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There are 5 posts in this series:
“Equity” means an ownership share of your company. Selling equity in your company provides the company with money, in return for giving up a percentage of ownership and decision-making authority in perpetuity to the equity holder.
There are several ways in which equity can be used to raise funds:
- Take one or more investors on as either active or passive partners
- Sell a “Convertible Note” to one or more investors. It is initially set up as unsecured debt (no collateral), but can be converted to equity under the terms described in the Note.
- Sell shares of the company (equity) directly to one or more investors
Depending on the strategy you pursue above, you may decide to incorporate (or revise your form of incorporation) into a specific legal entity (LLC, Partnership, C-Corp, S-Corp, B-Corp, etc.). SCORE mentors or your attorney can help you determine the best legal entity fit for your business.
There are several types of potential equity investors:
- Angel Investors are generally wealthy individuals. They may be “friends and family” to the company, a person who discovered the company through their network of friends and acquaintances, or part of an “Angels” group that regularly considers company “pitches” before either investing as a group or individually.
- Venture Capital is generally a group fund. The fund has professional managers, and raises money from multiple investors who are willing to accept higher risk in return for a hopefully much higher level of return. They may also provide access to a network of experienced professionals who can assist the company on a consulting basis. As a company founder, you would interact with the fund manager.
- Crowdfunding can also involve the sale of (future) equity in the company to investors.
- Future Owners may be interested in purchasing an equity stake in your company. This provides cash to help you grow, and allows them to observe your performance while they decide whether or not they wish to own the entire company. It also allows them to put less money at risk initially, and may also allow them to control who you can sell the company to.
These investors are familiar with high risk investing, and accept that many of their investments may turn out to provide zero return. They are willing to accept this risk in exchange for potentially very high returns from the businesses that succeed. That said, they still wish to minimize the risks they are taking. Equity investors will perceive companies that have done one or more of the following to be more interesting:
- Developed the product or service (prototypes or production units exist)
- Proven that a market exists for their product (some sales history exists)
- Established the potential for very high sales growth
- Built strong barriers to entry (patents, trade secrets, high levels of expertise needed, large capital needs, etc.)
- Committed to selling the company or going public, probably in less than 10 years
The last point above is how investors get paid back and is key for most equity investors. So, if you as a founder don’t like the idea of sharing control of your company in the short run and selling it outright in the medium term, you should have an alternative plan to provide equity investors this “exit”. Because of this, a family business or a lifestyle business is not likely to be a good candidate for equity funding.
The above criteria mean that many small businesses do not find selling equity appealing. Those that do pursue the equity fundraising route will find that it is a long and complex funding cycle:
- It may take 6 months or more
- Experienced securities law attorneys should be involved
- Much management time will be required
- Management must become familiar with securities law and learn new communication practices
For those companies that wish to pursue equity funding, it can offer some advantages:
- Significantly larger amounts of money can be raised
- Follow-on funding rounds may be part of the initial agreement, if conditions are met
- Affiliation with a Venture Fund can provide a network of contacts and expertise
- Equity investor expectations and pressure can drive the business to accomplish more than they would have otherwise
- Shared decision-making with experienced investors (many of them have been entrepreneurs in the past!) can lead to better business outcomes
The other articles in this series each describe a few of the other funding sources in more detail.
Additional resources you may find helpful include:
- Funding - Equity Term Sheets
- Venture Deals, by Brad Feld
- CFI: Equity Financing
- Investopedia: Equity Financing: What It Is, How It Works, Pros and Cons
- Venturize: Equity Funding Basics
To ask questions and/or learn more about funding for your business, register for a “Funding Your Business” workshop in the SCORE workshop calendar or request to meet with a SCORE Mentor (a free service).
