Equity Financing 101: A Guide For Founders
Building a startup is exciting.
From initial conception through to designing a go-to-market plan, right through the dozen or so pivots you make before finding that elusive product-market fit, it’s nothing short of a rollercoaster.
But, much like the aforementioned amusement ride, these things don’t come cheap ($8m, according to Ohio University, in case you were wondering).
Somewhere along the line, you have to get some cash in the bank, and so many founders, just like you, start wondering about their financing options.
In this guide, we’re going to go over one of the most popular financing options for startups: Equity financing.
By the end of this article, you’re going to be an expert in all things equity financing, and have a much clearer view of what it is, and whether or not it’s a wise move for your startup.
Table of Contents:
- What is equity financing?
- How does equity financing work?
- Where do you get equity financing?
- Pros and cons of equity financing
- How to decide if equity financing is right for you
- Equity financing vs. debt financing
What is Equity Financing?
Let’s start with a simple definition:
Equity financing is a process of raising capital through the sale of shares in your business.
Basically, you’re selling a portion of your company (or, more accurately, a ton of really tiny portions).
You get some capital in the bank to feed your business appetite, and in exchange buyers receive a chunk of equity.
That’s equity financing at a high level, though there are a few different ways it can be structured. Let’s look a little deeper.
How Does Equity Financing Work?
Like we just discussed, equity financing is essentially giving up part of the ownership of your company in exchange for cash (that is, selling it).
Here’s how it works:
Let’s say you’re the sole company owner. You own 100% of the shares in the company. You have all the equity.
But you need to raise some cash to fund expansion (or some other activity that’s going to drive your business first).
You decide to give up 10% of your ownership and sell it to an investor (or a group of investors, more on that soon) in exchange for capital.
Now you own 90% of the company, but you’ve got the cash in the bank to pursue your business goals.
Where things get a little more complicated is when you start talking about different kinds of equity.
Most equity financing revolves around the following types of equity:
- Common shares – What you think of when you buy shares on the stock market. Common stockholders have some influence over the business operation, and certain rights to company assets if the business goes under.
- Preferred stock – Similar to common stock but without voting rights, and with more ability to claim assets and earnings.
- Convertible preferred stock – Preferred shares that include an option for the holder to convert to common shares.
Common Sources of Equity Financing
Equity financing can come from a variety of places, which may influence the structure of the deal you strike.
The most common source of equity financing are:
- Angel investors – Angels are wealthy individuals with an appetite for investing in early-stage companies at a singular level (i.e. one company rather than investing in the stock market).
- Venture capitalists – VCs are firms that are specifically built to invest in startups like yours.
- Initial public offering (IPO) – This is generally reserved for later-stage companies who’ve already gone through several rounds of funding, or bootstrapped to a point where they’re making revenue. An IPO is the event that takes your company public, and issues a number of shares available for public investment on a stock market.
- Friends and family – Of course, if founders have friends and family who are interested in investing, this is always an option, and will be similar to angel investing.
Pros & Cons of Equity Financing
Equity financing has plenty of benefits, but it also has some pretty significant drawbacks. Let’s take a look at the pros and cons so you can make a more informed decision.
Pro: You Don’t Have to Pay Back the Money
One of the major benefits of equity financing is that, unlike debt financing, you don’t have to pay back the money you receive.
You’re selling a portion of your company equity in exchange for the capital, so the financial risk (of your company potentially not doing so well) is borne by the buyer.
Con: You’re Giving up Part of Your Company
The major drawback involved in equity financing is that you’re partially giving up ownership of the business.
That means that important decisions that impact the future of your company need to be run past shareholders, which is not only a bit of a pain, but can be a slow and cumbersome process if you have multiple shareholders.
Pro: You’re Not Adding Any Financial Burden to the Business
Unlike other types of financing, equity financing doesn’t burden your company with repayments to meet each month, making it a suitable option for pre-revenue-stage companies.
Con: You Going to Lose Some of Your Profits
Let’s say you own 100% of the company right now. You’re getting 100% of the profits.
But if you split out 20% of the company to investors in exchange for equity financing, you only own 80%, meaning you’ll only be entitled to 80% of any profits your company makes.
Pro: You Might Be Able to Expand Your Network
This one depends quite a bit on the source of your equity financing.
Obviously, if you go the IPO route, then you’re not exactly making any new contacts.
But if your equity financing comes from an angel investor or venture capitalist firm, then you’ll likely gain access to important business contacts and expertise, as well as other potential future sources of capital.
Con: Your Tax Shields Are Down
The last downside with equity financing (at least compared to debt financing) is that it doesn’t offer any tax shields.
When you distribute dividends to shareholders, this isn’t a tax-deductible expense (but the interest paid on debt is), so the cost of equity financing is higher in this respect, and is considered a more costly financing form in the long run.
How to Decide If Equity Financing Is Right for Your Startup
Still not sure if equity financing is the right move for your business?
Here are a few questions to consider:
What’s Your Revenue Situation?
Is your MRR consistent? Or are things still a bit sporadic?
If you’re pre-revenue, or you’re not able to consistently count on recurring revenue, then bearing a debt obligation might not be the best move (you need to be sure you can make your repayments), making equity financing a potentially better option.
How Important Is Control to You?
Are you comfortable giving up partial control of the company?
When you engage in an equity financing deal, you’re bringing other stakeholders in on the direction of the company.
If you’re comfortable with that, then equity financing could be a good move. You might even benefit from being able to rely on other decision-makers with whom you can discuss important issues.
What Are Your Immediate Options?
Startups need to be agile. A lot of the time, the whole “beggars can’t be choosers” adage applies.
So, if you’ve got an equity financing opportunity on the table, ask: “If I choose to forgo this opportunity, what’s the likelihood that a debt financing opportunity is pursuable?”
What Does Your Cap Table Look Like?
It’s fair to say that the decision to engage in equity financing (or not) is a lot easier if you’re the only one with equity in the company.
If, however, you have business partners or existing investors, then you’ve already split up some of the equity, which means two things:
- They probably have a say in this decision
- Opting for equity financing is going to further diminish your share in the business
Equity Financing vs. Debt Financing
Quick note: If you’re looking for a more in-depth rundown on debt financing, check out our full article here.
If you just want to know the basics, though, then here you go:
Equity financing involves selling shares of your company to an investor in exchange for capital.
You get cash, they get a share of the business, and you don’t have to pay anything back. Debt financing is like getting a loan. The investor doesn’t get any ownership in your business, but you need to pay back debt, with interest.
|Equity Financing||Debt Financing|
|Ownership||You give up partial ownership of the company||You retain ownership of the company|
|Repayment||No requirement||Requirement to pay back the debt|
|Tax||No tax benefits||Interest is tax-deductible|
|Networks||Often includes the ability to expand your network||Usually provided by financial institutions, with no opportunity to expand your network|
|Decision-making||Will need to consult with your investors||No consultation required|
Planning to Pursue Equity Financing?
Well, there you go.
We’ve covered off the important questions:
- What is equity financing?
- How does it work?
- What are the pros and cons?
- How do you know if equity financing is right for your startup?
- What’s the difference between equity financing and debt financing?
Now, there’s just one thing left to do: go out there and get some funding!
But wait! Before you do, you might want to double-check you’ve got all of your financials in order.
Check out Finmark (that’s us, the financial planning platform), and find out how we can help you build an organized financial plan to pitch investors with.
This content is presented “as is,” and is not intended to provide tax, legal or financial advice. Please consult your advisor with any questions.