A company can finance its operation by using equity, debt, or both. Equity is cash paid into the business—either the owner's own cash or cash contributed by one or more investors. Equity investments are certified by issuing shares in the company. Shares are issued in direct proportion to the amount of the investment, so the person or entity who has invested the majority of the money has the majority of the shares and in effect controls the company. Investors put cash into a company in the hope of sharing in its profits and in the hope that the value of the stock will appreciate (increase). They can earn dividends (their share of the profit), but they can realize the value of the stock again only by selling it.
Cash obtained by incurring debt is the second major source of funding. It is borrowed from a lender at a fixed rate of interest and with a predetermined maturity date. The principal must be paid back in full by the fixed date, but periodic repayments of principal may be part of the loan arrangement. Debt may take the form of a loan or the sale of bonds; the form itself does not change the principle of the transaction: the lender retains a right to the money lent and may demand it back under conditions specified in the borrowing arrangement.
Although many businesses use a combination of debt and equity financing, especially to raise initial capital, all businesses need to determine what form of financing they will lean on more heavily. Most lenders offer one form of financing or the other. Also, as Justin G. Longenecker and his coauthors point out in Small Business Management: Launching and Growing Entrepreneurial Ventures, the decision regarding equity financing is best made early in a company's history. This is because equity financing can impact the long-term financial life and the organizational structure of a company.
The dynamics of investing cash in a business—be it the owner's cash or someone else's—revolve around risk and reward. Under the provisions of bankruptcy law, creditors are first in line when a business fails and owners (including investors) come last and are therefore at a higher risk. Not surprisingly, they expect higher returns than lenders. For these reasons the potential outside investor is very interested in the owner's personal exposure in the first place—and the exposure of other investors secondarily. The more the owner has invested personally, the more motive he or she has to make the business succeed. Similarly, if other people have invested heavily as well, the prospective new investor has greater confidence.
The liquidity of the investment is another point of pressure. If a company is privately held, selling stock in that company may be more difficult than selling the shares of a publicly traded entity: buyers have to be privately found, and establishing the value of the stock requires audits of the company. When a company has grown substantially, thus making its stock appreciate, pressures tend to build to “take it public” in order to let the established investors cash out if they wish. However, if the company pays high dividends, the investors will often be hesitant to “dilute” the stock by selling more of it, which would cause them to get a smaller share of the profit.
Debt-Equity Ratio. If the company also used debt as a way of financing its activities, the lender's perspective also plays a role. The company's ratio of debt to equity will influence a lender's willingness to lend. If equity is higher than debt, the lender will feel more secure. If the ratio shifts the other way, investors will be encouraged. They will see each of their dollars “leveraging” a lot more dollars from lenders. In a section its website called “Borrowing Money for Your Business,” the U.S. Small Business Administration (SBA) offers this advice for the small business: “The more money owners have invested in their business, the easier it is to obtain financing. If your firm has a high ratio of equity to debt, you should probably seek debt financing. However, if your company has a high proportion of debt to equity, experts advise that you should increase your ownership capital (equity investment) for additional funds. This will prevent you from being over-leveraged to the point of jeopardizing your company's survival.”
According to Longenecker and his colleagues, small businesses often benefit by having some debt financing and some equity financing, because some debt financing can increase the return on investment for investors and therefore attract more investors to the business. In fact, the authors assert, in most cases where a business's return on its assets is larger than the debt cost, the return on equity will improve as the company uses more debt financing.
Control. For the business owner, control is an important element of equity dynamics. In the ideal situation, 51 percent of the equity invested would belong to the owner, guaranteeing absolute control. However, if substantial capital is needed, this is rarely possible. The next best thing is to have many small investors, which can be another difficult condition for the start-up to create. The larger each investor is, the less control the owner may have, especially if things get rocky. Some companies try to offer only limited partnerships to investors, hoping to secure financing without losing control over business decisions. However, attracting investors is harder when financing agreements are structured in this way.
ADVANTAGES AND DISADVANTAGES
For the small business the chief advantage of equity is that it does not need to be paid back. In contrast, bank loans or other forms of debt financing have an immediate impact on cash flow and carry severe penalties unless payment terms are met. Equity financing is also more likely to be available for start-ups with good ideas and sound plans. Equity investors primarily seek opportunities for growth; they are more willing to take a chance on a good idea. They may also be a source of good advice and contacts. Debt financiers seek security; they usually require some kind of track record before they will make a loan. Very often, equity financing is the only source of financing.
The main disadvantage of equity financing is the previously mentioned issue of control. If investors have different ideas about the company's strategic direction or day-to-day operations, they can pose problems for the entrepreneur. These differences may not be obvious at first, but may emerge as the first bumps are hit. In addition, some sales of equity, such as limited initial public offerings, can be complex and expensive and inevitably consume time and require the help of expert lawyers and accountants.
SOURCES OF EQUITY FINANCING
Equity financing for small businesses is available from a wide variety of sources. Some possible sources of equity financing include the entrepreneur's friends and family, private investors (from the family physician to groups of local business owners to wealthy entrepreneurs known as “angels”), employees, customers and suppliers, former employers, venture capital firms, investment banking firms, insurance companies, large corporations, and government-backed Small Business Investment Corporations (SBICs). According to the SBA, small-business “startups depend about equally on the owners’ cash injections and bank credit, and the most common sources of startup dollars are owners’ and relatives’ savings.”
It is important to note that equity financing obtained through friends and personal savings is not without risk. If a business does not succeed, the business owner may feel personally responsible for losing the investments of friends and family. In the event of an unsuccessful business, relationships with friends and family who have invested heavily in the business may become strained. Some friends and family who become investors may assume that they can make business decisions or offer suggestions, creating further problems, especially for the business owner who wishes to retain control. It is a good idea for the business owner not to rely too heavily on friends and family for financing. If there is no option, the owner should at the very least create solid business contracts and agreements and Page 456 | Top of Articlework to create matching funding from elsewhere so that the investments of loved ones are not unduly jeopardized. Also, using personal savings for equity financing may pose a problem if the business owner wishes to incorporate later. When creating a corporation, it is very important to keep personal finances and business expenses separate.
Venture capital firms often invest in new and young companies. However, because their investments have higher risk, they expect a large return, which they usually realize by selling stock back to the company or on a public stock exchange at some future point. In general, venture capital firms are most interested in rapidly growing, new-technology companies. They usually set stringent policies and standards about what types of companies they will consider for investment, based on industries, technical areas, development stages, and capital requirements. As a result, formal venture capital is not available to a large percentage of small businesses.
Closed-end investment companies are similar to venture capital firms but have smaller, fixed (or closed) amounts of money to invest. Such companies themselves sell shares to investors; they use the proceeds to invest in other companies. Closedend companies usually concentrate on high-growth companies with good track records rather than on start-ups. Similarly, investment clubs consist of groups of private investors who pool their resources to invest in new and existing businesses within their community. These clubs are less formal in their investment criteria than venture capital firms, but they are also more limited in the amount of capital they can provide.
Large corporations often establish investment arms very similar to venture capital firms. However, such corporations are usually more interested in gaining access to new markets and technology through their investments than in strictly realizing financial gains. Partnering with a large corporation through an equity financing arrangement can be an attractive option for a small business. The association with a larger company can increase a small business's credibility in the marketplace, help it to obtain additional capital, and also provide it with a source of expertise that might not otherwise be available. Equity investments made by large corporations may take the form of a complete sale, a partial purchase, a joint venture, or a licensing agreement.
The most common method of using employees as a source of equity financing is an Employee Stock Ownership Plan (ESOP). Basically a type of retirement plan, an ESOP involves selling stock in the company to employees in order to share control with them rather than with outside investors. ESOPs offer small businesses a number of tax advantages, as well as the ability to borrow money through the ESOP rather than from a bank. They can also serve to improve employee performance and motivation, because employees have a greater stake in the company's success. However, ESOPs can be very expensive to establish and maintain. They are also not an option for companies in the very early stages of development. To establish an ESOP, a small business must have employees and must be in business for three years.
Private investors are another possible source of equity financing. A number of computer databases and venture capital networks have been developed in recent years to help link entrepreneurs to potential private investors. A number of government sources also exist to fund small businesses through equity financing and other arrangements. SBICs are privately owned investment companies, chartered by the states in which they operate, that make equity investments in small businesses that meet certain conditions. There are also many hybrid forms of financing available that combine features of debt and equity financing.
METHODS OF EQUITY FINANCING
There are two primary methods that small businesses use to obtain equity financing: the private placement of stock with investors or venture capital firms and public stock offerings. Private placement is simpler and more common for young companies or start-up firms. Although the private placement of stock still involves compliance with several federal and state securities laws, it does not require formal registration with the U.S. Securities and Exchange Commission. The main requirements for private placement of stock are that the company cannot advertise the offering and must make the transaction directly with the purchaser.
In contrast, public stock offerings entail a lengthy and expensive registration process. In fact, the costs associated with a public stock offering can account for more than 20 percent of the amount of capital raised. As a result, public stock offerings are generally a better option for mature companies than for start-up firms. Public stock offerings may offer advantages in terms of maintaining control of a small business, however, by spreading ownership over a diverse group of investors rather than concentrating it in the hands of a venture capital firm.
Entrepreneurs interested in obtaining equity financing must prepare a formal business plan, including complete financial projections. Like other forms of financing, equity financing requires an entrepreneur to sell his or her ideas to people who have money to invest. Careful planning can help convince potential investors that the entrepreneur is a competent manager who will have an advantage over the competition. Overall, equity financing can be an attractive option for many small businesses. However, experts suggest that the best strategy is to combine equity financing with other types, including the entrepreneur's own funds and debt financing, to spread the business's risks and ensure that enough options will be available for later financing needs. Entrepreneurs must approach equity financing cautiously to remain the main beneficiaries of their own hard work and long-term business growth.
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Strauss, Steven D. The Small Business Bible: Everything You Need to Know to Succeed in Your Small Business. 3rd ed. Hoboken, NJ: Wiley, 2012.
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