What is equity finance and how does it work?
Do you want to raise finance for your growing business? If so then equity finance could be a great solution. It involves selling part of your business in exchange for finance, so you need to be sure it’s right for you.
Although you’ll lose some control over your business, you could also gain a highly experienced and motivated business partner. If you choose to partner with an Angel Investor, you’ll be able to get advice from an experienced entrepreneur.
In this guide we explain how equity finance works and the pros and cons of using it. We also answer common questions like “how do I get equity finance and “what are the different types of equity finance?”
Table of Contents
- What is equity finance?
- What are the pros & cons of using equity finance?
- How do I get equity finance?
- Frequently asked questions?
What is equity finance?
Equity finance involves selling part of your business in exchange for finance. The amount you can raise will depend on how much your business is worth and how much equity you want to sell.
There are lots of different types of equity finance, involving different types of investors. Finding the right fit for your business can be an opportunity as well as a challenge. Going into business with an Angel Investor, for example, means that you will gain a business partner with great business knowledge and expertise.
How does equity finance work?
Equity finance works by selling part of your business in exchange for cash. You need to work out what your business is worth before you negotiate with a potential investor.
For example: if your business is worth £1,000,000 and you need to raise £200,000 to help fund an expansion, then you would sell a 20% equity stake for £200,000.
Selling your business is a complex process so it's important to get advice from a specialist lawyers and accountants. You should ask for advice on:
- The valuation of your business
- Tax implications of equity finance
- How much involvement your business partner expects going forward
- How your investment partner will access their future profits
- The terms of your agreement, if there is anything unusual or something you need to watch out for
What can I use equity finance for?
Equity finance is popular with new business owners that want to fund an expansion. It’s sometimes hard for start ups to secure debt funding from traditional lenders. In contrast, Angel Investors will often consider funding new businesses if you have a great business plan and are growing rapidly.
Equity finance is also used by established businesses for bigger business projects like funding an expansion, a new product line or a new premises.
Different types of equity finance
There are many different types of equity finance including the following:
- Angel investors - high-net-worth individual investors who invest in start up businesses. They are often experienced entrepreneurs who have built up wealth by owning successful businesses. They will be able to give expert advice about how to expand and market your business. They may also be able to help with the future funding needs of your business.
- Venture Capital Trusts - a company set up to invest in small businesses. They are less likely to invest in start up businesses than angel investors.
- Mezzanine finance - a type of debt finance that converts to equity if you don’t pay off the loan at the end of the agreement.
- Crowdfunding - crowdfunding or peer-to-peer lending works by raising finance through a pool of investors. This is normally arranged through a crowdfunding website or platform.
- Family offices - private wealth firms that manage wealth for wealthy families.
- Seed enterprise investment scheme (SEIS) - a government-based scheme where investors can claim 50% tax relief on investments up to £100,000 per tax year.
- Enterprise Investment Scheme (EIS) - a government-backed scheme that offers tax incentives for investors who buy shares in new businesses.
- Tier 1 investment - another government scheme to attract investment from high-net-worth individuals who want to invest more than £2 million in UK businesses.
What are the pros and cons of equity finance?
Here are the main pros and cons using equity finance:
Pros
- Won’t have to pay interest - interest won’t be due on equity finance. This means that it can be cheaper in the short-term.
- Won’t have to pay back capital - unlike debt finance, you won’t need to pay back the investor’s capital, although they will expect their share of the proceeds if you sell your business.
- Possible if you can’t get funding elsewhere - equity finance may be possible if your business hasn’t got a proven track record or you have a bad credit rating.
- Expert advice - investors can give you valuable business advice, especially if they have previous experience in your industry.
- Access to more contacts - if you go into partnership with an experienced entrepreneur, they may have access to important contacts in your industry.
- Access to future funding - new businesses often have several rounds of funding and existing investors are more likely to consider investing more money.
- Motivated investors - because investors have invested their own cash they are highly motivated to help you make the business a success.
- Less risky - if your business expansion fails then you won’t need to repay a loan.
- More suitable for rapid expansion - if you want to expand quickly then equity finance can allow you to raise more finance than you would be offered for debt finance.
Cons
- More complicated - equity finance is often more complicated and can take longer to arrange than debt finance. You will need to agree the value of your business with a potential investor.
- Professional costs - you will need to get advice from lawyers and accountants on the legal terms of your agreement.
- Often more expensive in the long run - equity debt is often more expensive than debt finance because investors take on more risk and don’t have security if the business fails.
- Give up control in your business - you’ll share the ownership of your business with another partner so they may wish to be involved in business decisions.
- Reduces the profits you will receive in the future - equity finance waters down your ownership of the business so you may not earn as much in the future.
- Risk of falling out - some investors want to work closely with their business partners. There is a risk that you won’t get on with them and this could cause problems. That’s why it’s important to take your time making sure you and your investment partner are a good fit.
What other finance options are available?
There are several other finance options available if you don’t want to use equity finance. They include the following:
- Business loan - a simple secured or unsecured business loan is probably the simplest type of business finance and often works out cheaper in the long run.
- Peer-to-peer lending - this works like crowdfunding where individual investors pool their cash to lend money to businesses. It is usually arranged through a peer-to-peer lending platform.
- Bridging loan - a bridging loan is suitable for short term business funding but you will need to arrange suitable funding to pay it off.
How do I get equity finance?
Applying for equity finance can be a complex process. Here the mains stages of the application process:
Stage 1 - get ready You need to make sure you are well prepared before you start to meet or speak to potential investors.
Stage 2 - pre-screening Some websites pre-screen applicants to make sure they fit their criteria
Stage 3 - pitch investors will want to see:
- How much funding you require and how you will use it.
- Financial records and bank statements.
- Information on your business’s unique selling points - how are you different from the competition?
- A great business plan including financial forecasts; growth projections, details of any patents or intellectual property.
- Information on your team including their expertise in your business area.
Stage 4 - due diligence Investors will research your business in detail before making their decision.
Stage 5 - completion Investors will draw up an agreement setting out how much equity they will receive and what they expect.
Where to get equity finance
There are many ways to find equity finance. There are a growing number of investment platforms that connect business owners with potential investors. Here are some websites to consider:
Frequently asked questions {FAQs}
Debt financing is cheaper because it is less risky for the lender than equity financing. That’s because traditional loans are usually secured on assets and lenders can expect to receive interest and get repaid for their loan. In contrast, investors buying equity in a business are risking their whole investment if the business fails.
Equity finance can be more difficult to get as it involves a complex and detailed negotiation with an investor. However, it can be a great solution for some businesses that can’t get funding elsewhere, or want to find an experienced business partner.
Equity finance usually costs more than debt finance in the long run. This is because investors are taking a higher risk so expect to get a higher return on their investment. They will usually expect at least 20-25% of your business in return for their investment.
Initial costs for equity finance may be lower as you won’t have interest or capital repayments, although you may have significant legal and professional costs.
A convertible loan note is sometimes used when it’s difficult to value your business. It’s a type of loan that converts to equity at some point in the future.
Your agreement will include information on any interest rates charged on the loan. It will also set out how your business will be valued in the future - many convertible loans include a discount to market value at the conversion date.
How much you can raise depends on the value of your business and how much equity you want to sell.
Angel investors will usually consider investing between £50,000 to £200,000. Venture capital funds prefer larger investments so may be more suitable once your business has a higher valuation - investments typically start at around £100,000.
You should get advice from a specialist accountant about how to value your business. The valuation will take into account your existing profits and assets as well as your projected future revenues.