Board of Directors. Venture capitalists look for high rates of return when they invest their money.
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.
How equity financing is regulated
The equity-financing process is governed by rules imposed by a local or national securities authority. These regulations are designed to protect you from unscrupulous operators who may raise funds and disappear.
Equity financing is generally accompanied by an offering memorandum or prospectus, which contains a great deal of information that should help the investor make an informed decision about the financing.
Pros and cons
For small businesses, the chief advantage of equity is that it need not be paid back. In contrast, bank loans or other forms of debt financing have an immediate impact on cash flow and carry severe penalties unless payment terms are met.
Equity financing is more likely to be available for startups with good ideas and sound plans. Equity investors primarily seek opportunities for growth; they are more willing to take a chance on a good idea.
They are a source of good advice and contacts. Debt financiers seek security; they usually require some kind of track record before they will make a loan. Very often equity financing is the only source of financing.
The main disadvantage of equity financing is the issue of control. If investors have different ideas about the company’s strategic direction or day-to-day operations, they can pose problems for the entrepreneur.
These differences may not be obvious at first—but may emerge as the first bumps are hit.
In addition, some sale of equity, such as limited initial public offerings, can be complex and expensive and inevitably consume time and require the help of expert lawyers and accountants.
Overall, equity financing can be an attractive option for many small businesses, but experts suggest that the best strategy is to combine equity financing with other types.
These can include your own funds and debt financing, in order to spread the business’s risks and ensure that enough options will be available for later financing.
Entrepreneurs must approach equity financing cautiously in order to remain the main beneficiaries of their own hard work and long-term business growth.
This article first appeared in The New Savvy.
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