When you decide to start a business, there are many ways of raising the needed capital. While as many as 32% of all entrepreneurs use their own money to start up, there are millions of business-minded people who don’t have access to ready cash or cannot access SBA loans to fund their ideas. Some of them choose to look for funding from investors who, in return, own a portion of the business. It’s what equity financing is all about.
Whether by choice or due to circumstance, equity financing is one of the best ways to raise enough money to get your idea off the ground and turn it into a profitable business.
At the end of the deal, your business benefits from a huge amount of cash to operate on, and the investors get a share of the profits and offer strategic assistance towards the success of the business. Still, entrepreneurs consider it very formal and, instead, consult friends, family, or lenders for capital.
Perhaps the reason why equity financing is not the most preferred method of funding small businesses is that the entrepreneur splits ownership and profits with the investor. However, the fact that this method guarantees large amounts of cash in investment makes it very attractive.
Even so, you need to ask yourself whether equity financing is the right method for funding your business.
Is Equity Financing Right For Your Business?
The main sources of equity investment — venture capitalists and angel investors — mainly looking for early-stage companies with potential for explosive growth. If your business is more locally-oriented and does not have expansive, global ambitions, you’re more likely to find success with debt financing than equity financing.
However, don’t get discouraged and think that a smaller, more local business could never get equity investment. It’s always wise to weigh your options.
This article includes 6 types of equity financing available to choose from.
But first, equity financing is right for you if:
- Your business has exponential growth potential
- You are an entrepreneur looking for a mentor for guidance
- You want to avoid going into debt to finance your business
- You have global ambitions for your company
Debt financing, on the other hand, may be a better choice if:
- Your business does not yet have a plan for rapid growth
- You want to retain complete control over your company and all future business profits
- Your company only serves the local market
- You want to raise capital without concerning yourself with federal securities laws and regulations
If you have decided to go along with equity funding, here are the six most common types.
Initial Public Offering (IPO)
An IPO takes place when a company has decided to “go public.” It means that the company is offering up initial shares on a publicly-traded market such as the New York Stock Exchange. Once the company has “gone public”, it means that it is now a publicly-traded company, and can raise funds from public investors.
Your company must meet requirements by exchanges and the Securities and Exchange Commission (SEC) to hold an IPO. Once your IPO has been registered and approved, the SEC will give you a listing date on which the shares will become available on the market they will be traded on. It is advisable to have your business in operation on or before the listing date, as this will help attract investors to your shares.
Small Business Investment Companies (SBIC)
The US federal government regulates a program called the Small Business Investment Company (SBIC) program via the Small Business Administration (SBA).
According to the SBA, an SBIC is a privately owned company that’s regulated and licensed by the SBA to invest in small businesses in the form of debt and equity. Although the SBA doesn’t invest directly in small businesses, it provides funding to qualified SBICs with expertise in certain industries. Those SBICs then use their private funds, along with SBA-guaranteed funding, to invest in small businesses.
SBICs may invest in small businesses through debt, equity, or a combination of both.
The only limitation for startups is that SBICs typically fund mature businesses that have already established their profitability. However, different SBICs have different investment policies. There are three universal requirements for any business seeking SBIC funding:
- At least 51% of your employees and assets must be within the US
- Your business must qualify as a small business according to SBA size standards
- Your business must be in an approved industry
They are wealthy people or groups who look for high returns on their investment. Angel investors are very conversant with the businesses in which they invest. Although they tend to make smaller investments than do venture capitalist firms, angel investors usually take a more hands-off approach with the businesses they invest in.
Since angel investors are typically successful entrepreneurs, they may be more motivated by your personal qualities and take a more personal approach to what they invest in. They may also be open to funding a wider variety of early-stage businesses than a venture capitalist would. Depending on the kind of business you’re in, you may find angel investors to be a better source of funding than a VC firm due to their flexible terms.
Angel investors receive a piece of the action in return for their money and knowledge in helping a small business grow, especially if the founder is quite young in the industry. For example, Hannes Rydell was just 18 years old when he secured investment for what became DropInGolf Sweden AB, a Swedish booking service for golf clubs.
Many of the entrepreneurs who made up the list of investors in the Creative Dragons event in which Hannes’ idea was voted “Best Business Idea” were either in the golfing industry or had significant interest. They included PGA-Tour Player and entrepreneur Mathias Grönberg, ranked as the 65th golfer in the world at his time and also played with Tiger Woods in the 2003 Open Championship.
Venture capitalists are firms that provide funding in exchange for ownership, or shares, of your business. Unlike angel investors, venture capital firms don’t use personal funds for investing in startups. They usually have many competing businesses from which to choose and are, therefore, always on the lookout for high rates of return when they invest their money in a start-up.
Venture capital firms are mostly made up of a group of professional investors who bring their money together to invest in start-ups or growing companies. Sometimes they may want a seat on your board of directors as a form of managing the investment. As a result, such firms have taken up a mentoring approach to assist with investment growth.
Equity crowdfunding is a relatively new type of equity investing. It was officially recognized in 2012 with the passage of the JOBS act. Equity crowdfunding often works like backing a Kickstarter project, but instead of sending money to a campaign in exchange for a product or branded merchandise, you invest in a company in exchange for equity in the business.
In essence, equity crowdfunding websites put you in touch with a crowd of potential angel investors. However, instead of receiving a large investment from one angel investor, you’ll receive a lot of much smaller investments (from as low as $20) from investors who liked your online crowdfunding campaign.
Equity crowdfunding is best if your business project has mass appeal, but you haven’t been successful in securing any VC or angel investor capital.
Mezzanine financing utilizes aspects of debt and equity funding. The lender makes a loan and, if all goes well, the company pays the loan back under negotiated terms. They can set terms such as financial performance requirements for funding the company.
This method has an intermediate risk level and exists between lower-risk debt and higher-risk equity funding. One advantage for borrowers is that mezzanine capital may have more value than a traditional lender would be willing to issue. Also, since mezzanine debt is an improved form of equity and debt, accountants consider it to be equity on the balance sheet.
There are enough options to choose from if you are looking for equity funding for your business. Each promises amazing benefits to the entrepreneur as well as the investor. Try to match your business with the right form of investment as this will greatly influence how your idea plays out.