Duncan Ferris
Equity financing is the act of selling part of your business to raise money, normally for expansion. It can be a way to supercharge your company’s growth, both through an injection of fresh capital as well as with the experience and expertise of new investors.
But how does equity financing work, and what are the different ways in which businesses can access it? Read on to find out whether equity financing is the right option for your business.
How equity finance works
Equity finance allows businesses to raise capital by selling shares of their business to an investor or multiple investors.
You will retain ultimate control of your business as long as you don’t sell more than 50% of the company. However, investors with a minority stake may still expect to be involved in the decision-making process.
To sell shares, you first need to value your business. In order to do this, you should add up your business’s assets, income and future orders, before subtracting liabilities and debts. If your business has high future earning potential, you might also want to factor this into your valuation.
When you have completed this valuation, you can work out how much money you can raise by selling part of the business. For example, if your company is valued at £100,000 and you want to raise £10,000, you could sell a 10% stake.
While you don’t need to pay the investor back, they will enjoy other benefits from backing your business. They might receive income from the investment in the form of dividends and the value of their stake in your business will increase as the business grows, allowing them to sell it on for more than the purchase price.
Equity finance is distinct from debt financing, which involves a loan from a bank or other lender. With debt financing a business owner surrenders no control of their business but must repay the money borrowed along with additional interest.
Types of equity finance
If you have decided you want to boost your business’s coffers with equity finance, you need to consider what type of investment you want to attract. Here are the main options to choose from:
Crowdfunding
Equity-based crowdfunding allows a business to raise money from lots of smaller investors, rather than relying on one big fish. It is often used for an injection of capital in the very early stages of a business’s lifespan.
Business success stories like Monzo, Revolut and Oddbox have all used crowdfunding to fundraise, making it an exciting option for innovative companies. Businesses can raise millions with crowdfunding, all while building a community of investors and raising their company profile.
However, crowdfunding campaigns can be challenging to coordinate due to the need to stand out from the multitude of other businesses seeking funding. Additionally, the public nature of crowdfunding means that failing to deliver on promises can be very damaging to your company and you.
To learn about crowdfunding, including comparisons of the top crowdfunding platforms, check out NerdWallet’s in-depth guide.
Angel investors
An angel investor is typically an entrepreneurial individual who looks to make a large return by buying a minority stake in a small company. The investment is seen as more than the cash given as investors are often experienced business owners who will want to offer advice and be involved in decision-making processes.
They typically invest between £5,000 and £500,000 into a business in exchange for minority stakes of between 10% and 25%. This often takes place early in a company’s lifespan, sometimes as seed funding.
However, finding the right angel investor can be challenging and once they have invested, you may have to deal with losing some control of your business and added pressure to succeed.
To learn more about angel investors, including how to find one for your business, read NerdWallet’s full explainer.
Venture capital
Venture capital is another mechanism for young businesses to sell a minority stake to a single investor. However, it is distinctly different from angel investment for several reasons.
The first of these is the potential size of investment. Venture capital investments can be enormous, sometimes landing businesses with millions of pounds in funding.
Next is the fact that most venture capital comes from a venture capital firm, rather than an individual investor. This means a whole company, potentially including investors, board members and professional employees, will be invested in the success of your business.
Typically, growing businesses will receive multiple injections of venture capital as they expand, with these different rounds of funding known as Series A, Series B and Series C. Following Series C, a business might expect to publicly list through an initial public offering (IPO).
Private equity
Private equity is another common form of investment, usually appropriate to mature businesses that already have sustainable income and turn a profit.
Beyond this preference for more mature businesses, private equity is very similar to venture capital. However, there are some further key differences. For example, private equity firms often seek to acquire a controlling stake in businesses they invest in, or even buy them out altogether.
Additionally, a private equity firm will likely aim to sell its stake in the business more quickly than a venture capital outfit. This can increase the pressure on a business to grow and increase in value quickly.
Public listing (IPO)
An IPO is when a company begins selling shares to the public, which is typically a measure taken by businesses which have already undergone multiple rounds of funding and reached a certain level of maturity. As such, it is likely not appropriate for a small business.
Like crowdfunding, this allows a business to raise money by selling shares to a large number of small investors. However, there are more stringent requirements for businesses seeking to “go public,” such as a need to disclose financial information at regular intervals.
These rules will vary depending on the market on which the business lists, such as the London Stock Exchange Main Market or the Alternative Investment Market (AIM).
On the plus side, an IPO will increase a company’s profile and give it opportunities to raise capital in the long term, such as through issuing new shares or selling larger portions of the company to existing shareholders.
To learn more about how IPOs work, read NerdWallet’s full guide.
Advantages and disadvantages of equity financing
Here are some advantages of equity financing for your business:
- No repayments: Unlike a loan, you will not need to repay investors (although you may give them a share of the profits with dividends). That means there is no debt and you will not see your personal finances ravaged if the business fails.
- Eligibility: Traditional forms of financing, such as grants and loans, often have stringent requirements, including the need for a strong credit score or certain levels of income. Investors may be more willing to back a business that would be turned down by lenders.
- Access expertise: Some investors bring experience, contacts and invaluable knowledge to your business, and will be just as keen as you to leverage this into success for the company.
Meanwhile, here are some key disadvantages:
- Losing control: With each kind of equity financing, you have to surrender some control of your business. This can make decision-making harder and reduce the amount you might make if you sell the company.
- Time-consuming: Raising funds through equity financing can take a lot longer than using more traditional options.
- High expectations: Equity investing is much higher risk than lending, so your investors are likely to expect a high return on their investment. This can put a lot of pressure on the business to achieve continued growth.
- Tax costs: Unlike interest payments from debt financing, dividends are not tax-deductible expenses for a business. This means that equity financing can be more costly than debt over the long term.
Is equity financing a good idea for your business?
Choosing to use equity finance to fund your business’s growth is a big decision. It can mean surrendering control of your business and inviting other people into the decision-making process, potentially creating conflict.
That being said, equity finance can be a great option for businesses that might struggle with loan repayments or eligibility, or companies that require a helping hand from experienced contacts who can guide future growth.
Other business funding options
While equity finance offers one way for business owners to get the money they need, there are many other funding options for businesses, including loans, government grants, rolling credit facilities and asset financing.
Different sources of finance come with advantages and disadvantages, so it is best to keep your circumstances in mind when trying to work out the best option for your business.
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