Equity Financing: What It Is, How it Works, Pros and Cons
Equity financing can be a good option for startups and high-growth companies, but isn't accessible for every small business.
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Updated · 3 min read
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Lead Writer Key takeaways
- Equity financing exchanges ownership for capital, meaning investors are repaid through company growth and profits, as opposed to fixed loan payments.
- It’s best suited for startups and high-growth businesses, especially those that are pre-revenue or don’t qualify for traditional loans.
- Equity financing provides capital and offers expertise from investors, but you give up ownership and some control over your business.
Equity financing is a common type of funding for startups — especially for those that are pre-revenue, can’t qualify for traditional loans or want to avoid debt.
What is equity financing?
Equity financing trades a percentage of a business’s equity, or ownership, in exchange for funding. Equity financing can come from an individual investor, a firm or even groups of investors.
Unlike traditional debt financing, you don’t repay funding you receive from investors; rather, their investment is repaid by their ownership stake in the growing value of your company.
» MORE: How to get startup funding
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How does equity financing work?
The process of getting equity financing varies depending on the type of equity financing you’re looking for, your business and your investors. Generally, you can expect to follow these steps:
1. Prepare a business pitch
Before you start looking for investors, prepare a pitch that showcases your business and its growth potential. Your pitch should include documents like a business plan and financial reports.It should also outline how much capital you need and how you plan to use it.
2. Find investors
If you don’t have potential investors in mind already, consider leveraging your personal or professional network to understand your options. You can also use online platforms to search for investors, check LinkedIn or attend local networking events.
3. Negotiate how much equity to give to your investors
Once you’ve found investors, they may conduct their own business valuation to determine your company’s potential value and how much equity they’ll want in exchange for their investment.
Factors like business stage, amount of risk and expected return will influence this negotiation. Angel investors often request 10% to 30% of ownership, whereas venture capitalists may want up to 50%.
4. Use funds
Once you’ve negotiated a price, the cash you receive from investors may be used for product development, new hires, debt refinancing or working capital.
Once your business starts making money, your investors will be entitled to a portion of your profits depending on how much equity they have in your business. This percentage will be paid to your investors in dividends within a predetermined time frame. If your business fails to make money, original investments do not have to be repaid.
Common sources of equity financing
Equity financing can come from a variety of sources, including:
Angel investors
Best for: Business pitches and pre-revenue startups that want guidance in addition to funding.
Angel investors are high-net-worth individuals, most often accredited, who invest their own money in startups or early-stage operating businesses. It’s possible to find angel investors through platforms like the Angel Capital Association or AngelList, but they can also be personal acquaintances or members of your professional network.
Venture capitalists
Best for: Early-stage, high-growth businesses that are already in operation.
Venture capital (VC) is similar to angel investing, but instead of wealthy individuals, VCs are usually investing on behalf of a venture capital firm. In general, VC can be a little more difficult to qualify for, and firms typically get involved after angel investors have already made initial investments.
Crowdfunding
Best for: New entrepreneurs, smaller businesses, especially those with a strong online presence.
Equity crowdfunding draws on groups of online investors, some accredited and some not, to fund businesses. Crowdfunding platforms allow potential investors to learn about businesses or business ideas through online profiles created by the business owners. This can be a good option if you already have a strong online presence or following.
Keep in mind, online investing poses additional risk of fraud, so you’ll want to be diligent about vetting the platform you use. In addition, issuing more shares, however small, may dilute your ownership and increase costs more than using an angel investor or VC.
Pros and cons of equity financing
Pros
- No repayment terms. You don’t “repay” an investor in your company the way you would a lender. Instead, the initial investment is repaid by the prospect of the future value and profits of your business. While loans can be a great way to fund your business, not having monthly or weekly payments can be beneficial to startups or businesses that are focused on growth.
- Access to advisors. Most investors have experience investing in and running companies, making them a great resource to provide advice as you manage your operations. Plus, because they’ve put money into your business, investors have a special interest in helping you succeed.
- Larger funding amounts. You may qualify for larger amounts of financing with equity investors than with debt financing, especially if you’re a startup business. In addition, if you end up needing more money along the way, an investor may provide additional injections.
- Alternative qualification requirements. Rather than business revenue or personal credit, investors will typically look at things like your business idea’s potential and your background.
Cons
- Loss of ownership. Any time you receive an equity investment, your percentage of ownership in the business will decrease, which can affect your share of any future profits and value.
- Loss of control. When you hand over ownership, you may also be handing over some control of the business, which can become problematic if you and your investors don’t see eye to eye.
- Usually for high-growth, high-potential businesses. Equity financing is usually tailored for fast-growing businesses with high growth potential, which means many small businesses won’t be the right fit for this type of financing.
» MORE: How to fund your business idea
Is equity financing right for my business?
Equity financing can be a good option if:
✅ You’re a startup or early-stage business.
✅ You’re focused on rapid growth and scaling.
✅ You don’t want a monthly loan payment or to take on additional debt.
✅ You’re comfortable giving up a portion of ownership in exchange for capital and expertise.
Alternatives to equity financing
If you don’t think equity financing is a fit for your business, consider these alternatives:
- Small-business loans. Small-business loans are a common type of debt financing, and a fair alternative to equity financing. Loans can be either term loans or lines of credit, and may come from banks, online lenders, credit unions or nonprofit lenders like community development financial institutions (CDFIs).
- Small-business grants. If you want to avoid taking on debt and keep control of your business, and you don’t need a ton of funding, consider looking for small-business grants instead. Grants can be tricky to find and usually don’t fund in large amounts, but they can be worth it for funding that you don’t need to pay back.
- Self-investing. Tapping into your own savings can be a way to maintain full ownership of your business and avoid paying any interest. However, you risk losing your savings if your business fails, so it’s best to seek the advice of a financial professional to determine whether this option is right for you.
- Friends and family. If you have friends or family members you trust and who support you and your business, they may be willing to provide funding. Though this may feel less formal than receiving funding from a bank or other financial institution, you should still create a contract that details the terms of the business loan from your friends or family.
Frequently asked questions
What is the difference between debt and equity financing?
Debt financing involves taking out a loan, which is a lump sum of cash given by a lender that’s repaid over time, with interest. Equity financing involves giving up equity, or ownership, in your business in exchange for capital.
What is an example of equity financing?
Say you’re a tech founder that owns 100% of your company. You’re looking for $250,000, but don’t want to take on debt. You decide to give up 30% ownership in your company to an angel investor in exchange for the funds you need. Now, the angel investor owns 30% and you own 70%. The investor has a say in business decisions and receives a share of the profits.
What are the disadvantages of equity financing?
Disadvantages of equity financing include:
- Loss of control in your company.
- Loss of ownership in your company.
- Not a viable option for many small businesses.
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