6 Types of Equity Finances

What is equity? If you find yourself asking this question – then read on to discover what it is and the types of equity finances that you can invest in!

Equity

When you buy an equity share of a company, you are buying into the ownership of the business. As an equity investor, you are a partial owner of a company. When the new shares are issued by the company to the investors directly, it is called a “primary market”, where the transaction happens directly between the company and the investor.

The investors, who have bought the shares from the primary market, cannot sell the shares back to the company whose shares they are holding. A virtual marketplace is created for the benefit of such buyers and sellers called a “Stock Exchange”, where equity shares are bought and sold. The stock exchange is referred to as called a “Secondary Market”.

The two most common types of equities traders encounter are common stock and preferred stock. Share certificates bearing the name of the shareholder, the number of shares, and the name of the company represent these equities or shares. The number of shares a corporation is authorised to issue is prescribed in the corporate charter. When a company decides to sell additional shares to new or existing shareholders, this is sometimes referred to as raising equity.

Although shareholder rights vary by company, one of the most prominent characteristics of equity is that it entitles the owner to vote on certain matters and to do so in proportion to the number of shares he or she owns. The company’s articles of incorporation and bylaws determine the number of votes each share is entitled to.

Why it matters?

During the early stages of a company’s growth, particularly when the company does not have sufficient revenues, cash flow or hard assets to act as collateral, equity financing can attract capital from early-stage investors who are willing to take risks along with the entrepreneur.

For investors, equity financing is an important method of acquiring ownership interests in companies.  Investors are always wary that subsequent rounds of equity financing usually require them to dilute the portion that they own as well.

Kinds of equity finances

Financing with Money From Family and Friends

For business owners who have strong family ties or social networks, it may make sense to ask close contacts for investment funding. This type of funding, while relatively common, can be risky. Before asking for funding, it’s important for the business owner to feel comfortable with the idea that a friend or family member might lose their investment.

Small Business Investment Companies

The Small Business Administration (SBA) licenses and regulates a program called Small Business Investment Companies that provide venture capital to small businesses. While SBA funding is very competitive, it can also be a great way to get started.

Angel Investors as a Source of Equity Financing

Angel investors can provide second-tier financing to businesses. They are wealthy groups or individuals who are looking for a high return on investment and are very picky about the businesses in which they invest.

Mezzanine Financing

Mezzanine financing is actually a hybrid form of financing that utilizes both debt and equity. The lender makes a loan and, if all goes well, the company simply pays the loan back under negotiated terms. If, however, the company does not succeed, the lender has the right to convert their loan into an ownership or equity interest.

This approach protects the lender from the reality that most small businesses do fail. At the same time, it allows the business owner to keep ownership of their own business for as long as the business is profitable.

Venture Capital

If you get a venture capitalist interested in your business, you will give up a portion of your own and will probably have a representative of the venture capital firm on your Board of Directors. Venture capitalists are looking for high rates of return where they invest their money. Unless your business can offer them a high rate of return, they will probably not be interested.

Royalty Financing

Royalty financing is an equity investment in future sales of a product. It is a less formal process than angel or venture capital investing. Similar to a loan, it involves a funder providing up-front cash for business expenses; the funder is then paid a “royalty” when profits start to roll in.

How Equity Financing Is Regulated

The equity-financing process is governed by rules imposed by a local or national securities authority in most jurisdictions. Such regulation is primarily designed to protect the investing public from unscrupulous operators who may raise funds from unsuspecting investors and disappear with the financing proceeds.

An equity financing is thus generally accompanied by an offering memorandum or prospectus, which contains a great deal of information that should help the investor make an informed decision about the merits of the financing. Such information includes the company’s activities, details on its officers and directors, use of financing proceeds, risk factors, financial statements and so on.

Pros and Cons

For small business, the chief advantage of equity is that it need not be paid back. In contrast, bank loans or other forms of debt financing have an immediate impact on cash flow and carry severe penalties unless payment terms are met. Equity financing is also more likely to be available for startups with good ideas and sound plans.

Equity investors primarily seek opportunities for growth; they are more willing to take a chance on a good idea. They may also be a source of good advice and contacts. Debt financiers seek security; they usually require some kind of track record before they will make a loan. Very often equity financing is the only source of financing.

The main disadvantage of equity financing is the above-mentioned issue of control. If investors have different ideas about the company’s strategic direction or day-to-day operations, they can pose problems for the entrepreneur. These differences may not be obvious at first—but may emerge as the first bumps are hit. In addition, some sales of equity, such as limited initial public offerings, can be complex and expensive and inevitably consume time and require the help of expert lawyers and accountants.

Overall, equity financing can be an attractive option for many small businesses. But experts suggest that the best strategy is to combine equity financing with other types, including the entrepreneur’s own funds and debt financing, in order to spread the business’s risks and ensure that enough options will be available for later financing needs. Entrepreneurs must approach equity financing cautiously in order to remain the main beneficiaries of their own hard work and long-term business growth.