It’s essential that small business owners know their funding needs and the types of funds available for various stages of startup and growth.
In this article from the Pursuit Business Advisory Service team, you’ll learn the differences between equity financing and debt funding and get tips to successfully secure equity financing for your small business.
Equity financing vs. debt funding:
When financing a small business, you have options. One is to take out a loan that you’ll repay, usually with interest, with set payment terms (weekly, monthly and, sometimes, even daily). Another option is equity financing, in which the business owner sells equity – usually, shares or other ownership – in the business in exchange for funds. In this case, the funds may or may not need to be paid back and the equity investor may or may not make money on the deal.
Why small business owners choose equity financing:
Common reasons why a small business owner may choose equity financing to fund their business include:
- They are still in the startup phase and loans are too costly or not available
- They require a more substantial investment of upfront capital
- The business is assumed to have a long development time
- They do not qualify for a loan
If you’re interested in equity financing, here are some tips to help you secure equity financing for your business:
1. Know your pitch
Ask yourself: What’s the most compelling reason why an investor would make an equity investment in my business with no guaranty of getting their money or investment back?
If you don’t already have one, prepare a written business plan that includes financial projections. Tailor the executive summary – which is a one-page or so summary of the most important information in your plan – so that it can be used to deliver a verbal pitch, too.
2. Know your ask
Ask yourself: How much money do I need to fund my business until it starts generating sufficient positive cash flow?
Your business plan should contain a financial estimate of how much capital you’ll need to get your business off the ground. If your business requires substantial upfront investment before it begins generating sufficient revenue, it may be harder to fund with a business loan. Even if you were to get a loan, you may not generate sufficient cash flow for a long time. Either of these situations may be reasons to consider equity financing.
3. Know what you’re willing to offer
Ask yourself: What type of investors do I want and what kind of return on investment am I willing to offer?
Before you approach a potential investor, you need to know what you can offer. Is it shares in the business? An active partnership? Some investors simply want a return of the original capital (this is often the case with family and friends). While typical crowdfunding sites enable people to give money to ventures without repayment, there are equity crowdfunding sites that function as a sort of higher-threshold kind of funding. Other investors may look for an ownership interest in the business that can eventually be sold for a profit (these are often angel investors and venture capitalists).
4. Know your investors
Ask yourself: How well do I know or have I researched the people or organizations that are investing in my company?
Future investors and lenders will perform due diligence on any owners with a stake of 20 percent or more, so if you plan to offer an equity investor ownership in your company, be sure to conduct a thorough background and credit check on the person or organization.
5. Know the legal and tax implications
Ask yourself: Have I taken the necessary legal and tax precautions to protect myself, my business and my investors?
An equity investment is a contractual arrangement that should always be put in writing. Documentation eliminates any potential misunderstanding that can cause strained relationships or have legal or tax implications down the road. And in all cases, equity investors should affirm, in writing, that they’re aware that the investments are at risk for total loss.
Another important reason to capture this information is to have an accurate picture of your balance sheet to value your company when you sell shares or when apply for a loan in the future.
Ask an expert
Selecting the right source of funding for your small business is one of the most important decisions you can make, regardless of stage of growth. Pursuit’s business advisory services team can help you understand the advantages and disadvantages of various types of funding.
