The Ultimate Guide to Equity Financing for Small Businesses

Getting investors to believe that your company is worth their money is the most difficult part of equity financing. To achieve your goals, get a clear picture of your company's finances, including revenue forecasts, expenses, and market trends, as well as the obstacles you face. Prepare for the future of your firm by having a clear vision. Do you want to build the company and then sell it?

Equity financing is a high-stakes game for investors, who may lose money if the company fails. They are more willing to invest if they have confidence in your strategy, your staff, and your operations. They're also searching for a lot of money, so make sure your company has the potential to grow into a hugely profitable one. Maintaining at least 50% ownership of your firm ensures that you will always be in control of your company's decisions.

The best sources of equity financing are:

The Types of Investor Funding

When it comes to funding a business, investor-based fundraising is just one option among many, including rewards-based fundraising, personal investments, friends and family, and good old-fashioned bootstrapping. Before you decide to seek funding from investors, it’s important to be certain that investor support is the best—or only—way to move your business forward.

Once you’ve decided that pursuing investors is the right route for you, you have another choice in front of you: how are you going to do it?

There are three basic types of investor funding: equity, loans and convertible debt. Each method has its advantages and disadvantages, and each is a better fit for some situations than others. Like so much else about the fundraising process, the kind of investor-based fundraise that is right for you depends on a number of factors: the stage, size and industry of your business; your ideal time frame; the amount you are looking to raise and how you are planning to use it; and your goals for your company, both short-term and long.

In this chapter, we’ll explore each investor-based funding option in some detail, looking at the way each option is structured, situations in which each option is the most useful, and some advantages and disadvantages that entrepreneurs should keep in mind when deciding whether to choose each option. Keep in mind, though, that this is just a quick overview: you’ll need to do more digging of your own before you’re ready to say for certain which method is right for you.

EQUITY

Pursuing an equity fundraise means that, in exchange for the money they invest now, investors will receive a stake in your company and its performance moving forward.

Equity is one of the most sought-after forms of capital for entrepreneurs, in part because it’s an attractive option — no repayment schedule! high-powered investor partners! — and in part because it’s the form of capital that requires the most seeking.

How It Works

At the outset of your fundraise, you set a specific valuation for your company—an estimation of what your company is worth at that point. Based on that valuation and the amount of money an investor gives you, they will own a percentage of stock in your company, for which they will receive proportional compensation once your company sells or goes public.

EXAMPLE: The founders of Toasty Buns Bakery have decided to turn their business into a national chain, and they’re looking for $500,000 in equity investments at a company valuation of $2 million. Venture capitalist firm XYZ invests $250,000, earning 12.5% equity in Toasty Buns.

When to Do It

There are several situations in which an equity fundraise makes the most sense, or is the only real option for a company.

When you need a LONG runway

Not every business will start generating income as soon as it launches, but spending a few years in the red doesn’t mean your company isn’t a viable business proposition—or much more than viable. Internet companies, for example, are notorious for going years in operation without even attempting to charge their customers. If you’re going to need a sizeable infusion of operating cash to sustain your business before it starts turning a profit, equity investments are the only form of capital that makes sense.

When you have zero collateral

In order to take out loans, you need to have something to offer as collateral in case things don’t work out quite as you planned. If you don’t have anything of value to give loan providers that security, your only real option for funding is to find equity investors who are willing to take a chance on your idea with nothing to “sell” if the business goes south.

When you can’t possibly bootstrap

While home-growing your company from your kitchen or spare bedroom bit by bit may not sound as glamorous as hitting the ground with investors already in your lineup, most investors will expect you to start there before they invest. But some businesses—a private jet service, for example— require a massive amount of capital just to get off the ground. In those cases, you have little choice but to go directly to equity.

When you’re positioned for astronomical growth

Equity capital tends to follow businesses and industries that have potential for massive growth and exponential paydays. Your local coffee shop concept may do really well, but it doesn’t have the potential to become Google, so you’re not likely to attract many equity investors. On the other hand, if you’re looking to build the next Starbucks chain, and you have a vision and a plan that supports that kind of growth, chances are investors will be very interested in jumping onto your bandwagon on the road to IPO.

Things to Keep in Mind

Equity narrows your options: Choosing the equity route significantly narrows your options when it comes to the future of your company. Equity investors are interested in one thing: liquidity. That means they won’t be satisfied with a cut of your profits each year. Once you’ve accepted their money, they will expect that endgame for your business is either sale or IPO. Before they invest in the first place, they are going to look for assurances that your idea can sell and sell big, and that that is your plan, so before you pursue the equity fundraising route, you should be sure that that is your vision as well.

Equity investors expect big rewards for big risks: If every entrepreneur could walk into a bank and get a loan to finance their idea, many probably would. Unfortunately, banks are incredibly risk-averse, and only want to provide loans that they are sure will be paid back. That’s where equity investors come in: they are willing to take risks where lenders aren’t. But there are two sides to that coin: an equity investor isn’t looking for a simple interest payment on the money they’ve given you. They’re exchanging more risk for more reward—a lot more—and they’re going to want to see results.

Competition for equity investments is high: There are far more people looking for equity investors than there are checks being written. Most equity investors will see hundreds if not thousands of deals in a given year before they fund even one. Getting an equity investor is like getting a perfect score on your SATs: you have to be in the top percentile of the top percentile of the most prepared and motivated entrepreneurs in order to be one of the few that walks away with a check in hand.

Raising equity capital takes time: No matter how prepared you are, it can easily take 3-6 months to find the right investor, and that’s not counting the time it takes to complete the final legal documents that make the money available. So if you and your business are in a time crunch, equity fundraising may not be the best way to go.

Giving up equity is a one-way street: Once you give up equity, you’re not likely to ever get it back. It’s very rare for an entrepreneur to buy back the equity they have given away early in the creation of their company. And once you’ve sold a certain percentage—let’s say 45%— that’s 45% of your business that you can’t sell again to raise more money at a later time. Once you’ve sold equity to an investor, that investor is a part of your world, whether you like it or not. So as tempting as it may be to shake hands with anyone ready to write you a check, it’s important to look for investors you feel comfortable having as a part of your business for years to come.

LOANS

Loan or debt-based fundraising is the easiest of the three varieties to understand in basics: you borrow money now and pay it back later, with an established rate of interest.

Debt is also the most common form of outside capital for new businesses. While angel investors and venture capitalists get all the big headlines for funding exciting companies, it’s the debt providers that are behind most of the investment dollars that go into the 99% of companies that aren’t splashed across magazine covers and business websites.

How it Works

When you decide to pursue debt-based fundraising, you specify in your fundraise terms the rate of interest that will come with the repayment of the loans you receive. You may also provide an expected time frame in which the loans will be repaid.

The other important piece of the loan puzzle is collateral: some concrete, sellable thing your lenders can take from you in the event that your business goes under and you can’t repay your loans. The more collateral you have, the better your chances of securing large amounts of financing.

EXAMPLE: In order to start his new luxury car dealership, Rusty Parts is seeking $2 million in loans, which he will use to pay for his first round of cars to sell. In his fundraise terms, Rusty establishes that loans will be repaid with an interest rate of 10% APR. As collateral for these loans, Rusty offers the cars themselves, as well as mortgage on the property for the dealership, which he already owns.

When to Do It

As with equity, there are a handful of scenarios where debt is the most useful option for financing your company.

When you need less than $50,000

Debt raises lend themselves well to smaller amounts of capital. At such small amounts, giving up equity doesn’t make much sense anyway; and with those smaller goals there’s less risk—for investors and for entrepreneurs—than when there are large sums involved.

When you need capital quickly

Is there a time-sensitive market opportunity for your business that you’ll miss out on unless you raise funds now? Better not opt for equity, then—it’s a notoriously time-consuming process. Debt raises tend to move along faster, giving you a better shot at getting you the funds you need when you need them.

When you need the money for a very concrete, tangible reason

If your funding needs are in the physical realm—you just need real estate, for example, or computers or other equipment— a debt raise makes a lot of sense. You’ll have your collateral right there, and you’ll be in position to give your investors tidy timelines.

When equity isn’t available

If you aren’t ready to start offering equity—or just don’t want to—a debt raise may be the right course of action. Many entrepreneurs are understandably reluctant to give up equity in their company, and a straightforward debt raise has the attractive benefit of allowing you to retain ownership and control of your company.

Things to Keep in Mind

Collateral is the name of the game: Despite what you may think, banks and other lenders don’t make that much profit on a single loan, especially if a few go bad. For that reason, they only say “yes” to deals where they can be 100% sure they won’t lose out, and collateral is the thing that gives them that sense of security.

Lack of collateral is not the end of the world: Lack of collateral doesn’t completely rule out the possibility of taking out a loan. But if you don’t have any collateral and you don’t plan on signing for the loan personally, your options are mostly limited to smaller loans—usually less than $50,000—that are supported by the U.S. Small Business Association. In this case, our wildly indebted yet somehow solvent government plays cosigner to your loan. Uncle Sam is a bit tight-fisted, because he has a lot of checks to hand out; but he may be the only uncle that is willing to bet on your new idea right now.

Credit is comparable: In some cases, you can achieve the same goals with credit as you can with loans, since the upper limits of both tend to be about the same for business users. American Express, for example, offers both a 30-day charge card with a floating limit and a more traditional credit card that offers flexible monthly payment options. Going with credit has the advantage that the decision is much faster compared with the lengthy loan application process. Of course, credit is going to tie back to your personal credit at some level, so if your credit score isn’t great, or you’re trying to minimize personal risk as much as possible, credit isn’t going to do you much good.

Explore your options: When considering funding possibilities, it’s important to explore all of your debt options in detail to see what’s available and from where. Our position with debt is this: it’s always better to have financing and not need it than to need financing and not have it!

CONVERTIBLE DEBT

Convertible debt is essentially a mash-up of debt and equity: you borrow money from investors with the understanding that the loan will either be repaid or turned into a share in the company at some later point in time—after an additional round of fundraising, for instance, or once the business reaches a certain valuation.

How It Works

The specifics of how the debt will be converted into equity are established at the time of the initial loan. Usually that involves some kind of incentive for investors to convert their debt into equity, such as a discount or warrant in the next round of fundraising.

If you offer investors a discount—the most common are 20% and 25%–it means that they can convert their loan into equity at that discounted rate. For example, if an investor loans you $1 million with a 25% discount in the first round, they can get $1.25 million worth in equity in the next round.

A warrant is also expressed in percentages—for example 20% warrant coverage. If we take our same $1 million case with 20% warrant coverage, the investor gets an additional $200,000 (20% of $1 million) in securities in the next round.

You will also need to set an interest rate, as you would for a straight debt raise, in order to repay your investors until they convert, as well as the investors who opt not to convert.

There is also typically a “valuation cap” for convertible debt fundraises, which is a maximum company valuation at which investors can convert their debt into equity, after which point they will have missed the boat and will have to content themselves with having their loan repaid, or else re-invest in the company under new terms. However, in recent years more companies have been opting to leave their convertible debt offerings uncapped.

EXAMPLE: Savingz 4 Dayz, a mobile app that reminds you when your coupons are about to expire, is still in development but nearing completion. The creators are hoping to raise $500,000 to complete development and make some key expansions to their staff. They’ve opted to follow a convertible debt structure, offering 5% interest and a 25% discount in the company’s equity round next year.

When To Do It

A convertible debt fundraise makes the most sense for startups that are not yet ready to set a valuation for their company, either because it’s too early to determine one, or because they have reason to believe that the valuation will be much higher at a later date.

If you believe your company’s valuation is likely to skyrocket soon—but not soon enough that you can wait and do a straight equity raise at a later time—offering convertible debt has the advantage of getting you the funds you need now while enabling you to protect the value of your equity later.

Things to Keep In Mind

The best of both worlds: For investors, convertible debt offerings can be extremely attractive. For now, they have the exit strategy of the debt structure and the security that comes with it; but they also have the potential for a discount on your equity if they choose to convert. They also get a chance to watch how your business performs, allowing them to gather more information and decide whether they like where you’re going before they jump on the equity train.

Or not: Many investors do not look on convertible debt offerings with favor. They like knowing what percentage of a company they will own right off the bat, and they don’t like taking equity-sized risks and getting debt-sized returns, even if it’s just short-term. The way to sweeten the pot is by offering higher discounts so they will have the upside reward of paying less for equity than the next set of investors.

(Not) an entrepreneur’s best friend: Entrepreneurs in the early stages of a startup tend to like convertible debt fundraising because it moves fast and keeps transaction costs low. But if you’re committed to giving up equity, there’s also something to be said for setting a company valuation from the start and starting the process of growing that valuation early on.

Know what you’re doing: Because convertible debt raises are by nature a bit more open-ended than either debt or equity, if you choose to go down the convertible debt path, it’s doubly important that you can provide clear reasons for that decision and a clear expectation of how things are going to shake out, both for yourself and for the investors.

Conclusion

This chapter provides just a quick overview of the three basic kinds of investor-based fundraising: equity, loans, and convertible debt. Before you commit to a structure for your fundraise, it’s in your best interest to delve deeper into the specifics of that structure—or, better yet, explore each option thoroughly before committing.

Try not to get frustrated or discouraged: it’s a big question to tackle, and even experienced entrepreneurs aren’t comfortable with every type of capital. The more you know about your options, the stronger your position will be to make the best possible decision for yourself and for your business, and the more likely it is that your fundraising efforts will be a success.

Debt vs. Equity Financing: What's Best for Your SMB?

Debt and equity financing are two very different ways of financing your business.

Debt involves borrowing money directly, whereas equity means selling a stake in your company in the hopes of securing financial backing.

Both have pros and cons, and many businesses choose to use a combination of the two financing solutions.

This article is for small business owners who are trying to decide if debt or equity financing is right for them.

Unless you have an existing empire of wealth to build on, chances are good that you’ll need some sort of financing in order to start a business. There are many financing options for small businesses, including bank loans, alternative loans, factoring services, crowdfunding and venture capital.

With this selection, it can be difficult to determine which option is right for you and your business. The first thing to know is that there are two broad categories of financing available to businesses: debt and equity. Figuring out which avenue is right for your business can be confusing, and each option has its own pros and cons. [Read our picks for the best loans for small businesses.]

Here’s an introduction to both debt and equity financing, what they mean, and important things to know before making your decision. [Learn about other alternative financing methods for startups in our guide.]

What is debt financing?

Many of us are familiar with loans, whether we’ve borrowed money for a mortgage or college tuition. Debt financing a business is much the same. The borrower accepts funds from an outside source and promises to repay the principal plus interest, which represents the “cost” of the money you initially borrowed.

Borrowers will then make monthly payments toward both interest and principal and put up some assets for collateral as reassurance to the lender. Collateral can include inventory, real estate, accounts receivable, insurance policies, or equipment, which will be used as repayment in the event the borrower defaults on the loan.

Editor’s note: Considering a small business loan? Use the questionnaire below to get information from a variety of vendors for free:

Types of debt financing

The following types of debt financing are the most common:

Traditional bank loans. While often difficult to obtain, these loans generally have more favorable interest rates than loans from alternative lenders.

While often difficult to obtain, these loans generally have more favorable interest rates than loans from alternative lenders. SBA loans. The federal Small Business Administration is a popular choice for business owners. The SBA offers loans through banking partners with lower interest rates and longer terms, but there are stricter requirements for approval.

The federal Small Business Administration is a popular choice for business owners. The SBA offers loans through banking partners with lower interest rates and longer terms, but there are stricter requirements for approval. Merchant cash advances. This form of debt financing is a loan from an alternative lender that is repaid from a portion of your credit and debit card sales. Note that merchant cash advances have notoriously high annual percentage rates (APRs).

This form of debt financing is a loan from an alternative lender that is repaid from a portion of your credit and debit card sales. Note that merchant cash advances have notoriously high annual percentage rates (APRs). Lines of credit. Business lines of credit provide you a lump sum of money, but you only draw on that money when you need some of it. You only pay interest on what you use, and you’re unlikely to encounter the collateral requirements of other debt financing types.

Business lines of credit provide you a lump sum of money, but you only draw on that money when you need some of it. You only pay interest on what you use, and you’re unlikely to encounter the collateral requirements of other debt financing types. Business credit cards. Business credit cards work just like your personal credit cards, but they may have features that serve businesses better – such as spending rewards that business credit lines lack.

Pros and cons of debt financing

Like all types of financing, debt financing has both pros and cons. Here are some of the pros:

Clear and finite terms. With debt financing, you’ll know exactly what you owe, when you owe it and how long you have to repay your loan. Your payment amounts will not fluctuate month to month.

With debt financing, you’ll know exactly what you owe, when you owe it and how long you have to repay your loan. Your payment amounts will not fluctuate month to month. No lender involvement in company operations. Even though debt financers will become intimately familiar with your business operations during your approval process, they’ll have no control over your day-to-day operations.

Even though debt financers will become intimately familiar with your business operations during your approval process, they’ll have no control over your day-to-day operations. Tax-deductible interest payments. When it comes time to pay taxes, you can deduct debt financing interest payments from your taxable income to save money.

These are some downsides of debt financing:

Repayment and interest fees. These costs can be steep.

These costs can be steep. Quick start of repayments. You’ll typically begin making payments the first month after the loan has been funded, which can be challenging for a startup because the business doesn’t have firm financial footing yet.

You’ll typically begin making payments the first month after the loan has been funded, which can be challenging for a startup because the business doesn’t have firm financial footing yet. Potential for personal financial losses. Debt financing comes with the potential for personal financial loss if it becomes impossible for your business to repay the loan. Whether you are risking your personal credit score, personal property or previous investments in your business, it can be devastating to default on a loan and may result in bankruptcy.

[Read Related: Startup Costs: How Much Cash Will You Need?]

What is equity financing?

Equity financing means selling a stake in your company to investors who hope to share in the future profits of your business. There are several ways to obtain equity financing, such as through a deal with a venture capitalist or equity crowdfunding. Business owners who go this route won’t have to repay in regular installments or deal with steep interest rates. Instead, investors will be partial owners who are entitled to a portion of company profits, perhaps even a voting stake in company decisions depending on the terms of the sale.

Types of equity financing

These are some common types of equity financing:

Angel investors. An angel investor is a wealthy individual who gives a business a large cash infusion. The angel investor gets equity – a share in the company – or convertible debt for their money.

An angel investor is a wealthy individual who gives a business a large cash infusion. The angel investor gets equity – a share in the company – or convertible debt for their money. Venture capitalists. A venture capitalist is an entity, whether a group or an individual, that invests money into companies, usually high-risk startups. In most cases, the startup’s growth potential offsets the investor’s risk. In the long run, the venture capitalist may look to buy the company or, if it’s public, a substantial portion of its shares.

A venture capitalist is an entity, whether a group or an individual, that invests money into companies, usually high-risk startups. In most cases, the startup’s growth potential offsets the investor’s risk. In the long run, the venture capitalist may look to buy the company or, if it’s public, a substantial portion of its shares. Equity crowdfunding. Equity crowdfunding is when you sell small shares of the company to numerous investors via crowdfunding platforms. These campaigns usually require immense marketing efforts and a great deal of groundwork to hit the goal and get funding. Title III of the JOBS Act lays out the specifics of equity crowdfunding.

[Read our related guide on bootstrapping vs equity funding.]

Angel investors and venture capitalists are often highly experienced, discerning investors who won’t throw money at just any project. To convince an angel or VC to invest, entrepreneurs need a pro forma with solid financials, some semblance of a working product or service, and a qualified management team. Angels and VCs can be difficult to contact if they’re not already in your network, but incubator and accelerator programs often coach startups on how to streamline their operations and get in front of investors, and they may have internal networks to draw from.

“It’s true that equity often doesn’t require any interest payments like in the case of debt,” said Andy Panko, owner and financial planner at Tenon Financial. “[But] the ‘cost’ of equity is typically higher than the cost of debt. Equity holders will still want to get compensated somehow, [which] generally means having to pay dividends and/or ensuring favorable equity price appreciation, which can be difficult to achieve.”

Key takeaway: Equity financing is when you receive funding in exchange for shares in your business. Angel investors, venture capitalists and crowdfunding are common types of equity financing.

Pros and cons of equity financing

Similar to debt financing, there are both advantages and disadvantages to using equity financing to raise capital. These are some of the positives:

Well suited for startups in high-growth industries. Especially in the case of venture capitalists, a business that’s primed for rapid growth is an ideal candidate for equity financing.

Especially in the case of venture capitalists, a business that’s primed for rapid growth is an ideal candidate for equity financing. Rapid scaling. With the amount of capital a company can obtain through equity financing, rapid upscaling is far easier to achieve.

With the amount of capital a company can obtain through equity financing, rapid upscaling is far easier to achieve. No repayment until the company is profitable. Whereas debt financing requires repayment no matter your business situation, angel investors and venture capitalists wait until you make a profit before recouping their investment. If your company fails, you never need to repay your equity financing, whereas debt financing will still require repayment.

These are the main cons of equity financing:

Hard to obtain. Unlike debt financing, equity financing is hard to obtain for most businesses. It requires a strong personal network, an attractive business plan and the foundation to back it all up.

Unlike debt financing, equity financing is hard to obtain for most businesses. It requires a strong personal network, an attractive business plan and the foundation to back it all up. Investor involvement in company operations. Since your equity financers invest their own money into your company, they get a seat at your table for all operations. If you relinquish more than 50% of your business – whether to separate investors or just one – you will lose your majority stake in the company. That means less control over how your company is run and the risk of removal from a management position if the other shareholders decide to change leadership.

How to choose between debt and equity financing

Ultimately, the decision between debt and equity financing depends on the type of business you have and whether the advantages outweigh the risks. Do some research on the norms in your industry and what your competitors are doing. Investigate several financial products to see what suits your needs. If you are considering selling equity, do so in a manner that is legal and allows you to retain control over your company.

Many companies use a mix of both types of financing, in which case you can use a formula called the weighted average cost of capital, or WACC, to compare capital structures. The WACC multiplies the percentage costs of debt and equity under a given proposed financing plan by the weight equal to the proportion of total capital represented by each capital type.

Max Freedman, Adam C. Uzialko and Elizabeth Peterson contributed to the writing and research in this article.