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Debt is often seen as an inevitability when raising capital. Although there’s nothing wrong with taking out loans to fuel future initiatives, the strings attached to these IOUs can tie a business back just as it’s getting off the ground. Rather than adding the burden of debt to the balance sheet, some fledgling companies search for a more flexible source of funds.
Equity financing is one such funding method that offers access to fast, debt-free capital. Beyond helping meet financial needs, issuing equity may provide unique perks that help companies scale even faster. Before signing the dotted line for a debt repayment agreement, consider whether equity financing offers a better solution.
What is equity financing?
Equity financing is a funding strategy wherein companies sell partial ownership to interested investors. In other words, company leaders trade off some control over their business in exchange for a capital injection. Whoever buys the shares a company offers in its equity financing deal gets a percentage stake in the company’s performance, including possible voting rights, dividend payouts, and price exposure to its profits and losses.
How does equity financing work?
Imagine splitting a startup into smaller chunks and selling each sliver of ownership to a solo partner, firm, or investor. That’s the basic premise behind equity financing.
A business creates legally recognized shares in its enterprise, each representing a slice of the underlying company. Whoever buys these shares instantly becomes a co-owner in the underlying business, taking advantage of future price appreciation, potential voting privileges, and dividends. The value of each share fluctuates daily depending on multiple factors, including supply and demand, the company’s current valuation, and the amount of capital the founders aim to raise.
In exchange for handing off an ownership stake to investors, companies get cash in their accounts without worrying about the obligations and inconveniences of interest payments. Typically, startups use the funds raised through equity financing to invest in their business via further research and development, marketing, or infrastructure growth.
Types of equity financing
Equity financing always involves issuing shares of a business, but startups have a few avenues to secure their funds. Choosing where and how to issue shares will significantly impact who becomes a co-owner and the pool of available capital.
Angel investors
In the earliest stages of growth, startups may need the guiding hand of an experienced investor who can help them strategize and realize their full potential. In this inception phase, angel investors sometimes step in to help steer startups in the right direction.
Angel investors are wealthy individuals with a high risk tolerance who are most interested in companies in their infancy. In addition to giving startups a financial boost, they offer mentorship to their favorite projects to grant them a competitive advantage.
Venture capitalist firms
Like angel investors, venture capitalist (VC) firms get involved with startups and small businesses with a high risk-to-return profile. However, VC firms tend to enter the picture a smidge later. Additionally, since VC firms are organizations rather than individual investors, they often have access to more significant financial backing—along with expertise, connections, and resources—in exchange for private equity.
Initial public offering
More established companies may list shares on a public stock market like the New York Stock Exchange (NYSE) later in their growth cycle. An initial public offering (IPO) gives retail and institutional traders access to shares, opening up the floodgates for an immense influx of capital. At the same time, an IPO comes at the cost of significantly diluting ownership rights.
Crowdfunding platforms
Equity crowdfunding is similar to listing as an IPO since this investment option gives the public access to shares in a company. Sites like Wefunder and Crowdcube connect startups with investors interested in putting a little money to work in exchange for a few shares. The cumulative effect of these tiny investments makes it possible to raise significant funds without concentrating a majority stake in any single entity.
What is equity funding vs. debt? Debt financing vs. equity financing explained
Companies that need capital but aren’t keen on sharing ownership rights may turn from equity finance to debt. Rather than issuing an ownership stake to raise funds, debt financing involves borrowing a lump sum from a financial institution at a pre-agreed interest rate.
In this arrangement, the company takes full responsibility for repaying this loan. On the downside, the startup must add interest repayments to its expenses. It also doesn’t get access to potentially invaluable expertise from angel investors.
However, the company enjoys complete control over its business operations. Debt financing won’t dilute a startup’s decision-making power among various stakeholders. Also, the interest payments may be tax deductible.
Debt financing becomes more attractive for mature companies as they prioritize control, gain credibility, and boast a longer track record of predictable cash flows. By contrast, startups and early-stage companies tend to gravitate toward equity financing to minimize their financial burden and gain insight from experienced investors.
Pros and cons of equity financing
By avoiding the constant dread of debt payments, equity financing clears up valuable real estate in a startup leader’s mind. Still, although equity financing can benefit scalability, you shouldn’t rush to give away ownership rights without weighing the risks and benefits.
Advantages of equity financing
- No repayment obligation: There are no IOUs or interest payments when you raise money with equity. Although shareholders expect the value of their stake to increase over time, there’s no obligation on the part of the startup to repay investors by a specific date.
- No collateral required: Since the company determines the value of each share, startups don’t have to part with another source of funds to serve as collateral for a loan. This feature makes fundraising more accessible for startups with limited assets on hand.
- Better balance sheet: A company’s balance sheet always looks better without debt. By clearing away interest repayments and the risks of loan defaults, a business can instantly boost its financial position, helping it secure more funding in the future.
- Potential for guidance and strategic partnerships: VC firms and angel investors usually play an active role in shaping a startup’s growth. Companies who work with these insider investors get invaluable benefits, such as industry expertise, business strategies, and connections—all of which help with profitability prospects.
Drawbacks of equity financing
- Loss of control and influence: Although companies don’t take on debt with equity financing, leaders lose power over their operations. Selling equity means giving away a stake in your brand, which translates to a more diluted—and potentially divisive—decision-making process.
- Time-consuming and complex process: Often, issuing equity is a slower and more complicated way to raise funds versus signing a loan. Entrepreneurs spend valuable time pitching shares to potential investors, conducting meetings, and providing detailed financial and business stats—not to mention the extensive negotiations, due diligence checks, and legal documentation required to secure equity funding.
- Full tax exposure: One of the perks of financing with debt is that some interest payments are tax-deductible. By contrast, equity financing (including dividend payouts to shareholders) doesn’t provide any tax benefits for business owners. In the long term, the extra tax exposure of equity financing may cost a company more than if they took out a loan from the start.
Attract and retain global talent with equity compensation
Equity isn’t just for outside investors. Equity compensation benefits are a powerful way to keep teams motivated and retain top talent. However, rewarding team members with shares can be daunting when dealing with legal frameworks in different countries. That’s where Oyster’s global employment platform comes to the rescue. With our equity compensation assistance, startups and early-stage businesses have a simple way to ensure everyone on their team gets a stake in the brand while complying with laws in 80+ countries.
Book a personalized demo to learn more about how Oyster simplifies the process of attracting, hiring, and retaining a global workforce.
About Oyster
Oyster is a global employment platform designed to enable visionary HR leaders to find, engage, pay, manage, develop, and take care of a thriving distributed workforce. Oyster lets growing companies give valued international team members the experience they deserve, without the usual headaches and expense.
Oyster enables hiring anywhere in the world—with reliable, compliant payroll, and great local benefits and perks.
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