What is equity finance and how does it work?

 What is equity financing?

Equity financing involves selling a stake in your business in return for a cash investment. Unlike a loan, equity finance doesn’t carry a repayment obligation. Instead, investors buy shares in the company in order to make money through dividends (a share of the profits) or by eventually selling their shares.

They only make a return on their investment if the company is successful. This means it’s in their interest to help and support the management team to grow the business and take it to its full potential.

What are the advantages of equity finance?

You may be able to start and grow your business using your personal savings and cash flow generated from sales. But this can often take a long time. With equity funding, you could grow much bigger and faster, enabling you to gain a competitive advantage in quickly moving markets.

These are some of the main equity benefits:

• Freedom from debt - You can focus on your growth plans without the burden of regular loan repayments. To find out more about how debt and equity finance compare, read our blog post, What is the difference between equity and debt?
• More capital - You can generally raise larger amounts of money with equity finance than you can with debt finance.
• Business experience, skills, and contacts - Some investors will bring much more than just money. They’ll provide added value in the form of expertise, knowledge, and contacts, which can help drive the growth of your business.
• Follow-on funding - Investors are often prepared to provide additional funding as your company grows.

When should you use equity financing?

Equity finance isn’t right for every business and it’s always a good idea to do your research on all the funding options available. Here are a few scenarios in which it might be a viable method:

• You’re an early-stage company without the financial track record or collateral to secure a bank loan. This is often the case with tech start-ups that may have substantial intellectual assets but few tangible assets. Often at the pre-revenue stage they have expenses to cover such as research and development. If you need to raise a large amount of money just to get off the ground then equity investment might be your best or only option.

• You’re an established company and have plans for growth that require a large amount of capital. Perhaps you’re looking to expand operations, move into new markets, or diversify products. Making repayments on a loan might hinder your ability to grow as quickly as you’d like.
• You want to acquire another business or you’re part of a management team looking to buy out the owner. Management buyouts typically rely on funds being pooled together from several sources, which usually include equity finance. 
• You want to sell your business. Ideally your business will be at a stage of expansion when you put it up for sale. Raising equity finance could help you accelerate your company’s growth so it’s as attractive as possible to prospective buyers.

How does equity work?

As mentioned above, equity finance can be used at various stages of the business journey, whether you’re just starting out or you’re an established company looking to expand (including acquisition). Some businesses will raise several rounds of equity funding from different types of investors in their progression from start-up to successful company.

When you raise equity finance, the investor will own part of your company. But by taking investment you should be able to create a larger, more profitable business. With the right investor, you’ll not only get a cash injection but also the expertise and contacts to drive your business forward. Would you rather own 100% of a £100k company or 70% of a £1 million company?

Research by Beauhurst on scaleups in 2019 shows that companies with higher turnover growth are more likely to have secured equity investment. 56% of those who grew turnover by more than 100% used equity financing.

Raising equity finance can be quite a long and complex process. You’ll need to spend time finding the right investor for your company, negotiating the terms of the deal, facilitating the due diligence process, and completing the final legal documents, all while running your business.

But by being well prepared, which includes having a strong business plan, you can help ensure the process goes more smoothly and increase your chances of securing investment.

Equity crowdfunding

Equity crowdfunding allows private businesses to raise funds from the public. It works in a similar way to other types of equity finance - you exchange shares in your company for cash. What makes crowdfunding different, though, is that you obtain smaller amounts of money from a large number of people (the ‘crowd’). They then own a proportionate slice of equity in your business.  

This type of financing takes place online on equity crowdfunding platforms. These platforms vary in how they operate – for example, they may charge different fees, have different vetting processes, and specialise in specific industries. It’s therefore important to compare them and see which is right for you.

Most require you to set a funding target for your campaign and a timeframe in which to hit this target. If you’re successful, then you’ll receive the funds at the end of the campaign minus any fees that the platform charges. If you don’t reach your target, most crowdfunding websites will return all the funds you’ve raised to the backers, though some might let you keep them for a fee.

How does an investor make money from an equity investment?

Equity investors make money through “capital gains”, where they sell shares at a higher price than they paid for them, and/or by dividends. Dividends are a portion of the company’s earnings that are distributed to its shareholders, typically paid on a quarterly basis.

Not every business chooses to pay dividends. Some, particularly young companies, choose to reinvest profits into the growth of the business. Dividend-paying companies are most often larger, more well-established companies.

There are various ways an investor can “exit” a business (sell their shares), including:

• Management buyout – investors sell shares to the investee company’s existing management team
• Trade sale - the investee company is sold to a trade buyer, typically another company operating in the same industry
• Secondary sale – investors sell shares to a third-party buyer, such as a venture capitalist or private equity firm
• Initial public offering (IPO) - when a privately owned company lists its shares on the stock exchange

Read our business succession guide to find out more about different types of exit events.

Finding the right equity investor

When you secure equity finance you enter into a long-term relationship with your investor, so it’s crucial to choose the right one. This means looking beyond the money and considering what else they can add and whether you can work well with them. Asking yourself these questions might help:

• How involved do you want them to be?
• What resources do they provide? Can they offer knowledge, experience, and contacts?
• Do they often make follow-on investments in companies?
• Are they a good fit for your brand and culture?
• What’s their vision for the company and does it align with yours?

*Based on a Beauhurst report, The Deal: Equity investment in the UK in 2020