What is equity financing and how does it work?
Equity financing is a form of fundraising in which an investor provides capital to a company in exchange for an ownership stake in the entity. The capital is typically used to hire employees, attract new customers and fund the day-day operations of the business. Venture capitalists, angel investors, private equity groups and more all invest in companies via equity financing.
When do startups typically capitalize with equity financing?
Equity financing can be invested throughout the entire lifecycle of a company. Capital from equity financing can be used to help a company spin up, launch its first product, expand its operations, or even go public. Despite the broad use cases for equity funding, only about 5% of companies are actually offered and opt for this type of financing.
Why is equity financing used?
Equity financing is typically used by early stage companies because they do not have any assets to collateralize for debt financing. This rules out loans since banks and other traditional financial institutions are only willing to lend out cash if there are assets to back the loan in the event a startup can not fulfill its obligations. To fund their operations, startup founders must choose to either bootstrap the company without outside investments, or raise capital by selling an ownership stake in their company to investors (equity financing).
Investments in early-stage startups are inherently riskier than those made in late-stage ventures which is why early-stage investors receive more favorable terms in exchange for their risk level. As the startup matures the risk parity evens out, resulting in a reduction of terms and provisions for future rounds of equity financing.
What are the advantages of equity financing?
There are a handful of benefits that come along with equity financing—perhaps the most important is the alignment of interests between the startup and its investors. Both parties are focused on growth and operational success. As the company gets bigger and grows the valuation, investors also realize the rewards with a more valuable ownership stake.
Equity financing can provide more than just capital to a startup. Venture capitalists and other equity financiers typically bring industry expertise and connections to the startups they fund. The startup can leverage these connections to jumpstart and help scale operations, land key hires, or even attract the first customers.
The other two major benefits of equity financing over debt financing, is that there are typically less restrictions on the founding team and the capital received from equity financing does NOT have an obligation to be paid back. The company can invest every single equity dollar received into its operations without recourse to pay back equity investors, in the event of going out of business.
What are the disadvantages of equity financing?
There are a handful of drawbacks that come with equity financing, here are a few:
- The founding team’s ownership stake is diluted - with each round of equity funding a startup raises, the founding team owns less and less of the business. Meaning that in a liquidity or exit event, they’re entitled to a smaller piece of the payout than if they had held on to a larger ownership stake. In some instances this can turn out to be the difference between receiving millions versus billions of dollars.
- Loss of control - oftentimes equity financing comes with a series of contractual provisions meant to protect investors. These provisions give them a say in the day-day operations of the business and the strategic bets that they want to make. Some of the most common include: pro-rata rights, voting rights, veto rights, and the right of first refusal.
- Unclear cost of capital - With equity financing, the cost of capital is very unclear. Set aside the “cost” of the contractual provisions, the other costs are highly dependent on the ultimate exit valuation of the business. For example, say you own 15%, and liquidation occurs at $1B—you walk away with $150M (before taxes). Now, say you own 5% of the business, and liquidation occurs at $20B—you walk away with $1B (before taxes).
Can you provide an example of equity financing in action?
This is a very simple example, please note that a more realistic example would have convertible vehicles in place, dilution protection, many more shareholders and other various factors.
- Jabari founded JJR Inc. - she owns 90% of the company. She sets aside the other 10% to employees.
- JJR raises a seed round of capital from ABC ventures, which dilutes the pool by 10%.
- Jabari now owns 81%
- The employee pool now has 9%
- ABC ventures now owns 10%
- JJR continues growing and raises its series A of funding from DEF ventures, which dilutes the pool by another 10%.
- Jabari now owns 72.9%
- The employee pool now has 8.1%
- ABC ventures now owns 9%
- DEF ventures now owns 10%
- JJR grows again, raising its series B funding from GHI ventures, which dilutes the pool by 20% this time.
- Jabari now owns 58.32%
- The employee pool now has 6.48%
- ABC ventures now owns 7.2%
- DEF ventures now owns 8%
- GHI ventures now owns 20%
- JJR exits at a $1B valuation, without any debt on the books, the payouts are as follows (note: there would be a ton of fees which we’re ignoring, also ignoring vesting cycles):
- Jabari receives $583.2M, the employees receive $64.8M, ABC ventures receives $72M, DEF ventures receives $80M, and GHI receives $200M.
What are the common types of equity financing?
There are two types of equity financing—the sale of stock to investors through a private deal or the sale of stock on a public exchange. Within the former option, there are various channels by which a company can offer to sell a portion of its stock privately through: venture capital, angel investments, mezzanine financing, and crowdfunding.
What are the factors to consider when evaluating equity financing?
There are three main questions to consider when determining whether or not to take equity financing:
- Am I comfortable giving up some control over the company?
- Do I believe that the investors I am bringing on will add a disproportionate amount of value to the company, outside of their capital – connections, expertise...etc.
- Am I comfortable forgoing some of the upside of the company in the event of an exit, by giving over a piece of the ownership?
What are the typical terms of equity financing?
- Strike Price - what the investor will pay per share
- # Shares / Ownership Stake - how many shares the investor will receive and what their ownership stake (percentage) is in the business.
- Valuation Cap - what the company is “worth” based on the strike price the investor pays and the ownership stake that they receive.
- Provisions - these are the rights and privileges that your investors expect to receive.
Can you negotiate the terms in equity financing?
Absolutely! As with most forms of financing the terms are negotiable.
What is the difference between debt and equity financing?
Debt and equity financing couldn’t be more different. With equity financing, the company sells a piece of the ownership stake in exchange for funding, but has no obligation to pay the capital back. With debt financing, there is no exchange of ownership, but the company is now in debt and an obligation to pay back the principal plus the accrued interest. Also, with debt financing, the lender has no control over the business operations and once the loan is paid back the relationship with the creditor ends. Whereas with equity financing, the investor now likely has at least some element of control over the business.
Is equity financing more expensive than debt financing?
It really depends on the outcome of the business. For example if you take equity financing and the business becomes insolvent, the equity financing has no monetary cost to your business. In the same scenario, however, if you take debt and the business goes under, creditors likely get paid out first in the bankruptcy proceedings. That said, if your business is growing fast and you can make the required monthly repayments, then debt is likely the cheaper option because you’ll pay it back way before a planned liquidation event (such as an IPO). The nominal interest you pay will likely be much lower than the upside you lose out on because of the dilution.
Our take on equity financing
If you're running a high-growth startup and want to scale fast, equity financing may be a better option than debt financing because you’ll have access to more capital. It's also a good option if you find yourself in a position where borrowing money just isn't feasible. That said, the most founder-friendly alternative is revenue based financing (RBF), which combines the best offerings from both debt and equity.
With RBF, you can receive instant access to capital (by recognizing your future revenues), without diluting your ownership stake or taking on a traditional loan that will carry recourse on all company assets. Sure, the money needs to be paid back, but there are no restrictions that come along with the capital.