What is Equity Financing?

The challenge of financing early-stage business growth can be both exciting and intimidating. Whether business owners are looking to cover short-term operational costs or are seeking long-term investment, raising capital can be tough if they aren’t aware of all the options available to them.

Many businesses do not want to take on debt through conventional loans in these early stages and instead turn to selling equity to investors in exchange for capital. In this article, we’ll explain what equity financing is, what to consider before selling company shares, and the alternative strategies businesses can use to build working capital while retaining equity.

What is Equity in Business?

Equity is an important part of business finance. It represents the money invested in a business by third parties (shareholders that aren’t the business owner) and the percentage of the business still retained by the owner. In addition, equity serves as shorthand for the controlling interest that an individual or group has over a business.

Shareholder equity works by providing everyone who buys shares in a business with proportional ownership of that business. For example, if a business owner sold a 10% stake in their business to an investor, the investor would then own 10% of the business and therefore have significant influence over business decision-making moving forward.

Equity is also used to determine a business’s overall financial health. It demonstrates the ownership of a business (what percentage of the business is owned by the founder versus investors) alongside its net worth (the value of assets minus liabilities).

Equity Financing: Definition

When raising capital, whether to achieve short-term needs (like fulfilling a big order) or long-term goals (like adopting new technology or investing in a team), many business owners sell shares in the company to existing or new investors. As above, this gives shareholders either a degree of ‘residual’ ownership or control over the business. 

That doesn’t mean they own anything physically, but depending on the size of their stake it could mean they have influence over business decisions, as they’ll have an interest in business success.

Unlike debt financing, where owners borrow money to invest in their business, equity financing does not need to be repaid. Instead, the investor benefits from the performance of the business. If the business is sold or subject to a buyout, the investors receive benefits proportional to ownership percentage. Investors also have the option to sell their shares back to the business owner or to a different buyer.

Funding Rounds

Businesses typically go through several funding rounds to build working capital to invest in growth. These stages of equity financing include:

Seed funding: The first official equity funding stage is called ‘seed funding’. The capital raised in a seed round typically will go towards supporting a business to build its team, start developing its products and identifying its market. At this stage, friends, family and angel investors are the typical equity investors.

Series funding: Seed funding is followed by subsequent Series A, B and C rounds, and so on. At each round, the company receives a new valuation, measured by current revenue, market size, company potential and other factors. Investors use this funding valuation as a metric for deciding whether, and how much, to invest.

IPO: After three (or more) rounds of series funding, businesses often go public through an Initial Public Offering (IPO). This is where shares of stock are available on a public stock market and are open to any willing buyer for the first time.

Who Are Equity Investors?

There is a broad range of potential equity investors. Equity investors can include friends and family, but other sources include:

  • Angel investors: individuals who provide seed money in exchange for ownership. They are typically high-net worth and seek opportunities in businesses they see as promising.
  • Crowdfunders: a wide range of potential investors are offered securities in exchange for ownership in the company via an online platform.
  • Venture capitalists (VC): private equity investors who provide capital to companies based on perceived growth potential in exchange for ownership. VCs tend to invest in firms that are already bringing in revenue and are looking for more capital to fund ongoing growth.

When Should Businesses Sell Equity?

Building a business takes a great deal of hard work, grit and persistence. This means very few business owners will want to sacrifice a large percentage of ownership and control over their creation for growth. Despite this, selling equity can serve a purpose, especially if the owner is not in a position to borrow a large sum of money from a traditional lender.

In many cases, bringing in partners and investors, especially those with business acumen and expertise, can be a great strategy if owners can keep majority ownership as their support can help supercharge growth.However, it’s common for some equity investors to ask for a stake between 25 and 30%.

It’s important for owners to assess the risks involved in giving up any more than 10-20% of the business in these early stages. An added consideration is that as businesses grow, further funding rounds will progressively dilute the ownership share and cost owners considerably more leverage.

The key is to strike the right balance between raising capital and retaining control.

The Pros and Cons of Equity Financing

The pros

Accessible financing

Many growing companies see equity financing as a strong alternative to bank loans. Traditional lenders can be unlikely to provide funding to small businesses and startups, often because they lack credit history or physical assets. Equity financing, on the other hand, is often used for new entrepreneurial ventures if investors are able to see the business’s future potential.

ROI over loan repayment

Unlike debt financing, there are no fixed repayments required in equity financing. When equity investors put money into a business, they get paid out a percentage of profits (Return On Investment or ROI) according to the percentage of stock they’ve bought. They shoulder the risk of the loss of their investment.

Expert advice

Investment may come from investors with industry knowledge and business building experience. Since they have a vested interest in the business succeeding, they may offer valuable insights and resources to help it flourish, providing support with decision-making.

The cons

Dilution of control

Raising equity involves issuing new shares of stock which diminish the owner’s stake in the business. This decreases the level of control the original owners have over the business, giving more decision-making power to investors.

Profit sharing

When investors receive a stake in a business, this entitles them to a portion of any future profits. If investors buy preferred stock, rather than common stock, they will have a higher claim on distributions (dividends or profit payouts), but limited or no voting rights which can be a trade off that some owners favor..

Strategies to Maintain Equity

1. Alternative Financing

For those who can afford to borrow, equity financing is not the only alternative to debt financing through traditional lenders. Bank loans may be hard to secure as a startup, but other financing options are available. Business owners may choose instead to borrow from an investor and repay with interest, or apply for small business grants from the government.

For short-term funding requirements, purchase order (PO) financing helps with fulfilling orders once they’ve come in. This supports effective cash flow management, which is crucial to maintain business growth.

2. Bootstrap

In the early stages, it’s important for businesses to exhaust as many possibilities as possible before selling equity. Bootstrapping and being really strategic with cash flow management often feels overwhelming, but it is good business practice to maintain control of cash burn and only run large funding rounds when the business is ready. That means limiting funding to personal finances, operation revenue and other alternative solutions, like PO financing.

3. Choose investors wisely

Equity investors vary in their objectives and terms. For example, where some may offer a larger contribution in exchange for a higher stake, others will be more interested in a flexible arrangement.

The right investors will be those who understand the vision and goals of the business. They will also have realistic expectations, and will not attempt to take advantage of the business owner. Venture capitalists, for example, often have a “grow fast, exit fast” mentality, which may not be suited to all businesses and founders. Founders need to check potential investors’ past investments, along with references and any potential conflicts of interest, to avoid getting involved with someone that isn’t right for their business.

Setscale’s flexible solution supports small business growth

Having built businesses from the ground up ourselves, we understand the importance of retaining equity. Founders need to tread carefully when sourcing capital and managing cash flow, and the best partners are those who understand the business environment and can help small businesses to scale.

Our PO financing solution is designed to empower businesses to grow by helping them fulfill orders when they come in. Other financing companies will focus on credit score, but our approach looks at businesses according to size, background and their unique situation. Our solution has been designed to help businesses overcome obstacles to growth.

Read more about our PO financing solution, or browse more insights through our Resource Hub.

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