Equity funding basics
Equity financing basics
For most businesses there are two types of financing: debt and equity.
- Debt financing is a loan. The lender gives you money and you promise to pay it back with interest—the cost of borrowing the money.
- Equity funding means selling a piece of your business. An investor gives you money in exchange for owning a piece of your company.
What do investors want?
Investors want a significant return on their investment. Generally, an investor wants at least a ten times return on their investment in 5-7 years through an “exit.” This is why equity financing is for high growth potential companies, such as tech startups or multi-location restaurants.
What is an “exit?”
An exit is the sale of the company to another company, a private equity firm or new investors through an initial public offering (IPO). When the company sells, those who have equity split the proceeds.
Who are the investors?
- Friends and Family: The first people to invest are often the founders’ friends and family. Remember, once money is involved your friends and family become investors, and as such, you need a structured agreement with them called a term sheet.
- Angel Investors: The first round of formal equity financing is typically from angel investors—those who invest their own money. Angels fund a few thousand to around $1 million as individuals or together in structured angel groups.
- Venture Capital: Unlike angel investors, VCs invest funds from others. Their investments start around $2 million and they usually focus on later stage companies that are showing significant growth trends. VCs like to see a 30% return on their investment each year.
Tips before going after equity investments:
- Confirm that your business has the growth potential equity investors like.
- Make sure you’re comfortable with the idea of an exit.
- Be aware that you could lose control of your company.
- Join a local (or virtual) accelerator or incubator. They often provide education, mentorship and equity financing connections.
- Calculate the time and energy it takes to get funding—it’s not easy! Can you get customers to finance your growth for the same effort?
- Use a lawyer who knows equity funding deals. A lawyer can save you time, money and protect your interest during tricky negotiations.
- Select your investors carefully. A good fit can bring industry connections and insights along with funding to your business.
- Research which areas different equity groups fund and target your efforts.
Pros:
- Gain needed funds for product refinement and company expansion
- Owners do not have to pay back the funding.
- Investors often bring experience and connections into the industry
Cons:
- You give up control, and yes, founders have been kicked out of their own company.
- You could lose control of your company.