Updated on April 18th, 2023
The main advantage of equity financing is that there is no loan to repay. The main disadvantage is giving up control of the company.
Author: Brad Nakase, Attorney
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Jeff is the owner of a tech startup in Los Angeles, California. Because his company is so new, Jeff needs money to improve cash flow problems. Because of some proprietary software, Jeff feels that investors may be interested in his business. Therefore, he decides to pursue equity financing. He is willing to offer 25% equity stake in his business to an investor who is willing to give him $200,000 for equipment and payroll. But before he commits to the idea of equity financing, Jeff is careful to review the advantages and disadvantages of this kind of funding solution.
According to an Intuit Survey, 75% of small business owners reported that they relied on personal savings to start their companies. But starting a business is one thing and growing it is quite another. A business owner will likely require additional financing to keep a business growing apace. But it can be hard to get this kind of funding, especially for new business owners.
One major way of raising capital is for a business to look into equity financing. This article will review how equity financing works, as well as how a business can get it. Also, we will explore the possible benefits and disadvantages that come with this financing option.
Equity financing is a well-known method by which entrepreneurs raise money for their startups without coming into debt. In this case, the business owner sells shares of the company to equity investors in exchange for money.
While this sounds easy, getting equity financing is a major decision for a business that can have long-lasting effects. Before jumping into equity investments, it is important that a business owner understand the process of getting this kind of financing, as well as its pros and cons.
The main advantage of equity financing is its short-term affordability, availability, and limited risk. A business owner may not be able to get traditional financing because of his or her bad credit score, but equity financing is still on the table. This mas that the short-term cost is typically lower than debt financing because there are no fees or interest.
Also, because a business owner pays for equity financing in the form of business shares, he or she does not need to pay investors back if the business fails.
Some individuals prefer equity financing to business loans because they do not have to pay back money in a set period of time. If a business owner is worries about making loan payments on time, then equity financing may be a valid option.
The biggest negative associated with equity financing is the possibility of losing control of one’s company. Because equity financing requires that a business owner give up company shares, this kind of financing can cause an owner to lose some or all of his or her ownership rights. In just this manner, Steve Jobs was forced out of Apple.
Also, by selling ownership shares, a business owner receives a smaller percentage of company profits, which limits their earning potential.
A small business owner should be conscious of their earning ability. If selling equity shares limits future financial gain, then this may not be the best option to solve a cash flow problem.
If a business owner takes out a traditional loan, then he or she must repay the lender in full and on time. While he or she may be worried about paying the loan back on time, it is possibly better than worrying about losing control of one’s business. If a business owner wants to maintain control of his or her business, then a traditional loan may be a better option.
When looking into equity financing, a business owner may go to several sources. Common varieties of equity financing include the following:
The process for getting equity financing may be different depending on the funding source one selects. Venture capitalists require a business plan that show a high rate of return for their investment. Usually, this amount will need to be at least 25%, but it can be much more.
There will be similar challenges with Small Business Investment Companies. That said, these companies are SBA-backed, which means that they generally have less strict qualification requirements.
Other financing sources, such as angel investors and crowdfunding, may be as simple as convincing people that one has a good idea for a business. If the investors like the business idea they will be willing to offer money in exchange for ownership or some other benefit.
Still, the best chance one has to impress investors is to produce a well-crafted business plan. It will also be helpful to hire a lawyer to create contracts addressing the details of the equity deal.
For the business owner who needs a large amount of capital to start or grow a company, equity financing may be a solid option. However, a business owner should be comfortable with the equity financing deal, as well as be prepared to give up some or full control of his or her business.
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