Businesses often require additional capital to start, grow, or manage business operations. To satisfy this need, businesses can pursue a variety of financing options. In our previous article, we discussed the advantages and disadvantages of one such option – debt financing. This article discusses the advantages and disadvantages of another financing option – equity financing – and factors businesses should consider when determining whether equity financing is appropriate to meet its needs.
Equity financing is the process of raising capital by selling ownership interest to investors for cash. Equity financing may come from many sources such as an entrepreneur’s friends and family, private investors, or an initial public offering.
Equity Financing Advantages
Less Financial Burden: Allows business owners flexibility as equity financing does not usually include an obligation to repay the investors. Accordingly, businesses do not have to earmark a portion of its cash flow to make monthly loan payments and the business can invest the capital directly into the business to stimulate growth.
Creditworthiness: Unlike in a debt financing transaction, investors typically do not require a business have sufficient credit in order to receive equity. Accordingly, for businesses and/or business owners that do not have a credit history or have poor credit history, equity financing may be an option to raise additional capital.
Less Risk: Generally, a business is not required to repay an investor in the event the business fails. Moreover, debt financing usually requires the business owner to provide a personal guarantee if the business does not have sufficient collateral. If a business fails and is unable to repay its loan, the lender can seize both the company assets and the business owner’s personal assets. However, business owners can circumvent this risk to company assets or the business owner’s personal assets in an equity financing transaction.
Equity Financing Disadvantages
Loss of Control: In return for the capital, a business owner may have to give up a portion of his, her, or its ownership and potentially some control over the business. This could lead to management conflicts between the owner and investor.
Share of Profits: Because of the purchase of ownership interest by an investor, a business owner must share the profits of the business. Typically, investors will earn profits by way of distributions or dividend that are distributed to the owners of a business; thereby diluting the owner’s distribution or dividend.
No Tax Benefit: Unlike loan payments to lenders, dividends distributed to investors are not-tax deductible.
Accordingly, businesses should consider the following when determining whether equity financing is appropriate:
- Importance of retaining managerial control of the business.
- Confidence in the business’ ability to generate sufficient profits.
- Importance of retaining decision-making power.
Please contact Parker McCay’s Corporate or Commercial Lending departments to discuss whether equity financing or any other financing option meets your business’ needs and to assist with well-crafted documents to support your financing endeavors.
The content of this post is for informational purposes only and should not be construed as legal advice or legal opinion. You should consult a lawyer concerning your specific situation and any specific legal question you may have.