There comes a point where every startup needs to start considering how they plan on funding their growth in the coming years. Angel investments, growing rounds of financing and lines of credit are all options. There are many options, but equity financing is an increasingly popular one.
Most startups grow through successive equity rounds, and more recently many have entertained a mix of equity and debt at later stages. The reason equity is used at earlier stages is due to the risk during a startup’s earliest days — there are no predictable cash flows from which interest and principal payments could be made on debt. While equity can seem less expensive in the near-term, it has a dramatic downstream impact on board composition, employee options, any kind of liquidity event and much more. As with all options, it comes with pros and cons which need to be carefully weighed before moving forward.
Is equity financing right for your team? Here’s what you need to know before offering shares to new potential shareholders.
What Do I Need to Know About Equity Financing?
Simply put, equity financing is the sale of shares of your company. There are several ways executive and finance teams can put together an equity financing round.
The term “equity financing” is often associated with an initial public offering, where companies are listed on a stock exchange and offer stock to the public. But that isn’t the only way a startup can raise money through a stock sale.
Every startup begins as a privately held company. The original equity shares of the company are defined in the articles of incorporation. Over time, the owners may agree to dilute some of their shares to sell to friends, family, mentors, angel investors, or early-round investors in order to raise business capital. What kind of stock they own — convertible preferred shares or common equity shares — are defined during the sale.
Convertible Notes and SAFEs are very common amongst earlier stage companies because they avoid the necessity of a ‘priced round,’ which actually dictates the price of each share. As you can imagine, it is very difficult to derive a valuation for a very early, sometimes pre-revenue, company and these equity financing vehicles effectively enable a quicker and more streamlined financing process at earlier stages.
Equity financing rounds are used as a fundraising opportunity for companies to grow. It can either be a way to pay off bills from short-term growth (like paying deposits for office space or buying new hardware), to funding long-term goals identified in your business plan. Our recommendation is that your company always seeks 20-28 months of runway, depending on your team’s objectives and product milestones.
Is Equity Financing Different from Debt Financing?
Equity financing and debt financing are two completely different plans with the same goal in mind: expand your options to make short-term payments, or finance long term growth. The key contrast between them is in the return economics.
Debt financing could come in the form of a line of credit, term loan, revenue based financing, or a creative vehicle like venture debt. Often, the credit extended is limited to certain business activities or company needs, as outlined by a business plan and forward-looking financials. To secure debt financing, lenders look for key performance indicators found in a financial statement analysis, like debt-to-income ratio, interest coverage and burn rate.
This option can be attractive because the lender has no equity stake in your company, and thus has no say in how your business moves forward — their only concern is that you obey all covenants to the facility and make timely payments. It should be noted that debt facilities can default if certain conditions are not met, so be sure to engage experienced legal counsel when working through your funding plan with lenders. Last but not least, interest paid on the credit balance may also be tax deductible.
Under equity financing, shares in your company are sold to qualified investors to raise money. While these funds may not have the same restrictions as a line of credit, those owning shares may now have a say in how your business runs (depending on the type of shares they hold). Often, tech companies will split shares into preferred and common stock, affording different rights to different shareholder classes. While your team may not be bound to any covenants under an equity investment, they may be under the thumb of new board members, reporting requirements, and high-growth expectations given the nature of venture capital returns.
Should Our Startup Consider Equity Financing?
Opening an equity financing opportunity is not an easy decision. Should your startup make the move? The first question we recommend is: what type of business do you want to run? If you’re seeking a more lifestyle business or something with good work-life balance, equity investments may not be the best path forward. This is because they typically come with substantial growth expectations for technology startups. If equity financing doesn’t sound like the right fit, bootstrapping (airCFO’s chosen growth path), and self-financing your company’s growth is always an option.
On a positive side, equity can be seen as less restrictive growth funding for an organization. It can help bolster your team with strong hires, infrastructure and an experienced board. It is also one of the few avenues to truly tap into a rocketship growth trajectory. If you’re raising venture capital you’ll be doing a ton of networking, which you can leverage to attract intelligent business minds who can help you make introductions, open doors and provide executive advice. These contacts will be valuable not just for the most immediate round but future ones as well.
On the downside, equity financing also opens the door to diluted ownership — which means you get a smaller share of any sale or liquidity event. This can have a mix of upsides and downsides, as it’s likely your company won’t grow as quickly as it would with direct equity investments — but it also means that you have more control and can retain more of the returns from a sale. Any time you offer shares of your startup as a fundraising opportunity, you give up a portion of your vested interest. In addition, those investors may also have voting opportunities or other rights, giving them a voice in your company’s direction. If you aren’t willing to give up a portion of ownership or solicit new input, other finance opportunities may better suit your business.
Get the Best Advice on Equity Financing
Equity financing may offer an opportunity to raise money to drive immediate business plans forward. But it can only work to your advantage if your team carefully weighed the pros and cons.
Before you start an equity financing round, get the best advice on what options are right for your company. airCFO can help you understand where your business is today and the best fundraising options to further your goals. Start a conversation with us today and move your startup in the right direction.