There are three main ways with which a small business can finance their operation:
- And a combination of the two
Equity can come from several different sources. It can be cash that’s paid into the business by the owner, by investors, or through gathering investments through issuing shares in the company.
It seems counter-intuitive, but you can also use debt to bring cash into your business. You can borrow it from a small business loan provider at a fixed rate. The debt can be incurred through a loan or through the sale of bonds.
When investors look at the equity of your business, they see it in terms of risk versus reward. Investing in a small business is always a risk, but some are going to be riskier than others. If you’ve proven that you have the capital to back up the business, as well as a assurances that the business will make a good return for the investors, they’re going to be more likely to put up with that lighter level of risk, because the chances for reward are greater.
Outside investors will often judge how determine you are to make your business succeed by the amount of money that you yourself have invested in the business, as well as the commitment of other lenders that have invested in your business.
Defining Equity Financing
Once you have a firmer grasp on what your shares can mean to investors, you’ll have a better understand of how you can utilize equity financing to your business’ advantage. By selling off shares of your company, you’re giving away part of the ownership and control of your business, but you’ll also be bringing in usable cash that can help you to grow.
Investors are purchasing these shares in the hopes that it’ll provide a source of return for them, and they can have the option to sell off those shares in the future for potentially even greater profit.
Who Contributes to Equity Financing?
Unlike many types of small business financing, equity financing can be contributed to by a massive range of investors. This can include small local entrepreneurs, large-scale initial public offering groups (or IPOs) that could contribute billions by major corporations, or even your friends and family’s contributions. Equity financing can come from private as well as publicly listed and traded companies.
Your investors (both great and small) can be your source of equity financing. And if your new company eventually grows large enough to go public, you can sell off those equity shares for larger profit to other investors, and your investors may also sell those shares.
How Is Equity Financing Controlled?
The equity financing options of a company are regulated by both local and national organizations, although a local organization will of course be more involved in the day-to-day monitoring tasks of equity financing within the community. These rules and regulations are set forth not necessarily to protect your company, but rather to protect the average investor from fraudulent companies who would take their investment funds and then disappear along with the “company” that the investor had placed their trust in.
That’s why when it comes to equity financing, there’s usually a prospectus (also called an “offering document”) or some kind of offering memorandum (also called a “private placement memorandum” or PPM). These are a way to help provide the investor with all the needed information to help them make an informed decision about investing in the company. An explanation of pro’s and con’s, if you will.
Prospectus are filed with the Securities and Exchange Commission. The prospectus would contain details about the company’s objective, goals, risks, fund management tactics, investment strategies, past performances, distribution policies, and any fees or expenses. Whatever you call the document that’s given to potential investors in the process of equity financing, it’s essentially just a fancy (and extremely detailed) business plan.
These security measures are in place to help protect investors and to keep companies from taking advantage of the benefits of equity financing and the first wave of angel investors, who are often first-time investors like friends and family members.
What Controls the Demand For Equity Financing?
The current state of financial markets and more specifically, the state of the equity markets at the time. Similar to the stock market, the trends in equity financing can either signal success or failure; health or stagnation.
For example, just like the stock markets, a steady stream of equity financing is viewed as a show of confidence on the part of investors, which gives your business greater appeal to other investors. When everyone seems to be buying into something, it’s usually financially prudent to jump on the bandwagon while you still can, generally speaking.
But in the same way, a sudden onslaught of investors throwing money at your business can be viewed as a warning signal to outside investors. In all markets (including equity financing) a rapid influx of investment usually reveal excessive optimism, which is often forced. A smart investor will know that this overinflation of the value of a company typically signals an impending cap on the market, and eventually stagnation or decline. It means lost money for themselves.
There are countless examples of that happening on a global scale, and it’s ruined the markets, as well as the careers of many investors. So a steadily consistent approach to equity financing is more favorable than a sudden burst of investors clamoring to buy shares in your company. The former is the more financially healthy scenario.
The 3 Biggest Ways Equity Financing Can Prove Beneficial for Your Business
There are plenty of “pros and cons” to using equity financing to grow your business. But on the whole, there are more benefits than drawbacks. These are simply the three biggest reasons why equity financing is often a good option for small business owners, and how it can help you succeed and grow:
- It Keeps You Out of Significant Debt
As we mentioned earlier, using debt to improve the cash flow of your business is a perfectly viable option. But given the choice between accruing and trying to manage debt versus equity financing, it’s clear which is the safer option between the two.
And equity financing is just a consistently successful financing strategy for small businesses as debt financing is, so there’s no real reason to actively try to favor debt financing over equity financing. People tend to have fierce opinions in the battle between debt financing versus equity financing. Which is better?
- It Keeps You Free From Begging for Loans
When you’re a new business just trying to get off the ground, you probably aren’t going to have a lot of financial history to show off to potential loan resources. It’s going to be difficult for you to qualify for many types of small business loans, and it’s going to cost you dearly, even if you do succeed in obtaining a loan.
Plus, you’ll now have loan payments and potential debt to juggle on top of running your fledgling business in the most hectic stage of its life. Wouldn’t it just be easier if other people could give you the startup cash that you need? Yeah. Exactly. It’s much easier, and far less risky.
Even if you still can’t get enough funds from equity investors as you need, you can always take out a smaller business loan thanks to the help of equity financing. You’ll have an easier time repaying that loan quickly before debts set in thanks to the backup funds supplied by your investors.
Unlike lenders, you won’t owe any debt money to your investors. They knew the risks of investing in a small business. If they lose money, that’s on them. If you lose the bank money, that’s on you.
Equity financing is a safer choice for most new business owners, because if their young endeavor tanks and fails (as entrepreneur’s early forays into business often do) then they won’t have to deal with loan payments and debt management for the next several years. When you’re free from loans and debts, you’re also free to rethink, re-strategize, and re-attack the business world with a new plan if the first business doesn’t work out.
It may take you a few tries to get your business practices down to something that really works. For most entrepreneurs, the first business fails. The important trait of successful business owners is that they use the failure as a learning experience, gather funds again, and try it from a new angle rather than giving up completely.
- Investors Can Offer You More Than Just Cash
Many of your initial investors will be first-timers. Your friends, family, and colleagues will politely invest in your business, whether they fully believe that it’ll be a success or not. But those angel investors from the community or through private and public companies who spot your good idea and strong business plan are different.
They’re often seasoned business minds that can offer you valuable insight, suggestions, moral support, and provide you with some useful connections. They now have a financial stake in your business, and their investment is proof that they want you to succeed. So they’ll help you to do it!
Take them up on their help, and you’ll have the necessary funds as well as the all-around support of business-savvy people who are there to help you thrive, versus a lender who hopes that your business fails so that they can collect the interest on the loan payments and debts.