Raising enough capital is one of the top small business challenges in 2022. Several businesses have gone down, and many are at the brink due to insufficient funds—in this piece, we shared some equity financing options that could help you stay above the water.
Equity financing is often the best funding option for startups and small firms.
As of 2018, thousands of startups have received over $200 billion from venture capital funds (a form of equity financing), and the number keeps growing.
With its scintillating benefits and reasonable risks, equity financing might be the perfect opportunity to get the financial backing your small business needs to scale and level the playing ground with the competition.
This article covered 7 equity options you could explore to fund your small business.
Read on to find out.
What is Equity Financing?
Equity financing is a small business funding option in which the owner gives up some portions of their company (shares) to several investors in exchange for capital.
When you’re equity financing, your company’s valuation or worth determines the cost of shares, and your investors become partners in ownership.
Also, since you’re sharing ownership, the amount of equity financing you obtain often depends on how much management control you’re willing to share.
You can obtain equity financing for your firm from numerous sources, including initial public offerings (IPO), private equity investors, or even relatives and friends, as long as you’re comfortable with them being part owners of your firm.
If you’re raising capital for rapid firm growth or your industry’s research is expensive, you’ll likely undergo several rounds of equity financing.
Should Your Small Business Explore Equity Financing Options?
Equity financing is often your best funding option because, as a start-up, you might not qualify for other options due to your limited credit history and business age.
Even if you qualify for debt financing, equity financing is likely a better option because, with its aid, you, as an inexperienced small business owner, can obtain capital while enjoying the expertise and affluence of an experienced partner.
Two reasons you should consider equity financing include:
Alternative Funding Option to Debt
One key benefit of equity financing over other types of financing is that it provides an alternative funding source to debt.
Startups ineligible for large bank loans might get financial assistance from angel investors, venture capitalists, and crowdfunding sites. With equity financing, the firm owes no debt.
Because the corporation doesn’t need to make a monthly loan payment, equity financing is vital, especially if the business does not immediately turn a profit.
So, most people consider equity financing less hazardous than debt financing because the company doesn’t need to repay its investors.
Typically, investors do not anticipate a speedy return on their investment and instead concentrate on the long term. It enables the company to reinvest cash flow from operations to grow the business rather than focus on debt repayment and interest.
Grants Access to Other Financing Sources
Equity capital is also advantageous for a company’s management since some investors have a personal incentive to support a business’s success and desire to participate actively.
Thanks to their reputation, they can provide essential assistance in commercial relationships, management expertise, and access to additional financial resources.
Many angel investors and venture capitalists are eager to support enterprises in this way. During the early phases of a company’s development, it is crucial.
Equity Funding Options for Small Businesses
By now, you’re already picturing equity finance as your ticket to improving your business’s financial situation, but what are your options?
Small Business Investment Companies (SBIC)
The Small Business Administration (SBA) authorizes and oversees the Small Business Investment Companies (SBIC) program, which offers venture capital financing to small enterprises.
Investments in start-up, potentially risky company ventures are possible through venture capital firms that combine investor funds.
These investors may include Wealthy folks, investment firms, private pension funds, etcetera.
SBICs are similar to venture capitalists, but since a venture capital firm may be sponsoring many businesses and projects at once, it is a competitive type of funding.
Angel Investors for Equity Financing
Angel investors are another source of equity financing, but what are they?
They are wealthy investors that seek small businesses in which to invest.
Angel investors are either affluent individuals or groups seeking a high return on investment, so they’re often thorough in choosing a small business to finance.
Several angel investors look for and invest in newly established companies while providing operational and technical knowledge to these startup ventures.
After the initial investment, if they’re satisfied with a firm’s progress, these investors often provide a second round of funding to further grow the business.
Mezzanine financing is a funding option that often interests intermediate-sized businesses because its risk level falls between lower-risk debt and higher-risk equity financing.
So, we can say that mezzanine financing combines both equity and debt.
In this form of financing, a lender provides a loan to a company, and if things go smoothly, the borrower repays the loan under earlier negotiated terms.
In mezzanine financing, the lender can set several financial requirements for the borrowing company. The terms can include higher shareholder equity or a high operating cash flow ratio.
One significant benefit borrowers can enjoy from this financing option is that mezzanine capital often grants more value than a traditional creditor would grant.
Bear in mind that traditional loans are much cheaper than mezzanines.
Another advantage is that accountants consider mezzanine debt as equity in the balance sheet since it comprises debt and equity.
Also, the owner is less likely to lose control of the company since the lender is unlikely to interfere. Provided the firm grows and yields profit.
Initial Public Offering
An Initial Public Offering (IPO) involves a company publicly selling its shares for the first time. Furthermore, the firm raises capital from these public investors.
This option requires offering the shares in compliance with the Security and Exchange Commission’s (SEC) guidelines.
These guidelines require that the IPO register and gain approval, after which the SEC provides a listing date.
The listing date shows when the company’s shares will be publicly available for investors to purchase.
Also, the business needs to capture investors’ interests through campaigns.
Like angel investors, venture capitalists fund small businesses in exchange for your business’s shares or ownership.
They also seek a high return on their investment and often have numerous small businesses competing for their investment.
One key difference between angel investors and venture capitalists is that the latter don’t invest personal funds into small businesses.
They consist of professional groups of investors that combine their finances to invest in smaller firms.
Also, a venture capital firm will likely want a board of directors seat because most see it as a requirement for proper investment management.
Furthermore, many venture capitalist firms use mentorship to significantly boost investment growth.
So, if you’re looking for a venture capitalist to invest in your small business, ensure it wants to partake in your line of business.
Royalty financing (also known as revenue-based financing) involves investing in a product’s future sales. Unlike most other funding options, you must make sales before gaining approval.
Furthermore, investors expect to receive immediate payments because of the agreement with the lenders.
These financiers inject upfront cash to cover business expenses to receive percentage revenue payments from product sales.
Also known as investment crowdfunding, this equity financing method is common among early-stage companies and startups.
In this equity financing option, you sell your company’s shares to a crowd of potential investors in exchange for capital.
The stake an investor holds in your company is proportional to their investment.
Equity crowdfunding differs from other crowdfunding methods because the model helps raise capital for involved firms when they sell financial securities to investors.
Unlike other capital-raising options in which you sell shares to a small professional group of individuals, in equity crowdfunding, you target a larger group and secure capital from your investors’ contributions.
The Dark Sides of Equity Financing
While its advantages are attractive, equity financing also has 2 major disadvantages, which are:
Diluting ownership and administrative authority
Equity financing offers numerous benefits to small businesses but also presents several disadvantages you should consider before exploring the funding option.
Equity financing’s biggest drawback is that business owners must forfeit some of their corporate control and ownership.
The firm must also provide a specific portion of its future revenues in the form of dividends to its shareholders to remain profitable and successful.
Many venture investors demand an equity stake of up to 50 percent, particularly for firms without a strong financial foundation.
They battle constrained equity financing alternatives since many business founders and owners are hesitant to cede a significant portion of their corporate authority.
Wrapping it Up
As mentioned in the article, equity financing presents inviting benefits to small businesses.
The catch is you must be willing to bear the risk of giving up some corporate control since you’re selling a portion of your company’s shares.
Like any business decision, you must consider carefully before seeking equity finance.
Also, keep in mind that, apart from financing, there are other challenges you’ll face while growing your business. To help guide your journey, we’ve compiled the top 15 and how to navigate them. You might want to check out the free resources below.