Equity means ownership. Equity financing means that you give an ownership share of your business to your investor. Your new “partner” expects to share in the profits of your business. Equity financing differs from debt financing in two ways:
1. Lenders expect to get their money back plus interest. The amount of your obligation is fixed. There is a repayment schedule and that’s it. Once a lender is paid off the relationship is over.
2. Equity investors don’t expect to get their money back in the same way as lenders. They expect to get a stream of income out of the profits of the company. There is no payment schedule and the stream of income can vary over time. This is a riskier situation for the investor, so the hope is for an even higher return than a lender would get. Of course, investors are interested in more than the stream of income. They’d like to be able to sell their share in the business if they ever need to. That’s the return of capital, similar to a lender’s getting back the principal amount of a loan, but the amount is not fixed. Instead, it depends on what a buyer would pay for the ownership share.
How equity financing works
The clearest illustration of equity financing is the sale of corporate stock, but can get equity financing by selling partnership shares. Sole proprietorships can get equity financing as well, but they do so by becoming corporations or partnerships.
Let’s look at what happens with the sale of stock.
Assume you are in business with three other individuals. You each own 1,000 shares of stock for a total of 4,000 shares. Your business is worth $400,000, so you each have an equity interest worth $100,000 (and represented by 1,000 shares worth $100 each). It’s not as easy as this in real life, but this is your imaginary reality.
Now a business opportunity comes along that requires $80,000 more than you have. You explore various financing options but you come to the conclusion that you need to bring in an equity investor. The investor insists on receiving 1,000 newly issued shares in exchange for the 80 grand.
After the deal is over, your corporation will be worth $480,000 and there will be 5,000 shares outstanding. Each share is now worth $96. Your share of the business has now gone from $100,000 to $96,000. Your investor’s share is also worth $96,000. This is a good deal for your investor — to get a $96,000 ownership interest for $80,000. But why would you do it?
The answer is that you believe the new business venture will more than make up for the $4,000 “loss” you experience the moment the deal is done. And your fellow shareholders agree. In other words, are the four of you willing to spend $4,000 each (for a total of $16,000) to get into this venture? If so, the deal is worth doing. If not, look for another deal.
When would equity financing work for you?
Let’s say the deal we just talked about won’t start paying off for two years. If you took out a loan, where would you get the money for the monthly payments? If you don’t have a good answer for that, then equity financing is probably the way to go.
The down side is that you now have a new “partner.” In the example we just gave, your investor now owns 20 percent of the business. Is this significant? Well, it depends on how the original four owners reach decisions. Are you usually in agreement? If so, the 20 percent outsider is not going to make much of an impact. But what if you usually disagreed? The outsider then may hold the balance of power. The outsider could then become the one making crucial decisions.
Consider leveraging
Here’s another factor to consider. Taking out a loan has a different effect on your share of net profits than equity financing does.
Let’s say the deal we just talked about has the potential of producing anywhere from $5,000 to $20,000 per year.
If you had borrowed the $80,000, you might have annual payments of $8,000 per year. Subtract this from the range of profit you are expecting from the new venture. You’re looking at a net annual outcome of anywhere from a $3,000 loss to a $12,000 gain. Your one-quarter share of this (we’re now assuming a loan instead of a new investor) is a range from a $750 loss to a $3,000 gain.
Compare this to the equity situation. Since there is no fixed obligation, your net results from the new venture are the same as the gross results: $5,000 to $20,000. Your one-fifth share of this is an expected gain of from $1,000 to $4,000.
In this case, equity financing really improves your income. But the price you pay is that you have given up some measure of control.
Legal restrictions on equity financing
Federal and state securities laws place very definite limits on whom you can sell stock to. A public offering of stock is out of the question unless you go through a very arduous and expensive registration process. Even more limited stock offerings are hemmed in by regulations. Very restricted offerings are possible without this extra cost, but it’s a good idea to consult a lawyer to make sure you are not violating the law.
