Many new businesses cannot afford to cover startup costs and/or recurring expenses with their own money. Of course, this doesn’t mean the business has no shot of opening. The owner just needs to find another source of funding. In most cases, the search for funding ends with one of two solutions: debt financing or equity financing. Both options have become so accessible for startups that they can sometimes avoid covering their own expenses simply because they don’t want to.
Debt financing refers to the use of business loans, which can come from banks, online lenders, or peer-to-peer lenders. The business must then pay back the lump sum, plus interest and fees, by the agreed-upon due date. Aside from your obligation to pay off the debt, nothing else changes in regards to the way you run your business.
Equity financing, however, has completely different rules. If certain disadvantages of debt financing seem too restrictive, equity financing may give you more power to grow your business without damaging cash flow.
In this guide, we’ll define the various forms of equity financing and help you figure out which financing option makes the most sense for your goals.
What Is Equity Financing?
Equity financing allows businesses to obtain funding in exchange for shares of the business, or pieces of ownership. Selling shares eliminates the need to pay back the source of the funds. But despite the lack of interest and fees, the business owner relinquishes full control of the business.
Equity Financing: Expanded Definition
The shares you sell represent units of ownership. For example, let’s say your business has 1,000 shares of stock to issue. If you keep 500 shares and sell the other 500 to an investor, that individual now owns 50% of your business, or has 50% “equity.” So, even though you probably came up with the idea for the business and will manage the employees on your own, the investor technically has just as much power as you.
The amount of shares you sell usually corresponds to the amount of capital the investor gives you. An investor with 50% equity would have probably covered half (or more) of your startup costs. Once an investor distributes funding and receives shares of ownership, the title changes from investor to “shareholder.”
What Do Investors Get Out of Equity Financing?
Investors who buy equity in startups usually receive shares of “common stock.” Owners of common stock earn their ROI (return on investment) through dividends, or portions of the company’s profits. They also get voting rights at board meetings, where they can voice their opinions during decisions about policy, management structure, etc. Depending on the amount of money invested, certain common stock shareholders may have the right to multiple votes. In other words, the single vote of one common stock shareholder could essentially have the power of three votes.
Companies choose to issue different types of common stock: A-Class and B-Class. There’s no all-encompassing definition for either term. The availability of A-Class and B-Class stock merely denotes that one type of shareholder (A-Class) gets more advantages than the other (B-Class). For example, while an A-Class shareholder might get three votes, B-Class shareholders might get just one vote, or lower dividends.
Though most companies issue only common stock to investors, the company can choose to issue preferred stock as well. Preferred shareholders have no voting rights but they do have dividends along with higher claims on the business’s assets that common stock shareholders. Should those assets get liquidated, the preferred shareholders would make more money.
All types of shareholders, however, have the right to sell their shares. Shareholders typically do this after the business has achieved considerable success, which increases the share’s value. Despite the higher price, the business’s upward trajectory may still attract buyers.
As you can see, businesses can customize the stock they issue based on the type of investor they wish to bring onboard. But what kind of investors will you have to choose from, anyway? We’ll answer that in the next section:
The Different Kind of Investors in Equity Financing
Investors who buy equity in businesses usually fall into one of two categories: angel investors or venture capitalists.
Here’s what you need to know about each type:
The “angel” in angel investors comes from the trust these investors put in the business owner, even though they have little (if any) data to support their decision. It’s as if they have answered the entrepreneur’s desperate plea for an “angel” to believe in their dream and make it come true.
Angel investors (a.k.a. seed investors or private investors) typically use personal funds to bestow large amounts of working capital to new businesses in exchange for equity. They can distribute their entire investment at once or in portions as the business grows.
Since angel investors specialize in getting new businesses off the ground, they often understand that the business needs a lot more than just money.
What Motivates Angel Investors?
Every angel investor has his or her own reasons for helping new businesses succeed. Most, however, find their motivation from one or more of the following rewards:
1. Early Investment = High ROI
By definition, all equity financiers seek high ROIs. Angel investors have an especially good chance of achieving this goal because they make their investments during the business’s infancy. It’s just like the stock market: The greatest rewards often go to investors who take the risk of buying stocks in businesses that no one has heard of but eventually become massively successful. For this reason, the interest of an angel investor gives new businesses tremendous confidence.
2. Another Opportunity to Lead
Many angel investors are retired entrepreneurs looking to take on another leadership role. Maybe they love the challenge of business growth and want to test their skills in today’s climate. Maybe they want to bestow their wealth of knowledge onto someone else with a great business idea. All entrepreneurs make mistakes. Becoming an angel investor gives them the opportunity to put their experience to use by showing another entrepreneur how to avoid common missteps.
3. Compassion for Underdogs
Some angel investors specifically pursue entrepreneurs who have the odds stacked against them. This includes female entrepreneurs, minority entrepreneurs, or even businesses located in up and coming areas. These angel investors may seek to increase diversity within certain industries or simply bring the gift of entrepreneurship to more groups of people.
How Do You Find Angel Investors?
When it comes to the most important skills for entrepreneurs, networking sits right at the top. Superb networking skills make it much, much easier to obtain clients, partners, employees, and, yes, equity financiers. There’s no angel investor database to go to for funding. Instead, you must tap into your networking skills and find angel investors through certain people or events. You could talk to other entrepreneurs, financial advisors, investors, or simply anyone connected to wealthy social circles.
Venture Capital Firms
Venture capital firms have the same basic function as angel investors: funding early-stage businesses in exchange for equity.
But unlike angel investors, the money doesn’t come from one person. When you obtain funding from venture capitalists (“VCs”), the entire firm becomes your partner. So, instead of selling equity to one person, you sell it to another company.
And while angel investors show their namesake by putting faith in your ideas, venture capital firms tend to base their decisions on data. It’s all about the money for these firms, so they often need more hard evidence to support their investments.
Venture capital firms distribute funding in three rounds. The first round, or “Series A,” gets distributed during the company’s infancy, with Series B and Series C getting distributed as the company grows. Each round of funding comes with another exchange of equity.
The Difference Between Angel Investors and Venture Capital Firms
Every venture capital firm and angel investor has their own policies and procedures. But for the most part, here’s a few areas in which you can expect significant differences between the two:
1. Venture Capitalists Usually Make Larger Investments
Compared to angel investors, venture capital firms usually have the means to offer much more money. But remember: more funding for your company means more equity for the firm. Though each firm has their own minimum investment, you probably shouldn’t pursue venture capital unless you’re looking for at least $1 million. The size of the typical VC investment reflects their number one priority: explosive growth.
2. Venture Capitalists Expect More Power
Most angel investors allow entrepreneurs to manage their businesses on their own. Many VC firms, on the other hand, will only work with entrepreneurs willing to give up some degree of authority. This could range from providing suggestions here and there to creating an entire agenda that the business must follow in order to receive more rounds of funding.
3. Venture Capitalists Have Bigger Goals
Earlier, we mentioned that venture capitalists set their sights exclusively on companies with the potential for massive success. VC firms don’t just want to help your company make money. They often strive to turn tiny startups into publically traded companies. After distributing the final round of funding (Series C), VC firms sometimes move straight to an IPO, which can result in incredible earnings for early-stage VCs.
4. Venture Capitalists Work with Limited Industries
Since VCs only work with companies with high growth potential, they tend to favor industries with high growth potential as well. VCs also won’t work with industries they’ve never worked with before.
This differs tremendously from angel investors, who base their decisions primarily on the intelligence and character of the entrepreneur. As long as the angel investor believes in the entrepreneur’s idea, he or she might not care about factors like industry, data, or prior experience.
5. Venture Capitalists Need More Data
It’s clear that acquiring funding from VC firms involves much more effort than impressing an angel investor. The latter option might only need an elevator pitch or general business plan before agreeing to provide seed capital. In terms of documentation, VC firms will expect to see much more, like your going-to-market strategy or proof of market traction. Your business plan should show the firm that you know how to approach the different stages of growth and will only spend their money on growth-related initiatives.
In summary, most venture capital firms and angel investors have different objectives. While angel investors find satisfaction in turning nothing into something, venture capital firms only succeed when they turn small businesses into international sensations.
How Do You Find Venture Capital Firms to Work With?
Anyone with money can become an angel investor, so there’s no real limit on the angel investor marketplace.
Believe it or not, the number of official venture capital firms in the entire world reportedly does not exceed 300. And only some of those firms will want to work with businesses like yours. Still, you should start your search for venture capital firms in the most logical place: The National Venture Capital Association. This will show you how many firms specialize in your industry and which firms have distributed the most funding as of late.
Remember: Venture capital firms heavily favor businesses that seem fully prepared to grow. So, don’t contact any firms unless you’ve taken every necessary step in this direction aside from seeking funding.
The Pros and Cons of Equity Financing
At this point, you should have an idea of what it’s like to work with angel investors and venture capitalists. Now that you know what each option has in common, we can deduce the advantages and disadvantages of equity financing in general. Let’s recap why one business would choose equity financing and why another might seek another source of funding:
Pro: No Repayment Required
Debt financing involves owing money and paying it back by an agreed-upon due date, plus interest and fees. If you choose the most traditional type of loan, you’ll have to make fixed, monthly payments immediately after receiving funding. Short or medium-term loans might have shorter payment frequencies (daily, weekly, bi-weekly, etc.). Missed payments can result in penalties and hurt your personal credit score. It’s also hard to make fixed payments when revenue fluctuates due to uncontrollable factors like seasonality.
With equity financing, on the other hand, you don’t owe any money. Even if your business fails, your angel investor or venture capital firm cannot legally demand money from you. They knew about this risk before making their investment. When you take out a business loan, it’s the borrower who assumes the most risk.
Small businesses repay debt without damaging their cash flow all the time. But it’s easy for young businesses to borrow more than they can afford to pay back, especially without an established foundation for revenue.
Con: You’ll Earn Less Income
Choosing equity financing means sacrificing total ownership of your business. You must now split the profits with your angel investor or venture capital firm. Until your business becomes massively successful, you might have to put certain personal plans on hold.
Some entrepreneurs make the mistake of continuously taking on more equity financing without realizing the effect it has on their ownership of the business. Multiple rounds of funding might sound great, but each one takes away more and more of the original owner’s profits.
Forfeiting future profits could additionally prevent you from receiving the full reward of your hard work, especially if you plan to sell your business. Let’s say you eventually sell your business for $110 million. If you had previously given away just 10% of your ownership, $11 million could go to someone who (possibly) had no strategic impact on your success.
You wouldn’t lose anywhere near as much, however, if you borrowed a few million to finance your startup and paid it back over the course of several years.
Pro: You’ll Receive Valuable Business Advice
Though anyone can become an angel investor, most equity financiers have significant experience with business growth. Their wisdom becomes yours when you make them equity financiers with voting rights. Offering potential buyers the rights to multiple votes shows that you value their advice and intend to comply with their ideas. When faced with tough decisions or unforeseen curve balls, it’s often experience that ultimately guides the business in the right direction.
You might assume that any smart business owner should know how to make these decisions on their own. But most business owners do not excel at every element of their jobs. Someone who comes up with great ideas for new products, for example, might not know how to correctly market those products or decrease the cost of goods sold.
The guidance of your equity financier could prove especially critical if you’ve never managed this much money before. Distributing such a massive budget to an inexperienced entrepreneur could result in careless or rushed spending.
Debt financing tends to have the opposite effect: It teaches new business owners to spend carefully and efficiently. If you spend the money on the wrong investment or fail to generate
enough revenue, you won’t be able to pay it back. Many successful business owners benefited from learning how to manage debt early in their careers.
Con: They’ll Have Control of Your Business
Of course, selling equity also runs of the risk putting substantial power into the hands of someone you might not always agree with. Your equity financier might have completely different goals but keep them hidden until coming onboard. And since this person or firm is essentially keeping your business alive, it’s not as if you’re in the position to say no.
Some equity financiers might just want to make as much money as possible in the quickest time frame. Others might dismiss personal relationships with employees if letting them go makes more financial sense. For example, your equity financier could ask you to replace an employee who helped you start your business for someone else who could do the same job for half the salary.
To avoid this all-too-common situation, research your potential buyer’s previous ventures before selling your shares. You may even want to speak to their former partners about their management style and preferred degree of influence.
This segues into arguably the biggest advantage of debt financing. If you work with an online lender, you don’t even have to explain how you plan to use the money in order to be approved for a business loan. As long as you continue to make payments, you can run your business in any way you please. And once you make your final loan payment, your partnership with the financial institution ends.
Is Equity Financing Right for You?
Yes, equity financing clearly lacks some of the biggest disadvantages of debt financing. But the former option will undoubtedly have a much bigger impact on your business, as well as your future as an owner. When you accept a large investment, the entire trajectory of your business could change. From that moment forward, you absorb the additional responsibility of keeping your angel investor or VC firm satisfied, partially to ensure access to further rounds of funding later on.
While debt financing can’t offer you the same amount of money as equity financing, certain institutions specialize in long-term partnerships. Clients can continuously take out large-sized business loans with increasingly convenient terms. These institutions can also provide the expert advice associated with equity financiers. In order to recommend the right products and the most sensible terms, they find the underlying sources of their clients’ financial problems. This allows the institution to develop effective solutions, instead of a temporary fix.
So, before deciding which type of financing is right for you, be sure to consider the magnitude of equity financing, and remember that not all financial institutions are the same.