What Is Equity Funding?
Equity funding, also called equity financing, involves raising capital for a business in exchange for an ownership stake or equity in the company — a type of dilutive funding. Equity financing is not repaid like other business financing methods. Instead, startups repay their equity investors by growing the value of the company.
Equity Financing vs. Debt Financing
Debt financing is a non-dilutive funding method that involves borrowing money from a lender or financial institution, such as a business loan or convertible note. The key difference between debt financing and equity financing is that companies must repay debt financing with interest and they don’t have to give any equity in exchange for the capital raised.
Equity Financing vs. Private Equity
Equity financing can often be confused with private equity. Unlike equity investors such as venture capital firms or angel investors that invest in early stage startups, private equity firms invest in late-stage companies to increase their worth before eventually exiting the company.
Types of Equity Financing
Startups can leverage several types of equity financing — from venture capitalists to crowdfunding campaigns. Each type suits different stages of the startup lifecycle as well as the goals of both the investor and the startup seeking investment.
Venture Capital Firms
The most common equity investors for startups to raise capital from are venture capitalists. Venture capital (VC) firms manage funds or pools of money from a variety of sources. These investors are capable of investing a large amount of capital into high-growth businesses, typically taking a substantial amount of equity in the company. The goal is to secure a high return on their investment through a company's growth or initial public offering (IPO).
Angel Investors
Another common type of equity financing is angel investment. Angel investors are generally wealthy individuals who usually invest their own money in early stage startups, taking on more risk than other investors while investing less than venture capitalists. These investors often can provide more than just capital, taking on advisory roles in some cases. You can find angel investors through platforms like AngelList or within your professional network.
Equity Crowdfunding
When raising this type of equity financing, startups invite individual investors to contribute to a crowdfunding campaign in exchange for equity in the company. Commonly, these campaigns will be hosted on crowdfunding platforms like StartEngine or Wefunder.
Corporate Investors
While this type of investment is usually reserved for later-stage startups, that isn't always the case. Corporate investors are companies that invest in startups either through an internal investment fund like a corporate venture capital (CVC) fund or through partnerships.
Pros and Cons of Equity Financing
As with any business financing method, equity financing comes with several advantages and disadvantages. Understanding these pros and cons — and how they’ll impact your business — is important to determining if equity financing is right for your startup.
Pros
- You gain access to large amounts of funding. Both angel investors and VC firms can invest larger amounts of capital than traditional funding methods. For startups, this can be the key to the scale they need to succeed.
- You don’t have to repay the invested capital. Because equity financing requires a startup to sell ownership stakes in their company, there’s no requirement to repay the invested capital. Plus, startups don’t have to make interest payments as they would with other funding types like a business loan.
- You get additional perks from investors. Many angel investors and venture capitalists don't just provide funding for startups. Taking on investment from these parties usually means access to a valuable network, mentoring opportunities, and more.
- You may request extra funding, if necessary. With an established relationship with equity investors, startups may find it easier to acquire necessary cash infusions like bridge rounds.
Cons
- You’ll dilute your company’s ownership. By selling shares in your company, you dilute equity. That means your ownership percentage shrinks.
- You’ll decrease your control over your company. Equity financing not only means sacrificing a percentage of ownership in your company, but also may lead investors to take a seat on your company's board of directors. Ultimately, this means less control over your startup.
- You must share your profits. All shareholders are entitled to share profits. That means less profit for you overall — especially because these investors can take a large percentage of equity.
How Does Equity Financing Work?
To raise capital through equity financing, startups first need to determine how much money they need, what the capital will be used for, and how many shares of its ownership it's willing to sell to raise that amount.
Startups often determine the price of these shares by evaluating their company's overall worth, which can be complex and involves considering the company's assets, earnings, and future growth potential. However, they may also opt to negotiate the equity amount with potential investors.
Next, startups must determine the type of equity financing best-suited to their company and secure investors through pitches or by initiating a crowdfunding campaign. Investors then purchase shares, giving the company the capital it needs.
After a startup secures this capital, it can use it to expand, develop new products, or improve its operations. Any profit after this point is then shared with investors.
