Equity financing explained

Most business owners will know that growth and success require investment. But when the cost of that becomes larger than the business budget, some form of finance may be needed. Equity financing is one of the options available.

2 November 2019

By selling shares in their company, business owners can raise the money they need to take their enterprise through the next stage of growth. This method can be beneficial for all types of businesses, from start-ups through to more established companies. Even tech giants like Google and Facebook have turned to equity financing to raise funds.

In this guide, we’re going to get stuck into the detail – uncovering how it all works, the different types of equity finance as well as weighing up the benefits and pitfalls.

What is equity financing?

It’s possible to sell equity in a business to raise finance. When people do, their investors take a share of the company, along with voting rights and a slice of the profits and losses, in return for their funds.

It may be a useful strategy if the investment the business needs to make is high-risk but offers big rewards. You can share the risk among the shareholders and each of you will have a vested interest in success.

But in what situation would a business need to use equity financing? It’s likely those using equity financing will either be start-ups in need of money to get up and running, or well established businesses trying to fund the next stage of growth and expansion.

How does equity financing work?

While equity financing typically comes from angel investors or venture capitalists, it can also be funding from family, friends or the public. In return for becoming shareholders, investors can provide the funds you need to take your business to its next level. Some investors will be more involved in decisions made within the company.

It’s possible to go through several rounds of equity financing. But remember anyone who owns more than half of the shares becomes a controlling shareholder – no matter who started the business.

A simplified example of equity financing:

William has started a new business. Up until now he has invested £100,000 of his own money, so he owns all the shares of the company.

While the start–up is showing a lot of promise, it’s in need of capital to grow. William finds an outside investor – his friend Helen – to supply the funds he needs. Helen agrees to pay £40,000 for 40% of the business' shares. This means that the company has now raised a total of £140,000 in capital, and William has a 60% stake of his business.

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Types of equity financing

If you’re wondering how to raise equity financing, then you need to get to know the different types. Here are some of the options:

Business angels

Angel investors are often wealthy individuals who tend to have some entrepreneurial experience themselves. They use their personal funds to help businesses in need of capital. They may also bring their knowledge, expertise and business contacts to the table.

Angel investors can even be found close to home, with many businesses turning to family members, close friends and professional contacts.

Venture capital

Venture capitalists are employed by venture capital firms to invest other people’s money into businesses. They tend to invest larger amounts than business angels, but take on fewer investments.

Venture capital firms may also be looking for a seat on your board of directors.

Initial public offering (IPO)

An IPO is when a business sells shares of its stock to the general public for the first time. This is also referred to as “going public”, as it marks the transition from a privately-held company to becoming a public company.

Mezzanine financing

Mezzanine finance is a type of equity finance, but is also a type of debt finance. It blurs the lines between the two, making its own hybrid version of financing.

Mezzanine financing is where a business secures a loan, but the lender is able to convert this to an equity share after a set time frame. In plain English, it’s a loan which can be paid back if all goes well, but if it can’t be repaid then the lender can recover their costs by securing shares in the business. In some instances, it can even be agreed that some of the money will always need to be paid back as equity.

This method can be seen as more favourable than other equity finance options, as it offers a way to get the funds you need without giving up large shares in your business – if all goes well – allowing you to maintain as much control as possible, for longer.

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Debt and equity financing FAQs

In business, we sometimes have to turn to external help to get the funds we need. Generally speaking, financing options can be split into two camps: equity and debt.

As we now know, equity finance is all about raising the money you need by selling shares in your business. Debt finance is as you’d expect – borrowing money which needs to be repaid, along with interest.

They’re fundamentally different ways to get hold of capital, so it’s important to grasp their respective features and benefits so you can make the right choices for your business. Let’s dive into some of the details.

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What is the difference between debt financing and equity financing?

Both debt financing and equity financing are ways to help inject funds into business. The biggest difference between the two is what you have to give the lender.

Equity finance

With equity finance you need to be willing to give up some ownership of your business. In return for their money, the investor will become a shareholder. This means there isn’t a commitment to pay back what was originally invested, but it does give the investor a level of control.

Debt finance

Debt finance acts more like a household loan. A sum of money is released to you, within the arrangement of it being paid back under certain conditions, such as monthly with additional interest. This way, you don’t dilute your ownership of the business and instead pay back more than you borrow.

Weighing up which to choose is dependent on your current situation. Not everyone will be eligible for a loan, and therefore may have limited access to debt financing. Take start–ups for example, who have yet to prove that they are profitable – they may be seen as too risky for lenders, but could have better luck with equity finance if investors are more willing to take on the risk.

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Advantages of equity financing

  • There’s no commitment to pay back a set amount, and there’s no interest.
  • Investors can bring you more than just money. Some are able to offer their own experience and skills, and may be able to help with business decisions.
  • Investors may provide further funding as the business continues to grow.

Disadvantages of equity financing

  • Finding the right investors and raising the finance you need takes a lot of time and energy.
  • You’ll need to be willing to give up some control over your own business – as a shareholder, an investor may want to have a say in key decisions, and they might not always be on the same page as you.
  • Selling a cut of your business will also affect your share of the profits. Although it’s worth bearing in mind that your reduced share could become worth a lot more if the investment leads to your business becoming a success.
  • You'll need to keep any shareholders up to speed with how the business is doing, which can be time-consuming.

Is equity financing right for me?

With so many options available when looking at business finance, it pays to think ahead about what’s right for you. Equity finance can look enticing, and be useful if your cash flow situation doesn’t permit big loan repayments. However, this opportunity will almost definitely result in a reduction of control.

If you decide that a loan might be better for your business then that’s where iwoca can help. As one of Europe's leading lenders, we offer small business loans of £1,000 to £200,000, with applications that can be completed in a matter of minutes. On top of this, funds are usually available within 24 hours, enabling you to be faster and more flexible.

Martin Brackstone is a senior editor and copywriter who has years of experience writing about a broad range of topics, including business finance, pensions, home and motor insurance, premium bank accounts, reward credit cards and personal loans.

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Words by Martin Brackstone

Martin Brackstone is a senior editor and copywriter who has years of experience writing about a broad range of topics, including business finance, pensions, home and motor insurance, premium bank accounts, reward credit cards and personal loans.

Article updated on: 2 November 2019

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