The realm of equity can get very complicated and is rarely as straightforward as debt financing. It is a critical alternative to debt, however, and deserves careful consideration. Most small business owners will hear that debt is a better form of financing because you don’t give up ownership, which is true. However, most financial institutions require certain standards and covenanted restrictions to loan, such as a benchmark for times interest earned which is operating profit (EBIT) divided by all interest payable on debt. They want to make sure they will get paid, given all your other debt obligations. Many companies get to the point where debt is not an option and must start considering the use of equity financing.
When and How to Get Equity Financing
The best way to think of equity financing is to visualize a pie. In the earliest stage, you own 100% of the equity in your company, or the entire pie. As you go to partners and other small investors (like friends and family), the pie gets split and you will have a smaller percentage, but the pie is also getting bigger, so in reality, your portion may have green larger, but your percentage of the whole will have decreased. Not only is your company worth more, but now you have additional experienced entrepreneurs and business minds that are working to see your business be successful—its chances of success have likely increased.
You should be cautious, however, about giving up too much of your company. You should consider all the feasible options before giving up equity. Aside from traditional debt, bootstrapping is the term for being as efficient with your small business as you can and using only internally generated funds. If your business begins to take off faster than you thought and you need external financing to keep up with or fund the growth, these self-financing options may not make sense.
One of the first options to consider is partnering with someone else as a founder, which usually splits the equity based on anticipated contribution—commonly 50%. This is a big portion, but may be the only way you can incentivize someone else to take on the risk of your small business full-time. The next option is going to friends and family with smaller portions for actual cash. Uncle Bill’s $15,000 may or may not be worth 5% of the company to you, which is something you need to evaluate. The next step gets into the realm of angel investors and venture capitalists, which is beyond the scope of this article, but is equally important to consider if your business gets to that point. A temporary CFO can help to carefully analyze your specific business and decide what the best options are.
Lucky for you, you live in the Nation’s 4th best state for entrepreneurship. Among other high rankings, Inc.com ranks Utah as the 4th best state for entrepreneurship and innovation. What this means for you is that there is plenty of money ready to be invested in small companies that show potential. There are many angel investors and venture capital firms set up for just these purposes. So ask yourself, is it time?