The term ‘equity’ is commonly used when discussing business finance.
It often has two uses:
- Business equity, which refers to how much ownership someone has in a business (also known as share ownership)
- Equity finance, referring to a specific form of external finance which sees an entrepreneur give up shares in their business in exchange for funding
Knowing how equity works is crucial to unlocking other funding options and understanding the implications for your company.
This guide explores equity in more detail.
- What is equity?
- How do equity and shares relate?
- What are the implications of giving up equity in your business?
- What is equity finance?
- Pros and cons of equity finance
What is equity?
There are a few ways to define equity.
It most commonly represents how much money would be returned to each shareholder if all the assets were liquidated and debts paid off. The more equity a shareholder has, the greater the proportion of money they are entitled to.
Alternatively, equity is the calculation of a company’s asset value with its liabilities subtracted. In this scenario, it is known as the ‘value on paper’.
Equity is commonly used to determine a business’s financial health. It is also found on a company’s balance sheet.
Although we discuss equity generally, there are different types:
- Private equity – any funding or stock that reflects ownership in a private company (please note that private equity also has other connotations in equity funding terms)
- Shareholder equity – the asset value that will be distributed among shareholders after they’ve been liquidated and debts resolved
How do equity and shares relate?
The distribution of equity is commonly referred to as ‘shares’. When you give someone shares in your business, you offer them equity.
The amount of equity a person has will be dictated by how many shares they have purchased. It’s also known as buying stock in a company.
In equity finance, an investor typically offers funding in exchange for a set number of shares, which they will hold for the long-term.
What are the implications of giving up equity in your business?
When you offer equity in your business, usually in exchange for funding, the person given equity becomes a shareholder. These shareholders have specific entitlements in your company, including:
- A proportion of your profits and earnings (known as dividends)
- A proportion of the proceeds upon the sale of your business (through capital gains)
- Voting rights and influence over business decisions
Before you provide equity to a shareholder, it is possible to negotiate the terms of the relationship. It will also depend on how much equity they receive. In some cases, you may have very hands-on shareholders; in others, they may be more relaxed.
Some companies will have different classes of shareholders, which dictate their entitlements. These include ordinary shares, deferred shares, redeemable shares and preference shares. You can find out more about each of these in our blog.
What is equity finance?
As already touched upon, equity finance refers to a range of funding types where equity is exchanged for money. You do not need to repay it. Instead, the investor will be repaid through dividends, if any, and capital gains on sale of the shares.
Equity finance options include:
Each has specific criteria, so it is worth checking them in more detail to understand the best fit for your business.
Pros and cons of equity finance
Equity finance boasts high rewards for suitable companies, but there are also implications to consider. We have explored the pros and cons below.
Pros
No repayment required
Many companies choose equity funding over debt because there is no repayment required. This means you don’t have to worry about having monthly repayments coming out of your accounts or the subsequent pressures on cash flow.
It also means there is no interest charged. All you need to do is offer a return on their investment.
Access support
Bringing shareholders on board is an excellent way to gain expertise. It is in their interest to help you (as it will lead to an increased return on investment), meaning it is a mutually beneficial relationship.
Some shareholders, such as angel investors, will often have experience in the industry, which they will pass on. They also have access to valuable contacts and opportunities which allow you to boost performance and achieve long-term success.
Raise substantial funding
Equity finance offers the ability to raise substantial funding. Business angels will provide up to £500,000 in a single transaction, raising even larger sums as an angel syndication. Expect similar levels from other equity options, though remember the specific amount may vary depending on the funder and your company’s eligibility.
You may have multiple shareholders, which allows you to raise more overall funding. Many businesses undergo funding rounds where they continually seek finance to fuel their growth and fulfil various goals across their journey, maximising your funding potential.
Cons
Share dilution
A common negative implication of equity finance is share dilution. This is where the ownership of existing shareholders is reduced as you bring new shareholders on board. It risks aggravating the existing shareholders. However, it is an important method of growing businesses and allows other shareholders to exit if they aren’t happy.
If you are working with multiple shareholders, it’s crucial to have a careful strategy that allows you to satisfy every party and avoid dilution.
Reduced profit and proceeds
When you sell equity in your business, you lose a proportion of your profit (and proceeds if you were to sell up).
Instead, your shareholders be entitled to these (through dividends and capital gains), reducing the overall amount you receive. You must be prepared for this before you commit to equity finance, as the arrangement will last for many years.
Accounting for more opinions
Your shareholders are entitled to a say in your major business decisions. They may also have voting rights, meaning you need to inform them of your choices and allow them to vote on the action taken.
Some owners will find this frustrating, especially if you are used to having autonomy in your company. Again, it is vital to accept their influences before you commit to having shareholders.
It’s also worth ensuring any investors you pursue share similar visions and values to avoid clashes.
In summary
Understanding equity and its implications is crucial. When offering shares in your business, it is integral to remember that, although you may raise larger sums, there are long-term implications that you are now aware of.
It is also worth noting that most equity options require you to have a company that shows growth potential or commercial value, otherwise you will struggle to attract investors.
If you have decided equity finance is a route you want to pursue, the first step is finding the right funders.
Pegasus Funding will help you to prepare your company for investment, maximising your chances of receiving equity funding. We will also connect you with investors who align with your business for a successful long-term funding relationship.