In equity funding, business owners offer a portion of their business to investors in exchange for a desired amount of funding.
Benefits of equity funding:
- Risk is indirectly taken by the investor(s) providing the funding.
- There is no requirement to repay the funds if the business goes bust.
- It provides a recognizable valuation to a startup business.
Challenges of equity funding:
- It can be complex to understand.
- Business owners sacrifice part of their business share to investor(s).
- Important decision-making will require investor(s) approval.
- There are high costs associated with the legal, administrative, and procedural formalities.
- The funding time period can be very long.
- There are a limited number of investors willing to help start-ups.
- Maintaining investor relations is paramount despite their positive/negative influence on a business, as the overall reputation of the startup owner may be at risk within the small pool of equity investors.
Debt or Equity?
Securing funding of any type is not just about wanting 'x' amount of money and applying for it. Thoughtful consideration with a systematic approach can help one make the right selection. Debt forces obligations of future payments whether the business is a success or a failure. While equity takes away part ownership, limiting the freedom of a business owner to operate as he or she wants. (Remember, Apple, Inc. [AAPL] founder Steve Jobs was once fired from his own company due to differences with management and investors.)
- Choose a duration for your business venture (eg, number of months before roll-out). Be prepared with an exit strategy if things don't work out in the decided timeframe. Your funding requirements can come down drastically once you finalize the time horizon of your business venture.
- Decide your capital requirements over a suitable business timeframe (three months, six months, one/ two/three years).
- Accumulate all your personal savings. Add to it the projected income from your existing job or alternate income sources (such as rentals), over the desired duration of startup venture.
- Add to it the zero-/low-cost funding available from willing family members and friends (post-tax and interest considerations).
- Arrive at the deficit amount, which will now be an accurate indicator of your realistic funding requirement.
- If your required funding amount is moderate, go for the comparatively easier debt financing, provided you can afford the interest payments and terms of the lender.
- Moderate to large-sized funding requirements may make equity financing more attractive (after considering the complex nature of the deal and partial loss of business ownership). High-growth companies often go for equity financing, predicting higher future returns based on large investments.
- Larger-sized funding requirements may mean a business owner will want a mix of both debt and equity funding.
- Explore a time-bound mix. Start with a small to medium-sized loan, and if your startup shows signs of success by the end of the debt duration, go for larger equity funding.
The Bottom Line
No lender will fund a business unless there are sure signs of success and a perceived guarantee of returns. Startup owners should approach lenders with concrete business plans, clear business models, growth paths, and projected returns. Finally, convertible debt and convertible equity are other possible funding options that can be considered.