Equity Financing: The Basics to Know

Equity financing is one of the most widely-used financing methods for small businesses. However, before you commit yourself to it, you need to think about what it means to fund your business with equity and the advantages of equity financing.

What is Equity Financing?

Speaking the language of professionals, equity financing is a sale of all equity instruments, such as common stock, preferred shares, share warrants, etc. to a large investor or individual to obtain funds for business growth. 

Speaking informally, it is an exchange of business ownership for money. No payback. No obligation. Only you, your business growth and… a new partner. 

Equity financing is a fairly new approach and not without risks, but is often attractive to startups because of the growth opportunities.

There are many reasons why entrepreneurs may want to avoid borrowing money. For one, lending money, especially in the small business sector, can be risky for banks. Secondly, it is difficult for startup entrepreneurs to get approved for equity finance loans because of their lack of credit history or collateral. Thirdly, the approval process can take months or even years and require significant paperwork.

The most common forms of equity financing:

• Angel investors
• Venture capital
• Incubators and accelerators
• Friends and family
• Government funds
• Crowdfunding

Two Options: Stay Private or Go Public

You’ll have to choose either the Private Placement of stock with investors or the Public Stock Offering (IPO) for the first equity financing. Let’s take a closer look at both.

Private Placement

Or Regulation D offering is a sale of stock shares or bonds to sophisticated investors: banks, pension funds, insurance companies, wealthy investors, etc. or institutions.

Also, such processes do not have to be registered with the SEC. The only condition is to meet a certain private placement with the requirements stipulated in an SEC Rule. 

The participants can only be so-called accredited investors, individuals allowed to trade securities, who don’t have to register this with any financial authorities. This also means that after buying shares, the investors can do their due diligence and have much more bargaining power than the average investor. They have all financial information they need on hand. In fact, accredited investors do not need the SEC protection that is offered to less sophisticated investors.

Here we will stop for a moment to make things clear for this form of equity financing. The company is NOT required to provide a potential investor with a prospectus. Instead, the Private Placement is sold using the  Private Placement Memorandum (PPM). The PPM consists of the information primarily about the terms of the offering and the investment risks. Such a document can not be broadly marketed to the general public. 

The Private Placement process is definitely faster due to the absence of any complex requirements. You do not have to spend your time dealing with the SEC,  which allows you to sell more complex security. This is an advantage of such equity financing.

On the other hand, be prepared that your investors may be picky. They will try to find as many pitfalls as possible because they want to be sure they are not running a risk of losing money.  And this is a disadvantage.

IPO (Initial Public Offering)

This option of equity financing is a hardcore one. But that only makes it more interesting to explore. 

 Here you will be dealing with public investors. The IPO is offering shares of a private company previously unlisted to the public for the first time. 

Once a company gains a unicorn status (reaching a private valuation of approximately $1 billion) or it has a strong foundation for further development and meets the SEC requirements, it can qualify for an IPO. 

The whole process is really complicated, but in general, it has main 5 steps:

1. Selecting the investment bank (the underwriter) that will help with the underwriting process. Basically, this bank buys the shares from the issuing company and resells them to the public.

2. Choosing an underwriting agreement and documentary preparation. Depending on the preferred results of equity financing, the issuing company can choose one of the several options: whether it will gain a certain amount of money or not after reselling shares to the public, multiple managers or just one, etc. After that, the underwriter has to draft the specific documents: engagement letter, letter of intent, registration statement, red herring document. As soon as the company files all the necessary documents, a “quiet period” begins lasting through the 40 days after the stock starts trading. 

3. Book building process. Or the finding of the appropriate price for the shares that will be offered to the public market. 

4. Stabilizing bid. The underwriters purchase the stocks at the offering price to the public or below to create a preferable market.

5. The market competition itself. It starts with the end of the SEC “quiet period”. 

The IPO advantages are raising the capital and additional funds from public investing and increased transparency.

But for the fabulous pros, you have to pay a high price. So here come disadvantages as well. Not only is the process expensive, but also your information (financial, accounting, tax) is not private anymore.

The Pros and Cons of Equity Financing

In this series, we explore some of the most common types of financing that businesses use. Take a look at the next chapter to find out more.

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