Instead of taking on debt to raise needed capital, an option for a small business or a start-up company is to raise capital through the selling of equity. In many ways, it is like debt financing, except instead of paying a loan back, you’re paying shareholders in your business venture. If your business succeeds, everyone gets paid. If not, then you’re the only one who gets paid.
There are certain advantages to equity financing to consider, but there are certain disadvantages that must be evaluated as well. Here are some of the key points to consider.
What Are the Pros of Equity Financing?
1. There are no interest payments.
If you have investors who provide capital in exchange for equity, then there aren’t going to be any additional added costs to the transaction. The biggest advantage here is the lack of interest payments that would be associated with debt financing. Investors are going to get a percentage of company profits based on their equity, which may add up to a higher cost overall down the road, but for the short-term, money isn’t getting paid out without a profitable return being achieved.
2. There is no liability involved.
Investors who purchase equity in a company are doing so at their own risk. The decision is made based on their view that the company is going to succeed and provide them with a return. If the business doesn’t succeed, equity financing means the risks being taken are based on the percentage of equity obtained. If investors have all the equity and you have very little, then you lose virtually nothing should the business fail.
3. There are no monthly expenses.
Because there is no debt that needs to be managed with equity financing, cash movement improves each month because there aren’t payments that must be made. This helps companies running on a tight budget be able to continue growing so that a profit can be achieved at some point in time.
4. It improves the credit rating of the business.
With numerous investors involved, the credit scores of a company can quickly improve. Better credit means lower overall interest rates for when debt financing may be necessary in the future. Equity shares are typically fairly easy to buy and sell as well, which means investors can get an exit if necessary and not affect the credit rating of the business.
What Are the Cons of Equity Financing?
1. It requires giving up ownership percentages.
Although debt financing can be cumbersome, it doesn’t require business owners to give up a portion of their company in order to get the cash that is needed. Many equity financing arrangements are created because a company needs more cash to take care of expenses and inventory. With enough ownership, investors can even dictate how a business gets run without any choice from you.
2. It isn’t good for short term growth.
Equity investing is for long-term growth instead of a short-term cash infusion. If cash flows aren’t picking up and you’re not sure how to make ends meet, investors are going to look for a long-term advantage to the equity that is being offered. You’re not going to find a short-term investor who is willing to give their equity back. If that’s your need, then debt is pretty much the only way to go.
3. Your company could be sold without permission.
In equity financing, the percentage of control is important. If you own less than 50% of your company, then you don’t have any control over what happens to it. This means the other equity shareholders could decide to sell the company without your permission. Although you’d still be compensated based on your equity share, it would also mean the business you may have started from scratch is no longer yours.
4. There is regulatory compliance.
Whenever equity is sold to investors, there are certain rules that the company must follow. This includes filing reports, providing financial data to investors, and other mandatory items that can take up a lot of time. If there are questions about the data, expect to spend the time to answer them as well.
5. Equity financing makes sense in certain situations.
If you want to maintain control over a business and keep all decision-making powers, however, it may not be right for you. Consider all of the equity financing pros and cons carefully and you’ll be able to make the choice that is right for your particular business.