Last month, we identified three ways to finance a business (Small Business Financing page):  loans, equity and assets.  Additionally, we discussed the pros and cons of taking out a loan.  This month, I will discuss using equity to finance a business.

Equity

            Equity financing is another option for companies in need of cash.  What is equity financing?  Simply put, it means receiving cash in exchange for an ownership position in your company.  The portion of the company that an owner gives up in exchange for cash varies from a small percentage to majority ownership, depending upon the amount of the investment and the valuation of the company.  Most common sources of equity capital are friends or family, as well as angel investors, private equity or venture capital firms.

            There are several benefits of equity financing.  First, it is not a loan, so there usually is no set schedule of repayment, which usually allows companies to reinvest profits back into the business.  The investors usually do not have a set time frame, and are usually willing to keep their money in the business for many years.  Second, depending on who the investors are, they may provide business expertise or partnerships that can be tremendously valuable to a growing company.  Finally, through the investor’s relationships or their own deep pockets, there may be access to even more funds that could help a company continue growth in the future.

            Equity financing does have its drawbacks.  First, there is a cost for equity financing, but it is usually difficult to determine.  When a company takes out a loan, it is usually easy to establish the cost because it is stated clearly on the loan documents in the form of an interest rate.  With equity financing, the cost of the money is normally not known until many years down the road.  What we do know is that due to the investor’s liquidation position (who gets paid back first), they are definitely looking for a rate of return that is significantly above what a company would pay at a bank.

            The second drawback is that the business owner now has a partner.  Depending on the relationship, this partner may require daily, weekly or monthly updates.  The partner may have the right to purchase more equity in the business.  The partner may try to get involved in day-to-day activities, especially if things are not going well with the business.  You have probably heard horror stories of the venture capital firm taking over a company and pushing the founders out.  I think these stories are largely overblown, but it can and does happen, even if it is not as frequent as some would lead you to believe.

            The final disadvantage to using equity to fund a company is that the fundraising process is lengthy, arduous and sometimes expensive. Business may suffer as the company’s management devotes their efforts to finding investors. Often times a company may speak to many investors before finding even one that is interested.  Equity investors also will require much due diligence information before considering funding.  The entire equity raising process usually takes at least several months, and in some instances can stretch to a year or longer.

            Equity financing is a popular means to finance a business.  It is best for growing companies where reinvesting profits and cash back into the business is important.  Many successful companies began by taking equity in exchange for ownership, and it certainly should be looked at as a financing option for small and large businesses alike.

Next month we will discuss using assets to finance your business.  If you have any comments on this discussion or have a suggestion for future discussions, please don’t hesitate to email me at terracinaj@ifgtx.com.