Last Updated on December 28, 2022
Starting a new business presents many challenges, especially having insufficient capital. As a small business owner, you may not have enough money to start and grow your business. So you have to rely on others to provide you with capital.
Individuals and organizations willing to finance your business will give you different terms, depending on whether they offer debt or equity capital. What is equity financing, and how does it differ from debt? We’ll answer this question to help you make an informed choice. We’ll also discuss five types of equity financing you can use for your business.
What Is Equity Financing?
When starting a new business, most entrepreneurs use their savings as capital. Sometimes you can sell your assets and use the money as business capital. Anything you contribute to your firm becomes part of equity. It includes any business profit you plague back to the enterprise.
If your business needs more capital than you can raise yourself, you can get equity financing from others. In this case, investors will give you money in exchange for ownership. So you’ll be selling shares of your business.
Related: Business Financing Options
What Is the Difference Between Equity Financing and Debt Financing?
Debt financing is borrowed capital. And borrowed money needs repayment at some point. The investors in debt financing don’t have ownership claims to the business. Consequently, they don’t take part in business decision-making.
However, the investors expect you to pay them an annual interest at a fixed rate. This interest is compulsory and can accumulate if you don’t pay it. Investors in debt capital have priority in interest payment and claiming business assets.
That means you can’t take your profit share before paying interest on debt capital. Furthermore, in case of winding up where you have to sell business assets, you have to pay debtholders before paying equity shareholders.
Examples of debt capital include
- Bank loans
- Loans from friends and family
- Government-backed loans like Small Business Administration (SBA) loans
- Equipment loans
- Credit cards
- Lines of credit
Unlike debt, equity capital isn’t repayable. Instead of paying interest, you pay dividends to equity investors. This dividend is a share of the remaining profit. Its payment isn’t compulsory and doesn’t have a fixed rate. Therefore, if the business isn’t making profits, you don’t have to pay dividends. On the other hand, if the firm makes a huge profit, you can pay dividends at higher rates.
Types of Equity Financing
Here are five types of equity financing:
An angel investor is a wealthy individual willing to finance your business using debt or equity capital. Some angel investors are attracted to your business because your business idea looks promising. Others invest because they know you and want to see you succeed.
Unlike banks, angel investors have friendly terms. Even though they’re interested in getting returns for their investment, they’ll be patient until your business starts to generate profit. They may offer you training and management assistance to accelerate business growth.
Small Business Investment Companies (SBIC)
SBICs are privately-owned companies that provide equity and debt capital to small businesses. The government-owned Small Business Administration (SBA) issues licenses to these investment companies.
SBICs bring together investors who pool their money to invest in high-risk start-ups. They consist of investment banks, private pension funds, and wealthy individuals. Some SBICs specialize in particular industries while others are diversified. Their requirements are less stringent than an IPO.
Venture Capital Firms
These are organizations that invest in start-ups with high growth potential. Unlike banks that tend to avoid risk, venture capital firms are willing to take risks with the expectation of higher returns.
Due to the high risk involved, venture capital usually consists of well-off investors. They have multiple investments. So when they lose in one, they can gain from the others. In addition to giving capital, these investors provide mentorship and any required support to accelerate business growth.
Crowdfunding is a method of raising capital from a large pool of investors through the internet. Investors can contribute as little as $10. If many people make contributions, you can make a substantial amount. Those who offer online products and services such as games, software, and artistic work have the highest potential to benefit from crowdfunding.
Some crowdfunding platforms help raise donations. But others help connect entrepreneurs to profit-seeking investors. But depending on your jurisdiction, some restrictions may apply regarding who can contribute and how much.
Initial Public Offering
An Initial public offering (IPO) raises equity capital by selling shares to the public. Hence, it’s also called going public. This option becomes necessary when you need a substantial amount.
Before going public, you must meet the Securities and Exchange Commission (SEC) requirements. After approval by the SEC, you have to prepare a prospectus inviting members of the public to buy shares in your company. After an IPO, the company’s shares can be bought and sold through the securities exchange market.
IPO signifies a crucial transition from a private company to a public one. Though it’s a time-consuming and costly process, it can raise more money than other options.
Advantages of Using Equity Financing
Equity financing has the following advantages:
- It doesn’t increase business risk like debt capital. Business risk increases when you have more debt because you have to pay higher interest.
- Investors contribute to business decision-making. Shareholders are interested in business success. So they can train you and provide management support.
- You can raise more money than in debt financing.
- If the business isn’t doing well, you don’t have to pay dividends.
- The capital is permanent since you don’t have to repay it.
Disadvantages of Using Equity Financing
Equity financing has the following disadvantages:
- It dilutes ownership, giving you less control of the business.
- Conflicts may arise in case of differences on how to run the business.
- If the firm makes a high profit, you have to share it with shareholders.
The Bottom Line
New businesses experience hardship in getting loans from financial institutions. Banks prefer to lend to enterprises with good cash flow and lower risk. Fortunately, you can benefit from equity financing even with a low credit rating.
Equity financing is the capital investors provide to the business in return for ownership. Most firms combine debt and equity capital. But it’s considered safe to have more equity than debt. When deciding which equity financing to use, consider the availability and the amount you need.