In their early stages, startups must raise funding or growth capital to launch their businesses. While there are several options for raising money, one of the most sought-after types of startup funding is equity funding or equity financing.
What is Equity Funding?
Equity funding is the process of raising capital by selling company shares. It involves the sale of equity instruments like preferred stock, convertible preferred stock, and equity units that include common shares and warrants.
Investors can receive a stake in the company and its future performance in exchange for money they are willing to give now. Investors include angel investors, crowdfunding platforms, venture capital firms, and corporate investors. Once the startup has grown large enough to consider going public, stocks can also be sold publicly as an IPO (Initial Public Offering).
Equity funding is valuable for startups that are still a long way from generating cash flow. They can use the investments for short-term needs such as paying bills, financing plant assets, and funding initial operating expenses.
How Does Equity Funding Work?
Startup founders negotiate the funding amount based on the company’s valuation. In addition to the equity financing that investors provide, the investors own a percentage of stock in the company, for which they will receive proportional compensation once the company sells or goes public.
Successful startups can have several rounds of equity funding as the company evolves. Angel investors and venture capitalists are commonly the first to fund startups, favouring convertible preferred shares to fund new companies.
Equity Funding Sources
There are several ways startups are financed, including:
Angel investors
Angel investors are individuals who provide financial support or capital to various entrepreneurial ventures, most especially startups in the early stages of development. They are more likely to invest in the company during the seed stage and provide assistance in exchange for equity. They are valuable to startups as they can share valuable information and knowledge with startup founders. They invest their time, resources, and skills to help businesses succeed while maintaining a supporting role with less control and demand.
Venture capitalists
Venture capitalists (VCs) are individuals or groups of investors looking to invest in established startups or companies with a high growth potential, competitive advantages, and better chances of success. They are willing to provide large sums of money for equity funding, plus resources and connections, in exchange for a larger stake. They may also insist on managing the startup’s planning, operations, and daily activities to protect their investment.
Crowdfunding platforms
This type of equity funding source allows individual investors to invest small amounts of money into the company through online crowdfunding platforms like Kickstarter and GoFundMe. These investors share a common belief in the startup’s mission and want to help them reach their financial goals. The contributions are summed up to reach a target total.
Corporate Investors
Corporate investors are large companies investing in startups and private businesses. They typically provide the necessary funding to establish a strategic partnership between the two businesses.
Individual investors
Many startup founders choose to secure initial funding from friends, family members, and colleagues. Despite having little to no industry experience, their help remains valuable—and they require less convincing than VCs, angel investors, or corporate investors.
Initial public offering
Once the startup becomes well established, it can now raise funds through an initial public offering (IPO). The IPO allows equity funding by selling company stock shares to the public. This type of equity funding source is typically reserved at a later stage of development due to the expense, time, and effort that IPOs require.
Should I Choose Equity Funding for My Startup?
There are several ways for a startup to raise growth capital. The two most popular options include equity funding and debt financing, where the startup or business borrows money from a lender or a bank and then repays it at a later time with interest. However, traditional lenders may not always be amenable to extending loans to startups as they deem them new and “risky.” Therefore, in certain situations, equity funding is the most sensible choice for raising growth capital, such as when:
Your business needs a long runway.
Startups do not always generate income as soon as they launch, so equity funding can provide you with a sizeable amount of operating cash to sustain your business before it starts turning a profit.
Your business model is projected for exponential growth.
Equity funding tends to cater to startups with the potential for massive growth. For example, if you are targeting to be the next Meta or Uber, you can raise capital through equity funding.
You want to avoid debt.
Equity funding may be less risky than debt financing because there’s no loan to repay, nor is there a collateral at stake. Incurring debt means you must make regular repayments, which can hurt your startup’s cash flow and potential growth.
Advantages of Equity Funding
Equity funding is a viable option when established financing methods aren’t available due to the nature of your startup. Here are some advantages of equity funding.
It offers an alternative funding source for your startup.
With equity funding, the startup is not pressured to pay back its shareholders. Investors will likely focus on the long term and do not expect an immediate return on their investment. This allows the business to reinvest the cash flow from its operations and grow the business rather than focusing on debt repayment and interest.
It helps the startup expand its business network.
Investors can be personally motivated to contribute to the startup’s growth, lending their vast experience, business contacts, resources, and management expertise to the company. At times, they can even grant access to other sources of capital. These kinds of assistance are crucial, especially in the early stages of the business.
It makes the startup more attractive to buyers.
Through equity financing, a startup can raise substantial capital and experience greater, more rapid growth. This will make the company more attractive to buyers and make a sale possible, in case startup founders decide to sell the business.
Disadvantages of Equity Funding
Like any form of startup funding, there are also risks associated with equity funding. These include:
Reduction of ownership stake and loss of operational control.
As equity funding involves selling company shares, it also means startup founders must give up a portion of their ownership, thereby diluting control. Not to mention, once the company becomes profitable and successful, a certain percentage of profits must also be given to shareholders as dividends.
Investors who own large enough stakes and are entitled to voting rights could insist on actions like electing new directors, which can affect the business. In the event a startup gives up more than 50% ownership, founders can lose complete control of the company.
Absence of tax shields.
Compared to debt financing, equity investments have less tax advantages. While interest payments on debt are tax-deductible, dividends paid to shareholders are not. This increases the cost of equity financing.
Investors expect huge outcomes.
While investors may not expect an immediate return on their investment, they will expect massive returns from the business down the road. Since investing in a company carries a higher risk, investors expect greater returns to compensate for that risk.
Bottom Line
There is no one-size-fits-all approach to choosing a funding source for your startup. It’s crucial to assess your current financial health, your growth stage and future funding needs, and your long-term goals and vision to help narrow down your options. If you need access to cash without immediate repayment pressures, your startup is ready for rapid expansion, you need to scale quickly, and you are comfortable with giving up some control, then equity funding might be for your startup.
When you choose this option, it’s always advisable to consult with a lawyer to ensure that the terms of investment benefit both your startup and your investor. Let Lazarus Legal help you deal with all these legal matters and requirements so you can focus on growing your business!
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