Equity Financing

By Entrepreneur Staff

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Equity Financing Definition:

A method of financing in which a company issues shares of its stock and receives money in return. Depending on how you raise equity capital, you may relinquish anywhere from 25 to 75 percent of the business.

Venture capital is one of the more popular forms of equity financing used to finance high-risk, high-return businesses. The amount of equity a venture capitalist holds is a factor of the company's stage of development when the investment occurs, the perceived risk, the amount invested, and the relationship between the entrepreneur and the venture capitalist.

Venture capitalists usually invest in businesses of every kind. Many individual venture capitalists, also known as angels, prefer to invest in industries that are familiar to them. The reason is that, while angels don't actively participate in the daily management of the company, they do want to have a say in strategic planning in order to reduce risks and maximize profits.

On the other hand, private venture capital partnerships and industrial venture capitalists like to invest primarily in technology-related industries, especially applications of existing technology such as computer-related communications, electronics, genetic engineering, and medical or health-related fields. There are also a number of investments in service and distribution businesses, and even a few in consumer-related companies, that attract venture capitalists.

In addition to the type of business they invest in, venture capitalists often define their investments by the business' life cycle: seed financing, startup financing, second-stage financing, bridge financing, and leveraged buyout. Some venture capitalists prefer to invest in firms only during startup, where the risk is highest but so is the potential for return. Other venture capital firms deal only with second-stage financing for expansion purposes or bridge financing where they supply capital for growth until the company goes public. Finally, there are venture capital companies that concentrate solely on supplying funds for management-led buyouts.

Generally, venture capitalists like to finance firms during the early and second stages, when growth is rapid, and cash out of the venture once it's established. At that time, the business owner either takes the company public, repurchases the investor's stock, merges with another firm, or in some circumstances, liquidates the business.

There are several types of venture capital:

Private venture capital partnerships are perhaps the largest source of risk capital. They generally look for businesses that have the capability to generate a 30-percent return on investment each year. They like to actively participate in the planning and management of the businesses they finance and have very large capital bases--up to $500 million--to invest at all stages.

Industrial venture capital pools usually focus on funding firms that have a high likelihood of success, such as high-tech firms or companies using state-of-the-art technology in a unique manner.

Investment banking firms traditionally provide expansion capital by selling a company's stock to public and private equity investors. Some also have formed their own venture capital divisions to provide risk capital for expansion and early-stage financing.

Individual private investors, also known as angels, can be friends and family who have only a few thousand dollars to invest, or well-heeled people who've built successful businesses in a similar industry and want to invest their money as well as their experience in a business. Sponsored by the SBA's Office of Advocacy, the Angel Capital Network (ACE-Net) is a nationwide, internet-based listing service that allows angel investors to get information on small, growing businesses looking for $250,000 to $5 million in equity financing.

Small Business Investment Corporations (SBICs) are licensed and regulated by the SBA. SBICs are private investors that receive three to four dollars in SBA-guaranteed loans for every dollar they invest. Under the law, SBICs must invest exclusively in small firms with a net worth less than $18 million and average after-tax earnings (over the past two years) of less than $6 million. They're also restricted in the amount of private equity capital for each funding. Being licensed and regulated by a government agency distinguishes SBICs from other private venture capital firms, but other than that, they're not significantly different from those firms. For a complete listing of active SBICs, contact the National Association of Small Business Investment Companies.

Specialized Small Business Investment Companies (SSBICs) are also privately capitalized investment agencies licensed and regulated by the SBA. They are designed to aid women- and minority-owned firms, as well as businesses in socially or economically disadvantaged areas, by providing equity funds from private and public capital. As with SBICs, SSBICs are restricted in the amount of their private funding. For information and a directory of active SSBICs, contact the National Association of Investment Companies.

Before approaching any investor or venture capital firm, do your homework and find out if your interests match their investment preferences. The best way to contact venture capitalists is through an introduction from another business owner, banker, attorney or other professional who knows you and the venture capitalist well enough to approach them with the proposition.

More from Expansion Financing

Factoring

A financing method in which a business owner sells accounts receivable at a discount to a third-party funding source to raise capital

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Angel Investor

An individual who invests his or her own money in an entrepreneurial company

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Friends/Family Financing

Monies, usually in the form a loan, that a business owner gets from either family members or friends in order to help finance their startup or growing business

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Government Grants

An award of financial assistance in the form of money by the federal government to an eligible grantee with no expectation that the funds will be paid back. The term does not include technical assistance which provides services instead of money, or other assistance in the form of revenue sharing, loans, loan guarantees, interest subsidies, insurance, or direct appropriations

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