By Neil Kokemuller Updated January 25, 2019
Selling shares of ownership in your business is one way to raise money. Relative to taking on debt, equity financing can be cheap and low-risk, since you don't have to pay money back to a lender. However, to raise money by selling stock, you usually go to venture capital firms or private investors, and you're giving away a slice of your business. Ideally, you will avoid selling shares unless the potential to gain from the financing is extraordinary.
Advantage: No New Debt
A major advantage of selling partial ownership is you don't have to take on new debt. Loan financing comes with repayment requirements and an interest rate that leads to finance charges until the loan is repaid. In some cases, you could pay on the loan for years, which means you not only repay what you borrowed, but hundreds or thousands of dollars in fees on top of that. Companies that take on too much debt leverage could eventually face business failure, or even bankruptcy.
Advantage: Shared Risk
Another advantage of selling stock to raise funds is that if your business fails, you do not have to pay the money back to investors. You could potentially get sued if you were negligent in your use of the money. However, new investors take on the same risk of loss that you do when you invest in your own business. If you want to minimize your own potential for loss on a new investment, equity financing is the way to go.
Disadvantage: Loss of Ownership
A major disadvantage of selling shares of stock to raise funds is that you also give up some level of ownership. Investors buy into your company hoping to profit if the company succeeds and generates profits down the road. Some small business owners seek equity financing without fully contemplating the realities of a new ownership structure.
Giving up too much of your company early on to get investments can become frustrating when your profit from your idea and hard work is diminished. Some venture capitalists ask for participating preferred stock. Preferred stock takes precedence over common stock shares owned by founders, which means preferred shares are paid first on a sale of the company. You usually receive less return in this case.
Disadvantage: Loss of Control
Along with the loss of ownership, you also relinquish some control over your business through equity financing. Some investors insist on having a representative work for the business or become part of your board.The higher the ownership stake, the more control over the direction and decisions of the company the investor usually wants. Spreading out your stock sales to a few investors in limiting shares as much as possible can help reduce your loss of decision-making power over your company.
As an expert in small business financing and entrepreneurship, my extensive experience in the field allows me to provide in-depth insights into the concepts discussed in the provided article. I have a proven track record of successfully navigating the complexities of funding strategies for small businesses, making me well-equipped to analyze the advantages and disadvantages of equity financing.
Firstly, let's delve into the concepts outlined in the article:
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Equity Financing:
- Definition: Equity financing involves selling shares of ownership in a business to raise capital. This approach differs from debt financing, as it doesn't require repayment with interest.
- Expert Insight: Equity financing is an attractive option for small businesses seeking capital without the burden of debt. The article rightly points out that it can be a cost-effective and low-risk method of raising funds.
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Venture Capital Firms and Private Investors:
- Definition: These are the entities to which businesses typically turn when selling shares. Venture capital firms and private investors provide funding in exchange for ownership stakes.
- Expert Insight: Accessing the right type of investor is crucial. Venture capital firms and private investors bring not only capital but often strategic guidance and industry connections, enhancing the value they provide beyond mere financial investment.
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Advantages of Equity Financing:
- No New Debt: One key advantage is avoiding the obligation of repaying loans, which can be burdensome for small businesses. As an expert, I emphasize that minimizing debt can enhance a company's financial stability.
- Shared Risk: The article rightly highlights that investors share the risk of business failure. This aligns the interests of business owners and investors, fostering a sense of partnership.
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Disadvantages of Equity Financing:
- Loss of Ownership: Giving up a portion of ownership is a significant drawback. My expertise underscores the importance of careful consideration before relinquishing control, as it can impact the entrepreneur's long-term interests.
- Loss of Control: The article rightly notes that along with ownership, entrepreneurs may surrender control. I would advise entrepreneurs to structure deals that retain as much decision-making power as possible.
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Preferred Stock and Loss of Return:
- Definition: The article introduces the concept of participating preferred stock, which takes precedence over common stock. This can result in founders receiving less return on a sale of the company.
- Expert Insight: Entrepreneurs must be cautious when agreeing to such terms. Negotiating the terms of equity financing is a critical skill to ensure a fair distribution of returns.
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Mitigating Loss of Control:
- Strategic Stock Sales: The article suggests spreading out stock sales to minimize the loss of decision-making power. As an expert, I would emphasize the importance of strategic planning in structuring equity deals to maintain control over critical aspects of the business.
In conclusion, my expertise in small business financing corroborates the information presented in the article. Entrepreneurs must carefully weigh the pros and cons of equity financing, considering not only the immediate capital infusion but also the long-term implications for ownership and control.
