Definitive Guide to Equity for Small Businesses
April 24, 2021 | Last Updated on: July 24, 2022
April 24, 2021 | Last Updated on: July 24, 2022
Owners of any small business would be well advised to educate themselves on the meaning and importance of equity, if it is something with which they are not already intimately familiar.
Equity is defined as the difference between your assets and your debts and liabilities. Subtracting what you owe in your business from what your business is actually worth will give you a number that will determine what the current equity in your company.
How much of what you have actually belongs to you, as opposed to how much is still owed to banks and creditors?
The more your assets increase in value, the more your business’ equity will increase. Those assets will come to be defined by more than just the value of the commercial property you own, and will extend also to a growing base of clients, multiple income streams, the value of your brand, and, depending on the nature of the business, even franchise opportunities.
How much stock you own in a business is another form of equity. The principal owner of a small business obviously possesses equity in that company, but a minority shareholder in a larger business also owns equity.
A study by Gallup revealed that 77 percent of small businesses are launched using the personal savings of their founders as startup money. So, more than three-quarters of small business entrepreneurs are going it alone at the start, rather than leaning on outside sources, whether those are loans from banks or funding help from friends or associates who would also have some equity in the startup.
Another study by Kabbage showed that more than 30 percent of small businesses are launched with an initial outlay of $5,000 or less. The average small business, however, requires in the neighborhood of $10,000 to get going, according to a Wells Fargo Small Business Index study.
Ultimately, most entrepreneurs are starting their businesses with their own skin in the game, even if that initial outlay may not be, in relative terms, a lot of money.
Business owners have the right to all the assets in their own company. They are also responsible for their liabilities. Examples of liabilities include accounts payable, accrued expenses, wages payable and taxes payable. The transfer of cash or assets to another party is how liabilities get resolved, but the more liabilities a company has, the more of a drain it becomes on the value of the business. A company’s equity actually can be a negative number, if its liabilities outweigh the value of its assets.
If you are the sole owner of a business, you assume all equity, but a company with multiple owners requires that those owners share in the equity, which means a smaller piece of the pie for everybody. This can impact how quickly a new startup will become profitable for each individual who can claim some equity, because even when profits are initially realized, dividing up those profits can lead to a small amount for each of multiple owners.
The entrepreneur about to start his or her own small company may be weighing the relative merits of business financing through debt against those of equity funding.
Seeking a small business loan is a route that many entrepreneurs imagine taking when they are launching a small business. But although it has a Hollywood-like appeal, it is often not easy for business owners to get a loan if they don’t already have an operating business. First, when applying for a loan business owners must have a strong business plan in place. A business owner’s personal credit will come under scrutiny by lenders when a company applies for a small business loan. Maintenance of a solid personal credit profile is almost as essential as a good business credit rating in the eyes of lenders.
Lenders also will be looking at the debt-to-income ratio of a business to see if the company’s cash flow is favorable and if the income is consistent. The more income versus debt that a business can show, the better the creditworthiness of the business in the eyes of the lender.
A small business that is not yet well established might have more difficulty getting approved for a loan. Lenders do not like uncertainty, and a fledgling company has not been around long enough to establish its financial soundness or credibility. A business that’s been around for awhile has been able to build up a financial history upon which a bank can inspect to ensure that approving the loan application is a worthy risk.
How long does a company need to be in business before beginning to establish more reliable credibility with potential lenders? At least a couple of years would be a good baseline. A bank is also likely to look at annual revenue and how much current debt a business is carrying and what collateral the business is backing that debt with.
In order to get a small business off the ground, the company often will need a loan, but getting approved for a loan is a lot more difficult for a business that has not yet established itself or its financial stability.
The application process for a small business loan starts with proper preparation. A bank may start by questioning the need for the loan. The business owner should decide what type of loan is the best fit for the company. Getting a loan to launch a business is a tall task in a company’s first year because banks need to see cash flow as evidence that a borrower will be able to repay the loan on time.
Small businesses often rely on personal financing, business credit cards or crowdfunding in their first year as a means of helping them become established. Once a company has a history of sales for around a year, has established a balance sheet and has forged some kind of a credit record, more financing possibilities should open up.
The biggest drawback to debt financing for a small business owner just starting out is the specter of having to pay the loan off, and the sense of urgency that comes with that.
Equity financing in lieu of debt financing eliminates the daunting prospect of borrowing money. A business owner who chooses to fund a startup via equity financing is selling a stake in the company in exchange for financial backing. The choice between debt financing and equity financing comes down to whether the business owner would rather start out in arrears, or surrender control.
Equity investors are popular options with businesses that have not yet established themselves and thus, which might not have much in the way of either collateral or cash flow to qualify for a traditional bank loan.
Persuading potential investors to join in funding your company might pose a challenge in the early going, which often is the impetus for entrepreneurs to turn to the more familiar, trustworthy and trusting option of family and close associates or friends for financing.
Early funding from these sources could almost be considered pre-seed funding. The funding that comes from family and friends could take one of three forms: loans, gifts or equity. Even though you might know them very well, involving friends or family members in equity investments should still entail hiring a lawyer to clarify terms.
If family or friends like the idea of becoming an equity investor in your business, it still will require a formal agreement with the assistance of legal expertise.
A private investor willing to come through with seed money for a small business startup is known as an “angel investor.” The funding sourced from an angel investor often comes in exchange for a stake in the business. Angel investors frequently are either friends or relatives of the entrepreneur, and the funds these investors provide may either be a one-time investment when the company is just starting up, or part of an ongoing arrangement to infuse the business with more funding down the road.
An angel investor often is someone who has a lot of money to spend and risk capital to spare. Early-stage businesses may lean on an angel investor for a significant portion of funding because they are more trustworthy and “friendly” than dealing with banks or other sources that might be more “predatory.”
While the amount of an equity investment an “angel” to a new business might represent a large portion of that company’s funding, it, conversely, often represents a very small percentage of the angel investor’s own portfolio.
The primary advantage of angel investors is familiarity and lack of risk. Since it is an investment, rather than a loan, in the event that the business does not succeed, there is no loan for the entrepreneur to pay off. The drawbacks of relying on an angel investor are the loss of total control over one’s business. Another investor with a stake in the company will usually demand some say in its operation, so, while the entrepreneur doesn’t have a loan hanging over his head, he does need to be accountable to someone else besides himself.
Unlike an angel investor, a venture capital firm is a source of equity funding that is not usually a personal associate of the entrepreneur, and it’s often a company, rather than an individual.
Companies that specialize in investing in startups are venture capital firms, and they will take chances on new companies that they believe to have substantial potential for long-term growth and big profits. Sometimes the assistance provided by a venture capital firm does not come in the form of money, but rather in the form of counseling and expertise.
As is the case with angel investors, venture capitalists have a stake of some kind in the business, and therefore have a say in the decisions that are made within the company. How much equity a business owner is comfortable with giving up, and the amount of valuation the entrepreneur is willing to establish, helps determine whether an agreement with a venture capitalist or venture capital firm will be forged.
A relatively new player in the field of funding a small business, equity crowdfunding involves offering the securities of a business to multiple potential investors in exchange for financing. Every investor who takes part in the process is offered a stake in the company, with the size of the stake dependent on how big their investment is.
If you aren’t sure whether your business is one that will attract enough customers to thrive, crowdfunding could be a good way to find out. Crowdfunding is one method of financing a business that is open to literally anybody. Not all crowdfunding involves equity; some crowdfunding is based instead on a system of incentives and rewards, with tiers of rewards offered depending on the size of a person’s investment in a business. Some well-known rewards-based platforms for crowdfunding include Kickstarter, GoFundMe and Indiegogo.
Not to be confused with peer-to-peer lending, equity crowdfunding is based on an investment into a business and not a loan. In equity crowdfunding, contributors also do not receive a physical product or service. They instead are investing in the projected future success of the business in order to realize an eventual profit. Platforms that offer equity crowdfunding include Crowdfunder and Fundable.
Advantages of equity-based crowdfunding include quicker access to capital. An investor’s motivation for making larger donations to your company is based on the potential for a bigger return for them. Also, expedited growth is a stronger possibility with equity-based crowdfunding due to the more sizable donations coming from your investors. That could lead to achieving your business’ financial goals faster.
There are disadvantages of equity crowdfunding that must be considered before deciding on this form of financing. One of those drawbacks is that equity crowdfunding comes with a lot of moving parts. There are as many rules and regulations to wade through in this process as there are with a bank loan. Also, if you take the plunge, you will be surrendering a lot of control. It won’t be 100 percent your company after this point, which means your investors—who will be part owners themselves—will have a say in the decision making. Equity crowdfunding isn’t cheap, either. Just to launch a crowdfunding campaign based on equity will require a substantial amount of capital.
Startups carry with them inherent risk. There’s no way around this admonishment. Carrying basic insurance policies is advisable, and it will also provide some reassurance to investors that you are committed to your business for the long term.
The percentage of your business that you would be willing to offer to an investor in the company is really a subjective question. It depends on how much control you’re willing to part with, how much funding you need for your business and how comfortable you are with the identity of the equity investor.
One question you might want to ask yourself as you’re mulling how much equity you are willing to part with is: Will this investment improve the outcome of my company by more than the value of the equity taken by the investor?
If you don’t think that the investor will create more value than that investor is taking, then it’s a deal you might be best off avoiding. Conversely, if you let an equity investor take half the company, but the ultimate result down the road is a business that has expanded its value exponentially, then, even though you gave up a lot in the beginning, you would be ending up with much, much more than you started with before cutting this investor in on the deal.
Equity investing is also a solution for someone who is considering purchasing an existing business. An entrepreneur presented with an opportunity like this might have all the funds needed to make the deal himself or herself, but, if not, you can present the business opportunity to investors, and offer a deal that if they invest working capital in this business, you will provide a return on their investment.
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