What Is Equity Financing?
Equity financing is when an investor agrees to supply a specified amount of their capital in exchange for equity in your business. The most common equity financiers include venture capitalists and angel investors. However, there are some significant differences between these investors that we’ll dive into later.
The key benefit of leveraging equity as a financing option is that there’s no debt—you’ll never make a single loan payment. Equity investors aren’t interested in loan payments as they are interested in becoming an integral part of your business and getting a return from a percentage of your sales profits.
What influence do investors have over my business?
It’s crucial to understand the level of influence equity funders will have on your company. If you’re not interested in sharing your company with someone else, angel investors and venture capital firms may not be for you.
The exact level of influence an investor will legally have will depend on the amount of equity they get from the deal and its terms. There are a few different levels of ownership and influence you should know about:
- Majority ownership. This happens when an investor owns more than 50% of your shares. With majority ownership in your company, the investor essentially has complete control.
- Minority active. Your investor owns 20%–50% of the shares at this level. This does not give them total control over management decisions, but it does give them the right to influence your decisions. You’ll have to keep them in the loop and council over major decisions.
- Minority passive. Your investor has less than 20% of your equity shares at this level. Their small stake in your company gives them little to no influence over business decisions.
Another thing to consider is that there are venture capitalists and angel investors who will like your company, the way you run it, and the direction it’s heading in, and will happily let you make most of the business decisions despite their equity stake. You shouldn’t count on this, but it has been known to happen.
Almost all investors will expect a share of your profits as part of their equity deal. And they should be paid because they’re shouldering the bulk of the risk upfront.
The main benefit of an investor taking a profit percentage is you have to pay them only when you’re making money, keeping you out of debt.
How can equity financing benefit my business?
You shouldn’t count out the usefulness of bringing on an investor. The right investor or investment group may bring expertise and opportunity to your business to improve your cash flow and keep your business out of debt.
Often angel investors and venture capital groups are industry-leading professionals who have helped convert small businesses into major players. A lot of growth can come from having an expert mentor with a vested interest in the success of your company on your board of directors.
What should I look for in an investor?
The most important aspect of searching for an equity funding partner is finding someone whose vision and interests are a good fit for you and your company. You want to find an individual or group whose expertise and personality work well with you and your business.
Will my business attract investors?
If you feel pretty good about bringing on an investor to help run your business, you’re on the right track. The next question you’ll have to answer is whether your business will interest a venture capitalist or angel investor.
It’s crucial to figure this out because finding and securing equity funding can be a long and demanding process. You’ll be pitching your business over and over, so you should at least know whether you’ll be dead on arrival or have a fighting chance.
The first and most important thing any investor will look at is whether your business model is scalable. Equity investors want a quick and lucrative ride, so businesses without a lot of growth potential are completely out of the question.
What’s the difference between an angel investor and a venture capitalist?
There are some differences in the types of businesses venture capitalists will fund versus what angel investors will fund. You may be able to secure funding from one but not the other.
Angel investors are generally wealthy individuals interested in helping small businesses grow. The TV show, Shark Tank, is a reality TV representation of angel investors—individuals looking for companies that fit well into their networks and expertise.
Venture capitalists, on the other hand, are institutional investors from much larger conglomerates comprised of financial groups. These groups are interested in helping well-established, high-growth-potential businesses expand into large corporations. And these conglomerates often consist of financial firms, insurance companies, pension funds, and university endowments.
So with their individual goals, venture capitalists and angel investors tend to lean toward different business types:
- Venture capitalist groups tend to invest in experienced companies with established revenue growth.
- Angel investors typically prefer younger companies with strong growth potential.
Deciding whether to approach an angel investor or a venture capital group largely depends on the age and profitability of your business, though you should also factor in how much funding you need to reach your next growth stage.
Equity investors will push for a liquidity event
Most investors looking for equity in your business will push for an opportunity to cash out. Liquidity events are opportunities that allow them to do just that.
The two most common liquidity events are a business acquisition and an initial public offering (IPO). These events allow investors to convert their non-liquid equity in your business into cash.
Common liquidity event 1: Business acquisition
Your business reaching a point where another company is interested in an acquisition presents an opportunity for your investors to negotiate an equity payout. They’ll usually take a percentage of the total buyout value equal to their equity ownership percentage in your business.
Equity investors have a vested interest in making your company profitable and valuable because being acquired means a big payday for them and for you.
We won’t get into the nitty-gritty of the different kinds of acquisitions and what they mean for your business, but be aware that investors will likely be gearing toward this event in the medium to long term.
Common liquidity event 2: Initial public offering
An initial public offering (IPO) is the process of converting your business from a private to a public company. Your company will have to be valued at around $1 billion for an IPO to commence and must be mature enough in its processes to meet SEC regulations and reporting expectations.
These regulations are complicated and detailed. So when your company is at the brink of an IPO, be sure to get in touch with your accountant so you can be ready for the regulatory nightmare. Once that’s sorted, you’re ready to go public.
You’ll be able to issue shares when it’s a public company. For the investor, this presents an opportunity to convert their equity shares into cash. At this point, your investor may choose to cash out.
Going public allows you to bring a heaping pile of financing into your business as you issue shares to the public.
It’s worth considering that the investor or group you bring on may be with you for the long haul, so choose wisely.
Inequality is the biggest problem with equity financing
Now we get to the elephant in the room. In 2019, female founders received only 2.7% of venture capital funding.1 That leaves a whopping 97.2% left over for male-founded and mixed male-and-female-founded businesses.
Equity investment is a boys’ club. It has been for years, and there’s not a lot of hope for improvement in the future. Nothing makes us more bothered than having to recommend that women avoid equity funders due to historical prejudice.
That said, there are venture capitalist organizations and angel investors out there who prioritize female-led businesses. Women should seek out individuals and organizations interested in promoting their needs.
While equity financiers interested in connecting female entrepreneurs with capital are rare, there are a number of other financing options tailored to the needs of women-owned businesses.
Equity financing is a way for your business to get the funding it needs to grow in exchange for equity in your company. While this does mean you lose some say over the direction of your business, you’ll be bringing on an industry expert who can help you see inefficiencies and growth opportunities and can connect you to their network and resources.
These investors ultimately want to cash out, so they’ll steer your company toward an acquisition or an initial public offering. Your business will have to be in a solid state of growth and stability for either of these things to happen, meaning your investor wants to help you get there.
Equity investing is only one of many ways to finance growth. If you'd like to look into traditional business loans, check out our top picks for small-business loans in 2020.
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- Pitchbook, “The VC Female Founders Dashboard”