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Equity 101

Where can you get hard cash to help fund your company’s operations?

In simple terms, there are three sources of funding for businesses. The first source is debt. The second source is equity. And the third source is the positive cash flow companies receive from satisfied customers.

Prosperous companies can fund their operations with an ever-changing mix of debt, equity and customer payments. However, the more companies can rely on positive cash flow from customer payments, the less business owners have to pay out to lenders and investors to fund company operations.

Equity capital is the most practical and likely source of funds for startups that are developing their first products and services. In exchange for hard cash, company founders, friends, family members and independent investors (angels and venture capital funds) become partial owners of the business.

The shared objective for all equity investors is to own a stake in a business that will eventually be worth two, four or 10 times more over time. Does this sound too good to be true? Not at all. Here are the fine points worth knowing:

5 Advantages of Equity Capital

  1. Entrepreneurs are not liable for repayment or investment losses.
    Unlike debt, equity capital does not require businesses to pay back funds according to a fixed payment schedule. Equity investors bear all the risk of the investment. This means, unlike many types of debt, entrepreneurs are not personally liable to pay back investors which is especially important to entrepreneurs who start businesses over the age of 40.

  2. Patient funding for “Big Ideas.”
    Equity capital can help fund Big Idea innovations that require a large amount of capital or a long period of time to develop into a viable business.
    Fortunately the venture capital community is patient and will give business owners several years to build the salable value of their companies.

  3. Higher tolerance for risk.
    Equity investors can accept a higher degree of risk than lenders. Since they expect a high return on their invested capital, they are perfect partners for ambitious entrepreneurs who like to take chances. The shared mentality is to position companies to hit home runs in terms of revenue growth, not singles or doubles.

  4. Great for new economy entrepreneurs.
    Equity investors are mostly democratic in their investment choices. It’s all about funding entrepreneurs who have a workable concept to grow a sizeable business with long-term profit potential. Investment decisions are driven by a company’s prospects for growth. Entrepreneurs of any age, and any background can complete for funding.

    Furthermore, equity capital is well-suited to new economy service businesses which don’t have a lot of hard collateral, like inventory and machinery, to lend against.

  5. Strategic collaboration.
    Entrepreneurs who receive equity funding from angels and venture capital funds can count on investors to be highly engaged in the strategic direction of their portfolio companies. Investors can be helpful, thoughtful and a source of encouragement to entrepreneurs when their companies are surrounded by problems. In contrast, lenders are not known for rolling up their sleeves to help companies work through challenging situations.

5 Disadvantages of Equity Capital

  1. Not fast cash.
    Unlike some forms of debt such as credit cards, equity capital takes time to solicit and negotiate deal terms. The competition to gain funding from angel investors and venture capital funds is fierce but not impossible to obtain.

    Entrepreneurs have to be patient. Deals are done when investors are ready to write checks, not when entrepreneurs need funds. The best approach is to assume that company founders and CEOs will spend a good six to nine months to raise capital, provided that they have a persuasive story on how investors can one day get their money back with a sizeable profit.

  2. High investment profit expectations.
    It takes a leap of faith to buy an ownership stake in a business that may not have a developed product or a single customer. The risk of investors losing all of their cash investment is very high.

    To compensate investors for risk, investors expect financial return that far exceed the returns available from less risky investments in real estate, publicly-traded stocks or bonds, or even federally-insured certificates of deposit.

  3. Permanent partnership.
    Once entrepreneurs accept funds from equity investors, it is very difficult to get rid of their collective voice on how the company is managed. As such, entrepreneurs have to make sure that they see eye-to-eye with lead investors in terms of strategic priorities.

    Many entrepreneurs start business to be the boss and “do what they want to do.” However, entrepreneurs who run businesses that are funded with equity capital no longer work for themselves, but for all shareholders. The moment investors sense that their investment is in jeopardy is the moment they will seek greater influence in how company decisions are made.

  4. Forced “exit” or company sale.
    Investors can be patient...to a point. “Tired” investors and board members can push entrepreneurs to sell their businesses before the founder is ready to sell-out. Equity partners are not good funding fits for entrepreneurs who may want to employ family members or one day pass the business down to their children.

  5. Preference for high tech companies.
    Equity investors have a strong bias to invest in high technology companies rather than low technology service companies at the seed-stage and early-stage of business development. These industries historically deliver swift revenue growth, high gross profit margins and high multiples of revenues or earnings at the time of business sale. These financial fundamentals are the venture equivalent of a trifecta or “hat trick”.

Now that you know more about the pros and cons of using equity capital to fund your company’s advancement, search the Start on Purpose Funding Directory to find sources of equity capital that might be a good funding fit for your company’s location, industry and stage of business development.

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