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Equity financing is a means of raising capital where an entrepreneur sells shares or ownership equity in their business. It’s a great way to fund start-up ventures and business growth without incurring debt. This type of financing is what underpins the global multitrillion-dollar equity trading market. According to SIFMA, the US alone traded $436.2 billion worth of equity shares in 2021.
If you’re strapped for business capital, equity financing might be a solution worth considering. This article shows a summarized overview of equity financing and how it fares as an SMB funding option.
How does equity financing work?
If you've ever watched an episode of "Shark Tank" or "Dragons' Den" on TV, you probably have a good idea of how equity financing works. An investor or funder takes a share of the business in exchange for funding, becoming a part owner in that business. The partial ownership comes with a share of the profits (in dividend payments) and some level of influence in the business, depending on the equity percentage and agreement.
Equity funding can be structured in several different ways. Here are the main types of equity financing for start-ups and SMBs.
Initial public offering (IPO)
An IPO is an equity offering in which a company trades its shares in a public stock market such as the New York Stock Exchange (NYSE) or Nasdaq. This is also referred to as “going public.” Apart from raising capital, a company can issue an IPO to boost its public profile or diversify its insider holdings.
You just need approval from the Securities and Exchange Commission (SEC) to sell shares in the public stock market. Once approved, the SEC sets a listing date for the IPO. From there, it’s only a matter of advertising the offering to get investors excited about your listing.
Angel investors
Angel or seed investors are wealthy individuals or groups of investors looking to fund promising business ventures using their own money. Most prefer to invest in start-ups and early-stage businesses. In some cases, angel investors turn into strategic business partners by allowing entrepreneurs to tap into their portfolios, industry expertise, and business influence.
Venture capital
Venture capitalists (VCs) fund early-stage businesses with great potential for high returns. VC firms pool funds from a group of investors or companies, which they use to finance budding businesses. Compared to angel investors, VCs are very picky with their investment choices. In fact, many VCs invest exclusively in particular business models, niches, or industries.
Crowdinvesting/equity crowdfunding
This is a type of funding where a business secures capital from crowdfunders in exchange for equity. It's similar to an IPO, except it takes place on a crowdfunding platform rather than a public stock exchange, although SEC guidelines and regulations may apply. Crowdinvesting works for both start-ups and established businesses.
Royalty financing
This is an equity investment in a business’s future sales instead of ownership. The investor provides capital in exchange for a percentage or dollar share of each sale or cumulated sales revenue. This could be in perpetuity or until the investor recoups an agreed amount of money. A royalty financing deal suits businesses with large enough profit margins to afford the deduction.
Mezzanine financing
Mezzanine financing combines debt and equity funding, allowing the lender to convert outstanding debt into equity shares in case the borrower defaults. It’s a risky form of debt that bridges the gap between traditional business funding and equity financing. The upside is that the borrower can access generous financing offers by essentially presenting equity as a form of collateral. This financing approach is a good fit for start-ups and SMBs that can't qualify for debt-based financing, such as term loans and lines of credit, but would prefer not to give up equity unless they had to.
Equity financing vs. debt financing: The pros and cons
There are generally two approaches to business financing. You can either take out a debt and pay the lender back with interest, or bring in one or more investors to “buy” part of your business. Both options have their risks and rewards. Here’s how equity financing compares to debt-based financing:
The pros of equity financing
- No debt obligations (repayments, interest, fees, etc.) unless a debt is tied into the financing agreement.
- Your creditworthiness does not matter when seeking equity financing.
- Some investors can mentor and build you as an entrepreneur while strengthening the business through their lucrative connections.
- You get a massive capital injection depending on your company’s or offering’s investable value.
The cons of equity financing
- Giving away equity means surrendering some control of the business to outsiders, which can lead to managerial or cultural conflicts.
- You’ll have to share profits with the investor(s) in the form of dividends or royalties.
- Distributed equity can complicate things during mergers and acquisitions.
- Onboarding investors might be harder than landing a business loan.
Choosing between debt and equity financing
If your business is eligible for both debt and equity financing, the decision largely comes down to what you’re more comfortable with: incurring debt liability or giving up some ownership and control of your business. Some entrepreneurs are so fond of their business that bringing in partners or stockholders is completely out of the question. Meanwhile, others will go to great lengths to avoid taking on debt, even if it means giving away a large stake in the business.
From a more pragmatic standpoint, you’ll also want to consider the long-term costs and rewards of onboarding stockholders or investors. Moreover, think about how you’ll have to restructure your business to accommodate outside investments and whether doing so aligns with your goals and vision.
But if debt-based financing is out of reach, you might have no choice but to try investors. Equity funding is still a great way for non-creditworthy businesses, including early start-ups, to secure much-needed financing.
Make the right business funding choice with Lendzero
Ensure you’ve researched all your options before signing any business funding deal, whether it’s based on debt or equity. That’s the only way to get the best possible financing every time. But scouring the vast SMB lending market for borrower-friendly offers can be a painstaking, time-wasting, and discouraging ordeal. And that’s where Lendzero comes in.
Lendzero simplifies business financing by bringing curated funding options from competing lenders right at your fingertips. What’s more, all the offers are prequalified and pre-negotiated to save you the trouble of haggling with lenders.
Lendzero is a free marketplace for small business financing. All you have to do is sign up and fill out a brief one-time business profile to enjoy this unique funding convenience.
