First of all, lets get clear as to what we mean by equity financing.
Equity financing occurs when ownership in a company is sold in exchange for an agreed upon purchase price.
The purchase price becomes new capital in the business and is recorded as such on the balance sheet.
In the business financing world, there are basically three general forms of financing…debt financing, equity financing, and some combination of debt and equity.
Equity financing, in many situations, occurs when a business or company can not qualify for debt financing.
Part of the reason for not being able to qualify for debt financing may be a lack of equity on the corporate balance sheet. Once this has been corrected through an equity investment, the business entity may immediately be eligible for different types of debt financing programs.
When a business is in a startup and development mode and has not generated revenues nor is cash flow positive on a monthly basis, then an equity investor is typically required to provide the cash flow necessary to complete the development process and get to a cash flow positive position.
Higher rate forms of asset based lending that provide financing debt to equity ratios higher than conventional lenders, will say that they are renting equity to the business due to the high level of debt and risk that the business is covering.
All things being equal, most business owners will prefer to debt finance their business needs as it comes at a lower cost than and equity investment in most cases, and the business owner retains ownership and control of the company.
That being said, debt financing can be difficult to manage, especially when you are working with more than one lender where the risk of being offside with some lender covenant is going to be that much higher. Debt financing sources can also demand repayment at times for no reason or wrong doing on the part of the business, potentially leaving the business owner or manager scrambling to manage cash flow.
Because equity financing is connected to ownership, its typically not always straightforward how an owner will be able to sell their shares and exit the business. Most corporations have shareholder’s agreements that outline this process, but it can still take considerable amount of time to exit and there is no guarantee that the initial investment will be reclaimed.
Equity financing in many cases is considered to be a more patient form of capital as its placement is usually connected to the future earnings potential of a given business versus existing financial returns.
The higher risk associated with speculating on future returns also demands a higher risk which is going to be expected by most any equity investor.
More and more often, we are seeing business financing solutions with both debt and equity elements where the investor/borrower is only looking to be in place for a period of three to five years, exit the business, and make a high rate of return on the capital provided upon exit.
For most start up business situations, the entrepreneur is first utilizing their own equity to get the business going, leverage debt to grow the business, and then use third party equity financing to scale out the business in order for it to reach it market potential.
So depending on where you are at in your business cycle, there can be different debt and/or equity financing solutions that are going to be more relevant to you.
The key point here is that each situation is unique and as a result most business financing solutions are customized towards available sources of debt and equity that are available and relevant at the time of need.