What Is Equity Financing? – Types, Sources, Pros & Cons

Running a successful startup requires a lot more than just a great idea. It also involves a lot of money; and this money is generally sourced by taking loans (debt financing) or selling equity (equity financing).

While loans are preferred by entrepreneurs who don’t want to dilute their decision-making power, it is usually considered a significant liability that keeps the startup from climbing ladders with ease.

On the other hand, equity financing is usually a go-to-strategy for most founders to raise funding, get strategic guidance, and run a successful long-term startup.

But what exactly is equity financing, how it works, and what are its sources?

Let’s find out.

What Is Equity Financing?

Equity financing is the method of raising capital by selling the company’s shares in exchange for a monetary investment.

In simple terms, equity financing refers to selling a part of the company’s ownership. The person or persons who invest via equity financing are referred to as the company’s shareholders as they buy the shares and receive an ownership interest in the company.

The proportion of the ownership that is sold to the investor, however, depends upon the amount invested and the company’s worth.

For example, if the company’s post-money valuation comes out to be $100,000 at the time of the investment and the investor invests $40,000 in return for equity, he now owns 40% of the company.

Typically, startups prefer this type of funding over taking loans as

Loans are considered to be liabilities that often slows down the startup’s growth. They are hard to get as startups operate in a highly risky business environment.

How Does Equity Financing work?

To sustain, grow, and expand, a startup requires additional capital that usually comes in in the form of equity financing.

Even though the term is a standard for selling company’s shares, equity financing works differently during different stages of the startup –

During the initial stages (pre-seed and seed funding round), when the startup valuation isn’t possible, equity financing witnesses the signing of convertible equity notes like SAFE, KISS, convertible notes etc. where investors invest in the startup in exchange for a right to get shares when the valuation is possible. Founders’ friends and family, angel investors, and accredited investors invest during such rounds.

In the other rounds (like Series A, Series B, etc.), when startup valuation is possible, other equity instruments like common stocks and preferred stocks are provided to investors like venture capitalists, angel groups, corporate investors, etc. in exchange for monetary investment.

All such equity offerings are counted as private equity and witness fewer restrictions and investment guidelines from regulators like the Securities and Exchange Commission.

Once the company gets large enough, it goes public and sells common equity to institutional and retail investors. Such equity offerings are available to all types of investors in a stock market and are considered to be safer as a body like SEC regulates them.

Importance Of Equity Financing

Capital is vital for a business to stay afloat. Equity financing brings in this much-required capital in the form of partnered ownerships and helps the company –

Stay away from additional liabilities: Debts are liabilities that take interest from the working capital of the company. This prevents the company from working at its full potential.

Debts are liabilities that take interest from the working capital of the company. This prevents the company from working at its full potential. Raise the exact money required: Equity investments usually amount more than debt investments as they come with a reward of shares ownership. This helps the company raise more than it would have using debts.

Types Of Equity Financing

Generally, equity funding can be categorised into six types according to the type of contract signed. These are –

Equity Investments: These are simple equity financing contracts where equity is provided in exchange for monetary investment by the investors. Mezzanine Financing: It’s a hybrid of equity and debt financing where the lenders provide the companies with a loan with specific terms that include repayment in the form of equity interest if cash flow isn’t available. In simple terms, the mezzanine lender has a warrant enabling him to convert the security into equity at a predetermined price per share if the borrower company fails to repay the loan on time or in full. Convertible Notes: Convertible note is a short-term hybrid-debt-equity-investment tool used to invest in early-stage startups that the investor can choose to convert into common shares at a later time or an event when it is easier to determine the company’s valuation. Royalty Financing: Royalty financing is equity financing in the future sales of the product. In this type of funding, the investors expect to receive a percentage of revenue received from the sale of the company’s offering(s). Equity Crowdfunding: This type of equity financing involves the company selling its shares to a crowd of people instead of one or a few key investors. Initial Public Offering: IPO takes place when the company goes public and lists its shares on a publicly-traded market like New Your Stock Exchange. It requires the company to comply with the guidelines established by the regulatory body of the country.

Sources Of Equity Financing

The different types of equity finance come from other sources. These are –

Individual Private Investors: These investors invest in the business during the very early stages. They usually come under the FFF (friends, family, and fools) circle who trust the entrepreneur than the company. Angel Investors: These are high net-worth individuals who invest in high growth businesses in return for a share in the business. Along with monetary investments, these investors also contribute their expertise and network to help the business progress even more. Usually, angel investors use their personal funds for investments. Venture Capital Firms: Venture capital firms are professional investment firms formed by a group of high-net-worth investors, corporate firms, and other professional investors, that funds business ventures in exchange for an equity stake. Unlike angel investors, venture capital firms use money from the pool of funds collected from the group members. Such firms also have boards that make such decisions, and strategic teams that help the startup with its non-monetary requirements. Crowdfunding Platforms: Certain crowdfunding platforms like AngelList, CircleUp, Fundable, etc. act as an intermediary between the company and the group of lenders who provide monetary investment to the company in return for equity ownership. Stock Market: Stock market is a regulatory market that helps the company get public and offer it shares to be freely traded by the public.

Equity Financing Pros And Cons

Equity financing comes with its own set of advantages and disadvantages.

Equity Financing Advantages

Comes With Less Risk: For businesses that struggle with positive cash flow, equity financing poses less risk as it doesn’t have to repay hefty interests every month.

For businesses that struggle with positive cash flow, equity financing poses less risk as it doesn’t have to repay hefty interests every month. Doesn’t Require Certified Creditworthiness: Usually, debt financing requires a background check and is only possible if the borrower has good creditworthiness. Moreover, it’s not possible to raise a considerable amount as loans for a startup. Equity financing comes out as a rescue for such startups.

Usually, debt financing requires a background check and is only possible if the borrower has good creditworthiness. Moreover, it’s not possible to raise a considerable amount as loans for a startup. Equity financing comes out as a rescue for such startups. Helps Maintain Good Cash Flow: With no interest repayment, the company makes use of its cash flow to grow its business and the value of its share.

With no interest repayment, the company makes use of its cash flow to grow its business and the value of its share. Is More Than Just Monetary Investment: Usually, by selling shares to industry experts also helps the company make use of such investors’ expertise, skills, and network for the good of startups.

Equity Financing Disadvantages

Dilutes Ownership Rights: Selling out company shares in exchange for monetary investment dilutes the ownership and decision making authority of the founders.

Selling out company shares in exchange for monetary investment dilutes the ownership and decision making authority of the founders. Shares Profits: Selling shares means the founders also have to share the profit amount with other owners depending upon the ownership percentage.

Selling shares means the founders also have to share the profit amount with other owners depending upon the ownership percentage. Can Result In Potential Conflicts: Since decision-making authority is shared with other shareholders, this can result in potential conflicts if there are differences in vision, management style, and business running outlooks of different shareholders.

Equity Financing Vs Debt Financing

Both equity and debt financing come with their favourable and unfavourable terms that may suit or not suit the company.

Equity Financing Debt Financing Process Speed Takes considerable time as the company is required to comply with all the regulations and it’s not easy to negotiate with the investors. It’s faster when compared to financing through equity. Ownership Dilution Requires the founders to dilute their ownership rights and share it with the investors. Doesn’t involve dilution of ownership. Creditworthiness Team’s past performance and ability matters more than the creditworthiness of the business. It depends fully on the creditworthiness of the company or the individual who takes the loan. Effect On Cash flow It doesn’t require the startup to pay periodic interests on investment so it doesn’t affect cash flow. Debt financing requires the business to pay periodic interests on investment and affects cash flow.

Go On, Tell Us What You Think!

Did we miss something? Come on! Tell us what you think about our article on equity financing in the comments section.

Choose your funding type

Self-funding

Often called 'bootstrapping', self-funding is often the first step in seeking finance. It involves funding from your personal finances and business revenue. Investors and lenders will expect some self-funding before they agree to offer you finance.

Family or friends

Offering a partnership or share in your business to family or friends in return for equity is often an easy way to get finance. However, consider this option carefully to make sure it doesn’t affect your relationship.

Private investors

Investors can contribute funds to your business in return for a share in your profits and equity. Investors (such as business angels) can also work in your business to provide expertise and advice.

Venture capitalists

These are often big corporations that invest large amounts in start-up businesses. The businesses usually need to have potential for high growth and profits. Venture capitalists:

typically require a large controlling share of your business

often provide management or industry expertise.

Stock market

Also known as an Initial Public Offering (IPO), floating on the stock market involves publicly offering shares to raise capital. This can be a more expensive and complex option. There is also a risk of not raising the funds you need due to poor market conditions.

Check out ASIC MoneySmart website for more information about floating on the stock market.

Government

In general, the government doesn't provide finance for starting up or buying a business. However, you may be suitable for a grant to:

conduct research and development

expand your business

innovate

export your goods and services overseas.

Find grants and programs for your business.

Crowdfunding

Crowdfunding is way to raise money by asking a large number of people each to invest in or donate to your product idea or project. You generally do this through a crowdfunding website.

There are four main types of crowdfunding you can use to get finance for your business. Each uses a different way to attract funding and may have different tax responsibilities for the parties involved.

Find out what crowdfunding type suits your business best and how to set a campaign up.

Equity Financing - The Pros & Cons Of Equity Raising Methods

Types of equity financing

Angel investments

Equity crowdfunding

Venture capital firms

Initial public offering (IPO)

An angel investor (also known as a private investor), is a wealthy individual who provides capital for a business. In exchange, they receive ownership equity (a part of your business).Angel investors can be friends, family, entrepreneurs or retired business owners themselves. As financiers, they’ll usually invest when a business is in its early stages and they are confident they’ll get a return on their investment.A common way to raise money for your business is through equity crowdfunding. This can take place on crowdfunding platforms like Kickstarter, AngelList or IndieGoGo.Equity crowdfunding is similar to crowdfunding (where money is raised by a number of individuals to fund a project or business). However, equity crowdfunding donors become investors by getting a small share in your business in return for their investment.Venture capitalists are like angel investors, but multiplied tenfold. Instead of a single investor, you’re raising capital through a firm. These firms look at businesses that either have demonstrably high growth or the potential for it.Unlike angel investors, venture capitalists tend to invest in more mature, established businesses and will also take a more active role in your business. Although they invest less frequently compared to angel investors, they also invest more capital. When they invest in your company, they want to see that you’re ready and prepared to use this capital to scale the business.An Initial Public Offering (IPO) , is when a company offers its shares to the public for the first time. This type of equity raise is used to generate additional capital for a startup company, and in exchange, shareholders get an early slice of your company. After IPO, the company’s shares are traded in an open market.