Equity financing and debt financing are the two major options for start-ups seeking funding. Debt financing basically involves taking out a loan either from the bank or a private investor, who could be your friend, family, or a stranger. While equity financing, also involves you taking out a kind of loan as indeed you still need to pay back, the difference is that you wouldn’t have to pay back in the regular sense as with debt financing.
With equity financing, you get to pay your investors when your business succeeds. This payment will be from your profits and based on the percentage jointly agreed upon by you and the investor. Equity financing involves raising capital by selling shares, and three are various sources of equity financing.
Angel investors are individuals who have enough wealth to invest in businesses by purchasing stakes in the business, believing the business will be able to generate higher returns in the future. Another source of equity financing is crowdfunding, and this implies that some people come together to invest in the company, howbeit in small amounts.
Venture capital firms are also a great source of gaining equity financing. Compared to angel investors, venture capital firms invest a higher amount of money into businesses and when the business profits, they also receive a larger stake in the company. Other forms of equity financing include private equity financing, financing from corporate investors and initial public offerings (IPOs).
For some entrepreneurs, equity financing might seem to be a better option when compared to debt financing. However, entrepreneurs must understand the pros and cons of equity financing before giving out a piece of their companies for cash.
Pros of Equity Financing
No Liability
One of the best reasons people tend to swing in the direction of equity financing over debt is that unlike debt financing, even if your business doesn’t succeed, you’ll still have to pay back your loan. This type of financing protects you from this risk. If your business doesn’t succeed, your investors take the hit on your behalf. In other words, investors share in the risks just as much as they share in your profits.
No Interest Payment
Another great advantage of equity financing is that it does not require you to pay your investors any interest. While you have to repay both principal and interests when you take a loan, with equity financing, you’ll only owe them a portion of your profits as your business advances unless you choose to buy back the shares given. This helps your business and prevents it from being under unnecessary pressure, thereby giving you room to save and make the necessary investments for growth.
Your investors are committed to your business’s growth
With this type of financing, your growth is tied to the growth of investors’ funds as well. When you make profits, they also make profits. This is great because it makes your investors committed to your business’s growth. Consequently, equity investors could join you in exploring growth ideas while also suggesting ways for expansion and business scaling.
Sometimes, they offer skills which could be valuable to your business, and they might even introduce some contacts to you to help grow the business. They also contribute in terms of experience and assist you with making major strategic decisions.
Cons of Equity Financing
While this kind of financing has its merits, there are a few downsides to be considered as well.
Giving Up Ownership
One of the most apparent downsides to this kind of financing is that you have to give up a percentage or a part of your company. Equity investors possess a portion of your business. At the same time, it could be harmless when the stakes owned by investors are significantly smaller than what you own as the business owner. There is always a possibility of giving up control.
Share of decision making
Another implication of having investors is that because they have a stake in your business, they too have a say in your decision making process. This is only natural as the decisions you make as a business owner affects them directly.
While this could be a good thing when you and your investors are on the same page, it could pose a huge setback when you have different opinions on how things should be done. The higher their available shares in your business, the harder it will be for you to ignore their opinions. Essentially, you lose a level of your management power and will not make independent decisions like you used to.
Demanding and time-consuming
The process of raising equity could prove to be demanding and time-consuming as potential investors will expectedly require comprehensive information on your company. This process is sometimes burdensome and can be very distracting as management might no longer focus on other profitable activities until the fundraising process is over.