The basics of equity financing for small business

The costs of launching and managing a business run more profound than most entrepreneurs' pockets. To help raise the capital needed to hang their shingle, many small business owners consider equity financing.

Read on for a primer on equity financing for small business to help determine whether the approach is right for you and what equity financing options are available.

What's equity financing?

Equity financing is a means of raising capital for small business by way of selling shares in the company to investors. The shares usually take the form of common stock. Alternatively, they may also take the form of preferred stock or convertible preferred stock. The conversion of preferred shares into common stock is also possible.

It's important to remember that by choosing equity financing, you are, in essence, selling an ownership interest in your business to your investors. You might give up 25, 50 or even 75 percent of your business for equity financing. This decision means you give up some managerial autonomy and, often, a portion of your profits.

Commonly used by publicly traded businesses is equity financing, but it is also available to private companies. For this reason, the business entities most suited for equity financing are corporations and LLCs because they allow for raising money from multiple outside investors.

Partnerships and sole proprietorships generally limit funding to the partners' or owners' assets. Which isn't as practical if the partners or owners do not have sufficient funds themselves and require outside resources.

What's the difference between equity financing vs. debt financing?

With debt financing, you're borrowing money from a financial institution. The "debt" commonly takes the form of a loan or a bond obtained from a bank. As such, you have to repay the notes owed, plus interest, through monthly payments. Because of the risk of forfeiture, banks will generally ask you to provide a personal guarantee or collateral to secure the loans.

When you obtain equity financing, there's no debt owed or compensation required. For the reason that you're raising money by selling an interest in your company. This method allows you to redirect cash to areas of the business that need an infusion of capital to grow.

What are the types of equity financing for a small business?

The crux of raising money through equity financing is the sale of stock to investors. But herein lies the difficulty of obtaining equity financing: you'll first need to find the investors, i.e., the sources of your funding. The three main types of equity financing include:

• Crowdfunding: A crowdfunded investment usually comprises numerous small investments made over an Internet-based crowdfunding platform by a large number of donors. If you choose this option, be sure to choose a funding platform that supports equity-based crowdfunding, such as Fundable or CircleUp.
• Angel investors: These are generally family members, friends and other trusted contacts willing to invest in your business. Drawing from individual investors of natural wealth generally means that the amount of investment will be smaller than $500,000. But this is a trade-off many small businesses are willing to make for the more hands-off investment approach of many angel investors.
• Venture capitalists: These are professional investors who are generally capable of investing the most ($1 million+ investments are not uncommon). But in exchange for investing more, they also expect more. They're more picky about which businesses they invest. In addition, they may want to be more involved in the direction of the business.