Understanding Equity Financing

Unlike a small business loan, which includes regular periodic payments, equity financing offers investors ownership equity in exchange for capital—without a periodic payment. What’s more, equity investors are often willing to invest in younger businesses, which might not find success by approaching a bank or other small business lender, in exchange for a bigger payday down the road. By investing in the business, an equity investor assumes a risk associated with backing sometimes younger businesses with shorter track records—but has the opportunity to capture exponential profits if the company is successful at scale and able to increase in value.

Does Equity Financing Make Sense for Your Small Business?

Many different businesses, in many different industries, could be a fit for an equity investor, but those that do share some common traits. Unlike a lender, investors aren’t looking for a regular stream of periodic payments or a long track record—they’re looking for a great business idea that will create exponential profits down the road. Instead of regular payments, they are looking for what’s called an equity event in the future. By equity event, think in terms of an Initial Public Offering (IPO) when a business goes public or the sale of the business where they can capture profits along with the business owner. Investors are looking for businesses that can grow very quickly with the infusion of additional capital. This could be a good fit for your business if:

• Your business can scale profits quickly with the goal of an IPO or sale
• You are willing to offer ownership equity in your business to a future investor in exchange for capital
• You are willing to give an investor a seat at the decision-making table
• You see the advantage of a potentially more experienced voice(s) in helping guide your company

There are pros and cons associated with equity financing you should be aware of before you accept an investor’s money. They could include:

• Unlike a small business loan, equity investors don’t typically require regular payments. They’re looking for an equity event in the future to capture their share of profits.
• Equity investors often provide experience and guidance to young entrepreneurs that can help a business grow.
• One of the biggest sources of financing for early-stage businesses is from friends and family. Giving them an equity stake in your business can be a source of startup capital.
• Accepting investment from friends and family can create tense relationships if their investment is taken cavalierly and they are never able to recoup their investment along with a return.
• Finding the right investor can be time consuming and more complicated than applying for a small business loan.
• There are long-term consequences to accepting equity financing because the offer of a percentage of ownership to a third party includes the implication that there will be a payout at some point down the road—meaning an IPO, sale, merger, or some other capital event.
• The business owner is losing exclusive control over future business decisions.
• Equity investment is not a guarantee of success.

What Does Equity Investment Look Like?

In the same way there are different types of lenders, there are different types of equity investors.

Angel Investors

Angel investors are individuals who invest their personal resources into businesses that interest them. Some angel investors work alone, while others operate as part of a network. The term “angel” is derived from the practice of interested investors who provided financial resources to Broadway plays to finance the productions. Angel investors often invest in very early stage businesses that spark their interest before other equity investors like venture capitalists would be interested.

An angel investor typically not only invests capital, but also offers guidance and valuable advice. For these reasons, angel investors are highly sought after, and many take their time deciding the companies in which they will invest.

Venture Capital

Venture capitalists are either individuals or companies that manage funds set aside to invest in new businesses. Modern venture capital (VC) firms tend to focus on young, high-growth companies—typically tech startups. This type of equity investor differs from angel investors and other equity investors as the firms are primarily interested in high-value opportunities (think millions of dollars rather than thousands or tens of thousands of dollars). When a venture firm invests in a high-growth company, the investor expects to either be a member of the company’s management team or sit on its board of directors, thereby taking an active role in the operations of the business.

Friends and Family

Friends and family are a popular way for many early-stage businesses to access capital. Before approaching a friend or family member, it’s important to contemplate any relationship with a potential investor. It’s considered best practice to enter into a formal agreement before engaging in a relationship with a friend or family member. Although it might be tempting not to do so, treating a family member the same way as any other investor is considered a good way to approach this type of equity investor.

Raising Equity Financing

Equity financing can be an informal agreement (especially in the case of friends and family), but it shouldn’t be approached that way. Prepare a well-considered business plan and make sure to address how the business might be valued based upon projections of future earnings.

It is also advisable to speak with an attorney about particular investments that would potentially need to be registered with the SEC. Here are some additional success tips:

• You will find the best success by approaching angel investors or venture firms that typically invest within your industry, so avoid wasting time seeking investment from firms that do not.
• Most angel investors appreciate business owners who have done adequate research before you contact them. You can start your search by checking out the following resources: the Angel Capital Association, Angel Resource Institute, and the Angel Investment Network.
• Be prepared to confidently talk about future plans for your business. Equity investors hear pitches from small businesses all the time, your proposal will only float to the top if you have a plan, exude confidence, and can answer their questions about the scalability and upside potential of your business.
• Make sure you clearly understand any agreement before you sign on the dotted line and accept an investment.
• Make sure you feel comfortable working with an equity investor for the long term. Don’t be afraid to walk away from an investor you don’t feel good about. Equity transactions mean investors will have a say in your business so you should be discerning about whom you allow to participate in your enterprise.

Equity financing can be a good way to fund a business, provided you have the right type of business, are aware of the challenges, and willing to share ownership. It can be an alternative to bootstrapping or debt financing, but there are other considerations before finalizing a deal. Consult a qualified attorney familiar with this type of transaction before finalizing any agreement and treat every meeting with potential investors (including friends and family) professionally.