The Role of Equity Financing in Business Growth

This is a contributed article.

In the venture capital world, we often discuss equity financing. Equity refers to ownership in your company. It represents your shareholding, distinct from debt, which is a liability against your company’s assets.

But how does it affect the potential scalability of your business? Whether you’re a startup business owner or not, it’s important to understand this type of funding. Learn more about equity financing and how it affects your business growth.

What is Equity Financing?

As an entrepreneur building your company and seeking venture capital, you’ll likely raise equity. This means you’ll be selling an ownership stake in your company to investors. Venture investors typically seek a significant ownership stake so that when your company succeeds, its value grows proportionately.

There are two main types of equity investments in a company. As the founder, you typically own common equity, consisting of common company shares. Common shares generally do not carry special rights or privileges but represent proportional ownership.

On the other hand, investors often prefer to invest in preferred equity or stock. Preferred stock grants investors specific preferences over common shareholders, including priority in receiving returns.

One key is liquidation preference, which ensures that investors recoup their investment before common shareholders receive anything in the event of liquidation or sale of the company.

These elements of equity financing, particularly the distinction between ordinary and preferred equity, are crucial for founders and investors alike to understand in venture capital transactions.

Pros and Cons of Equity Financing

Equity financing is money investors put into your business for a share in the company’s ownership. As it’s based on shares, this type of funding is not available to sole traders or partnerships.

Investors receive a return on their investment either through the pay of dividends by the company or by the value they get for their shares when they sell them. Investors want to know two things:

• How big is the return they’ll get on their investments?
• What is their exit plan (that means how and how quickly they can leave the deal and move on to the next)?

It also isn’t based on a company’s assets. The investor faces the same risks as the business owner and other shareholders. If the business fails, they lose their money.

Pros

There are several advantages to equity finance. First, you can use money from investors to fund your business without making loan repayments to a bank or other organization. You don’t have the burden of debt.

It’s best that you’ve prepared a prospectus for your investors and explained the risks in your business so they can understand that if the company fails, they lose their money.

Also, depending on who your investors are, they may offer valuable business assistance or bring skills and experience that you don’t have. This can be important and valuable, particularly in the early stages of your business’s development.

For efficient financial management in handling equity funding and investor relationships, consider exploring Genome. They provide digital banking solutions that streamline processes, ensuring transparency and security.

Cons

Of course, there are also disadvantages to equity finance. The first is that the investors own a piece of your business. How much depends on how much money they invest.

This means you no longer wholly control the business, and investors may want to have a say and make decisions. To help mitigate this, it’s advisable to create two classes of shares:

• Founders and directors
• Investors

The shares owned by the founders and directors enable them to decide on business strategies and give them the right to vote. The shares owned by investors do not give them any rights to have a say in the business direction. A good shareholder agreement is essential to manage this effectively.

Another disadvantage is that investors expect a share of the profits. However, if you have debt financing, the lender only requires that the loan be repaid. This can be an advantage in the first few years; the investor doesn’t expect to be paid if you don’t make a profit.

However, after all your hard work, when you do make a profit, you may not want to give a share of it to your investors. Also, since your investors own a piece of your business. You need to act in their best interests, as well as yours. This may prove difficult if they have very different views about the business.

Conclusion

It’s important to weigh the advantages and disadvantages of equity funding for your business. While it can be a demanding, expensive, and time-consuming process to secure investors, there are considerable benefits to be had as well.

While the most common type of equity finance is through angel investors or venture capitalists, you can offer ownership opportunities to family and friends in return for their investment. That may be something to consider for your business.