Guide to Equity Financing
for Small Businesses
What is Equity Financing?
Equity financing is a way for businesses to raise funds by selling shares. Companies seek funds for a variety of reasons, including a sudden need to pay bills or a long-term goal that requires resources to expand. When a company sells shares, it basically sells ownership of the company in exchange for cash.
When it comes to equity financing, the amount you take out may be determined more by your willingness to share management control than by the business's investor appeal. In a few words, you give up part of your autonomy and managerial privileges when you sell shares in your company.
How Equity Financing Works?
Selling common stock, convertible preferred stock, and equity units that incorporate both common and warrant shares are all examples of equity financing.
In order for a start-up to succeed, it will require a number of rounds of equity investment. Depending on the stage of its development, a company may employ a variety of stock instruments to raise the funds it requires.
Unlike a loan, equity funding does not demand repayment. Rather, investors purchase stock in a company in order to profit from dividends (a portion of the firm's income), or by selling their stock later.
Benefits for Investors
Repayments—which are funds that are repaid through an investment exit plan rather than a set sum—are the key benefits for investors. Investors often provide essential expertise, management or technical skills, contacts or networks, and reputation to the firm, in addition to capital.
Furthermore, there is no loan to repay with equity funding. An important consideration for companies that don't start making money immediately is that the company doesn't have to make monthly loan payments. As a result, you'll be able to put more money into your expanding company.
Why Choose Equity Financing?
The primary benefit of equity funding is that you don't have to pay back the money; instead, you get a piece of the earnings. This means that you won't have to reimburse investors if your company fails.
When other financial options are unavailable, or the sums are insufficient, equity financing is a viable option. Equity finance is a possible alternative if you can't bootstrap or if your business requires a large sum of money just to get off the ground.
Pros of Equity Financing
- There is no obligation to pay back the money.
- There will be no additional financial strain on the company.
Cons of Equity Financing
- You must sell a portion of your company to investors.
- You must distribute your gains to investors.
- Any time you make a decision that has an influence on the firm, you must consult with investors.
Is Equity Financing Better than Debt Financing?
Debt and equity finance are the two most common forms of financing for businesses when they need to raise funds. In contrast to debt financing, equity financing includes selling some of the company's stock. While both equity and debt financing have different advantages, most companies use a combination of the two.
A loan is the most popular way to get debt funding. Debt financing, on the other hand, entails a company's duty to repay the money it receives as well as interest. In contrast to equity financing, a loan does not require a corporation to give up any of its ownership in exchange for the money.
Debt financing does not provide the lender any say in the company's day-to-day operations. After you've paid back the loan, your connection to the financial institution is officially over.
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Types of Equity Financing
Seed Capital
A startup's initial funding is referred to as "seed capital," and this is the money that is utilized to get it off the ground. Private investors supply money typically in exchange for a stake in the firm or a cut of the earnings from a product they have invested in.
Equity Crowdfunding
Equity crowdfunding is a way to raise money for a private company by bringing in investors via the internet. A portion of the company's equity is given to investors as a reward for their capital contributions.
Angel Investors
Individual investors or a broader group can function as angel investors. These are the kind of investors that can put up a substantial sum of money in a company and who choose to put their money into a sector they know well and have worked in the past.
As the name "angel investor" implies, they are capable of making a significant financial investment in your company, but they can also provide invaluable advice.
Typically, angel investors are looking to get engaged in the early stages of a business and monitor its following development.
Private Equity
An alternative investment class, private equity, is made up of funds that are not traded on a public exchange. Publicly traded companies might be bought and sold by private equity funds and investors in order to delist their stock.
Venture Capital
A venture capitalist can be either an individual or a major company. Venture capitalists often have far more money to invest in a company than other investors. Entrepreneurs that work as venture capitalists tend to be particularly interested in finding companies that have the potential to grow rapidly.
A high amount of money invested in your firm means that venture capitalists will most likely demand greater control over your company's future and may have significant influence over your company's growth in order to protect their investment.
Venture capitalists can provide your company with a significant infusion of funds and provide you with access to a broader network. You may find yourself in the hands of your customers when it comes to how you manage your business and how aggressively you want to grow.
Equity Financing for Each Business Entity
Sole Proprietorship
With a sole proprietorship, you'll be able to exercise complete control over your business while reducing the amount of paperwork you have to deal with.
Because of the ease of paperwork and taxes, many small firms choose to operate as sole proprietorships. To get started right away and to be the sole owner of your company, a sole proprietorship may be the ideal option.
A sole proprietorship, as the name says, is a business with only one owner.
But, as is the case with so many other things in life, simplicity frequently comes at a cost. A single proprietorship is the most restricted form of business organization when it comes to seeking equity finance for your venture because you are shutting yourself out from the input and control of others, including their money.
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Sole Proprietorship Advantages
If your new business is run by a sole proprietorship. You'll be able to have:
Exclusive Control
If you decide to sell your business, you'll be able to keep full control over its administration and development.
Affordable Formation and Maintenance
Creating a sole proprietorship is a simple process, as long as you don't need any special permits for your line of business. Make sure to check your state's rules if you plan to use a business name other than your own. You may be required to submit a "DBA" (Doing Business As) in the county where you plan to conduct business. Creditors will be able to locate the person or persons legally liable for the business's affairs using this DBA certificate.
Simple Tax Treatment
As a result, you'll have a lot less paperwork to deal with while filing your personal tax return, which is often on Schedule C. When you start a new firm, you may be able to deduct losses from your personal tax return to balance income from other sources, such as a job.
Sole Proprietorship Disadvantages
While the benefits of being a sole proprietor are undeniable, there are also some drawbacks:
Full Personal Liability
When it comes to Uncle Sam's eyes, you and your business are one and the same, as are your personal obligations. A company's contracts and taxes, as well as its employees' legal liabilities, are all under the control of its owner. With the right insurance, though, you can reduce some of these risks. Being a sole proprietor does not have to make you always more vulnerable to personal liability under business contracts.
Limited Financing Options
Your ability to obtain a loan is constrained by the state of your credit report. You are the only source of equity funding if you are unwilling or unable to sell off any of your company's ownership holdings. Debt financing may also be a challenge unless you can put your own assets up as collateral for a secured loan.
General Partnership
A general partnership is a grouping of two or more people who come together to run a business together for financial gain. All of the risk and decision-making power is not held by a single firm owner, and neither is the finance, unlike a sole proprietorship.
Equity funds here can be raised in a variety of methods, including:
- Via use of your own financial resources.
- By bringing in other collaborators.
- In order to reflect new contributions, current partners' ownership interests should be restructured.
Debt financing gives you access to a larger pool of creditworthy individuals, but the owners still have a significant influence on the company's trustworthiness.
General Partnership Advantages
With a general partnership, the management and financial responsibility are shared by a number of partners. What you and your associates can take advantage of is:
Low-Cost Formation and Relatively Simple Maintenance
When it comes to starting a business, partnerships can be very inexpensive and simple to set up and manage. There is no legal requirement for a contract to be done, but it is recommended that all partnerships have a formal agreement in place. There are no formalities or expenses associated with this process. Even so, if you choose to get your small business going under a fictitious name, you may be obliged to register with the appropriate state authorities.
Favorable Tax Treatment
The partnership is exempt from taxation, whereas the partners are subject to individual income taxes. Income and expenses are split among each partner according to an agreed-upon allocation of partnership interests in the business (hence the written partnership agreement we mentioned earlier). Due to the common occurrence of short-term financial setbacks for newly formed small enterprises, the pass-through tax treatment may be an advantage. If you do this, you can avoid the double taxation businesses must pay by having your company's taxes "flow-through" to your individual partners' tax returns instead. Pass-through tax treatment allows a partner (ideally you) to quickly use any business losses against other sources of income, lowering their taxable income.
Sharing Expertise and Risk
Many businesses know right away that having additional owners means that financial and legal risk isn't only on one owner's shoulders. That is unquestionably a bonus. However, having several owners means that each partner brings a unique set of skills, experiences, and education to the table.
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General Partnership Disadvantages
General partnerships also have drawbacks:
Personal Liability
A general partner, unlike a sole proprietorship, has unlimited personal accountability for business debts. Contractual and tort duties of the business are jointly and severally owned by each partner. You can, however, reduce your financial risk by acquiring liability insurance to some extent.
Limited Transferability of Ownership
As a general rule, partners have limited options when it comes to ending the partnership or transferring their ownership stakes. When things don't go your way, it's rare that you'll be able to quit your job.
Limited Financing Options
If you have a smaller partnership, you'll have a harder time getting financing. If you seek out equity financing under a general partnership, you must either bring in more partners or each current partner must increase their contributions for a larger stake in the company. The other option is adding a new partner, which usually necessitates the consent of all current partners. A partnership with more than one member will have an easier time getting debt financing since the credit of each partner is equal to the credit of the partnership as a whole.
Limited Partnership
Only one general partner is required to take personal culpability for the business's liabilities in a limited partnership, but several general partners are permitted.
Limited partners (passive investors) are not personally liable for the actions of the other partners.
Limited Partnership Advantages
A limited partnership is an acceptable investment vehicle for equity investments for the following reasons:
Investing is a risk-free endeavor for the investor; limited partners are exempt from having to participate in management duties. Prior tax law's liberal passive loss regulations made limited partnerships popular in specific areas like real estate, where they were especially popular in the past. Added to this advantage are:
- The ease with which partners can make use of losses.
- Profits and losses can be transferred more easily between partners.
Limited Partnership Disadvantages
By limiting passive loss deductions, the existing tax legislation limits the appeal of limited partnerships to many investors.
Unlike the limited partnership, other entity forms (such as corporations, limited liability companies, and limited liability partnerships) also allow each participant the option of being actively involved in the business without forfeiting their limited liability, which is a feature that the limited partnership does not have.
Corporation
Large, multinational corporations with thousands of employees aren't the only thing that counts as a corporation. Corporations are legally recognized entities that exist apart from their shareholders or directors in the most basic form. In exchange for the state agreeing to consider the business as a separate legal entity for the purposes of legal liability and taxation, the corporation signs a corporate charter with the state.
Corporation Advantages
Incorporation offers the following benefits to many small businesses:
Ease in Raising Capital From Multiple Investors
Your firm might be owned by a wide range of people if you want to form a corporation. It's the simplest way to raise money from a wide range of investors, especially those who aren't interested in getting involved in the firm. It may be more difficult to persuade one person to invest $75,000 than to get 15 to invest $5,000.
Alternative Types of Corporations
A variety of corporate structures are available to small enterprises, including S corporations, C corporations, and LLCs. Even while each has its own set of rules and regulations, all allow for the sale of stock in exchange for a capital contribution of cash or property. Depending on your negotiating strength and the interests of your investors, small businesses can restrict the amount of ownership control that is sold by setting a limit on the number of shares for sale or the rights attached to each class of stock. Shares that don't vote can be called non-voting, preferred, redeemable, or a variety of other hybrid shares.
Corporations Disadvantages
Consider the following issues before you join a corporation:
Expensive and Burdensome Administration
The laws and regulations of each state are subject to change. Even if they don't, you (or a worker or service provider) must complete a significant quantity of documentation to keep your company in good standing.
Double Taxation of Profits While Operating
You and your shareholders are independent entities, so Uncle Sam loves to collect taxes on both.
Best Sources of Equity Financing
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:
Angel Investors
As mentioned before, angel investors are often rich individuals that invest in start-ups or established small businesses that are eager to grow and diversify their portfolios. In addition to contributing capital, angel investors can provide a network of contacts, expertise, and guidance.
Venture Capital Firms
Existing companies are often the focus of institutional investors and corporations like theirs. Investments might be substantial with high hopes for the company's future profitability and expansion.
Unlike venture capitalist groups, angel investors are more likely to get involved in the day-to-day running of your company.
Crowdfunding
There are crowdfunding platforms like CrowdCube and Seedrs that allow you to list your business. Individuals might buy a small amount of equity in your company through this method. In the end, all of the investments add up to a larger sum of money.
Stock Market
Shares exchanges serve as a hub for both buyers and sellers of stock. Securities traded in the equity market can be listed on the stock exchange as "public" or "private" securities.
We know that the world of loans is not an easy one to wander, less when you have a small business to run. We hope this guide has given you an idea of how to approach equity financing and take advantage of it. The Quick Capital Funding team is always available to answer all your questions and get you the loan you're looking for.
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