Equity Financing for Small Business

Decisions, decisions.

If you need funding to start, grow, or sustain your company, you’re definitely not alone. Very few businesses – next to none, in fact – are able to self-fund their operating and growth plans entirely with funds put up by the owner or owners.

So sooner or later, you’ll need cash from outside sources. But where to start? And what to do?

Broadly speaking, the small business (or any size business) funding universe breaks down into two categories.

1.) Debt Financing, which is money you receive from lenders and that you have to pay back.

2.) Equity Financing, which is also money received from external sources, and that, while you don’t pay it back in the conventional sense, still comes with obligations.

Either choice – debt or equity – comes with its own set of issues and long-term implications, so consult carefully with your financial advisers. Here’s an introduction to the mechanics of equity funding.

The Basics of Small Business Equity Financing

In an equity funding arrangement, your company brings in investors who provide funds – or capital – in exchange for a share of ownership in the business.

Usually, investors or financial partners come on board because they expect to make money when your operation becomes successful. In a sense, it’s the same principle that’s in play when an investor buys shares (or partial ownership) in say, Apple or Ford. Granted, exchange traded stocks typically represent much larger companies, and the ease of exit from the investment is easier – that’s called liquidity – but in either case, investors are looking for a return on investment (ROI) that can compensate them for the risk they perceive they’re taking for parting with their money.

Advantages of equity financing include:

  • Your investors take on the additional risk, not you. If the business struggles or even fails, you’re not saddled with the burden of paying back the money your equity investors have put in.
  • Equity investors see the big picture and tend to be patient. Unlike banks and similar lenders, you typically aren’t forced to make regular payments to equity investors.
  • Cash flow management is easier. Without the regular payments required by debt financing, you’ll have more cash on hand to grow and expand the business, and to meet monthly overhead and operating obligations.
  • Access to expertise. Many small business investors are or were very successful business owners or operators. They tend to have experiences and contacts (customers, suppliers, media, and additional investors) that can be very valuable to a growing company.

But equity funding is not perfect. Here’s an overview of the possible downside.

Disadvantages of equity financing include:

  • Finding investors will take time. Pack a lunch. Finding, pitching, and finally getting an investor to scratch a check can take months. And that’s assuming your business plan, operations and prospects for the future are rock-solid. Getting equity funding is a marathon, not a sprint.
  • You will lose ownership and some of the upside. Your investors are taking a risk, and expect to be rewarded when your company grows and succeeds. More about this in a moment.
  • Equity financing can be expensive. There are no absolute, concrete formulas to apply, but it often works out that in a dollar-for-dollar analysis, equity funding can end up being more expensive than what securing similar funding from a bank would have cost you.
  • They CONTROL you. Well, not literally. But investors who put their hard-earned cash into your enterprise expect to have some input into how the business is run. In many cases, you’ll need to consult with them on major decisions. If you’re the Lone Ranger type, or need to do things your way all the time, consider looking elsewhere for your funding.

Small Business Equity Financing: The Million Dollar Question

For your investors, the ROI mentioned earlier can take the form of dividends, distributions, additional ownership in the company, an increase in the value of the original investment if the company is sold, and certain other forms of payment.

So here’s the (maybe literal) million dollar question:

How much are you willing to give up?

Equity financing isn’t free and it doesn’t generally come cheap. In exchange for money now, you’re selling a portion of future revenue streams and a cut in the “upside” when the business succeeds.

Maybe that’s not so bad. You could even make the argument that it’s a “win/win.” Many, or most, industry giants have been built with equity funding. Just try to get a handle on what you’re potentially giving up.

And it’s not just up to you. Your potential investors will have very strong opinions regarding what they want in exchange for their funding help. Their requests or demands will be based on the amount of money you’re asking for, the track record established by your company to date, and – perhaps most importantly – the future prospects for your business.

Listen carefully, and respect every offer. But also don’t be afraid to negotiate. Remember, after all the checks have cleared, you’re still the one making the business go and putting in the long hours. Make sure you leave yourself in a position to benefit.

Getting Started with Small Business Equity Financing

The process of raising equity funding is complicated. It’s never easy, but the potential benefits are often worth working toward. Give yourself plenty of time (at least twice what you initially think it might take) to work through the funding procedures.

The good news is, should you need more money at some point, the next rounds of funding are generally easier.

In any case, make sure you have competent legal, accounting and financial advice to guide you through the process.

Image courtesy Carlos Delgado

Does your company need to get a cash flow management plan together? MP Star Financial provides invoice factoring, purchase order financing and other alternative and asset-based lending services. Call to discuss your options with a no obligation consultation. (800) 833-3765, extension 150.

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