Startup Equity 101

Equity investment means you’re trading funding for a stake in your company. Unlike a debt provider like a bank or lender, an equity investor isn’t looking for a simple interest payment on the money they’ve provided you. They are exchanging more risk for more reward – a lot more.

The “more reward” part is what you should be paying attention to. Equity investors aren’t interested in earning 8% on their money with these types of investments. They are looking for 50%, and most likely a lot more. That means you’ll need to prove that your investment can yield a massive return on their capital.

Not Every Business Makes Sense for Equity Capital

Equity capital tends to follow businesses and industries that can experience massive growth and have exponential paydays. If you’re starting a local coffee shop, you may do really well, but it doesn’t have the potential to become Google, so you’re not likely to attract many equity investors.

On the other hand, if you’re looking to build the next Starbucks chain, and you have a vision and a plan that supports that kind of growth, investors would be very interested in participating on your path to IPO.

There aren’t that many industries that have the potential for this type of growth, which is why you tend to see venture capitalists flock to hot areas like technology, retail, and healthcare where there is so much room for new companies to explode.

Equity Investors Take Chances Where Banks Won’t

If every entrepreneur could walk into a bank and get a loan to finance their idea, many probably would. Unfortunately banks are incredibly risk averse. They only want to fund loans that they are sure will be paid back.

That’s where equity investors come in – they are willing to take a bigger chance for a bigger reward. And most businesses are, frankly, a really big risk.

The Competition for Equity is High

Most equity investors will look at hundreds if not thousands of deals in a given year before they fund even one. That’s because there are far more people looking for equity investors than there are checks available to be written.

Getting an equity investor is like getting a perfect score on your SATs. You have to be among the most prepared and motivated entrepreneurs to be considered in the top percentile of fundable candidates.

Great Uses for Equity Capital

We encourage entrepreneurs to look at all types of funding, from bootstrapping to debt to equity. With that said, there are some scenarios where only equity capital is going to be helpful in growing your business.

You need a LONG runway. Not every business will start generating income as soon as it launches. Internet companies, for example, are notorious for going years in operation without even attempting to charge their customers. These types of businesses need a lot of operating cash to sustain themselves before they can start turning a profit. For businesses like these, an equity investor is the only form of capital that makes sense because servicing a loan payment isn’t an option.

You have zero collateral. If you’re opening a restaurant or planning on flipping a house, there’s usually an asset you can use as collateral for a loan. But if you’re starting a consulting company, there’s nothing to lend against – the only assets are people. In this case, your only real option for funding is to find an equity investor that is willing to take a chance on your idea with nothing to “sell” if the business goes south.

You can’t possibly bootstrap. Most businesses can be grown from your kitchen into a bigger business. You stay lean, you sell a few customers, and you grow a little bit each month. That’s great unless you’re starting a business that requires a massive amount of capital just get off the ground (like starting a private jet service). If you can fund the business yourself, investors will expect you to start there anyway, so saying you “don’t want to use your own money” isn’t an excuse for talking to investors.

Giving Up Equity is a One Way Street

The downside to trading your equity for cash is that you’re not likely to ever get it back. It’s very rare that an entrepreneur will buy back the equity they have given away early in the creation of the company.

That means whomever you’ve sold that equity to is now a part of your world – whether you like it or not.

Not only will you not be able to get that equity back, you’ll also lose your ability to “sell” that equity again. That means if you’ve just given an equity investor 45% of your company, that’s 45% you can’t sell again in order to raise more money (unless you can convince that new investor to sell some of their equity as well to raise more capital later on).

Your Only Outcome is a Sale or IPO

Choosing an equity investor also changes the number of options you have to grow your company. If you own 100% of the stock, you may choose to stay small, take home all the profits at the end of the year, and focus on enjoying the benefits of business ownership. An equity investor isn’t likely to share your path.

Equity investors want one thing – liquidity. That means once you’ve taken their money they are only interested in either the sale or IPO of the business. That’s when they can convert their stake in your company into a big fat paycheck, which is how they make their money.

And they have to. That’s because there is a lot of risk in equity investing, which means that many of their investments will likely fail altogether, which means the ones that do succeed need to make up for the losses of all the rest.

This means they aren’t going to be interested in a cut of future profits each year. They want to know that what you’re building is going to be focused on being sold. If you don’t share that vision, you’re going to have a difficult conversation with potential investors.

Raising Equity Capital Takes Time

Raising equity capital isn’t like applying for a credit card. No matter how prepared you are, it can easily take 3 – 6 months to find the right investor, and that’s not counting how long it takes to actually complete the final legal documents before money is available.

There are no hard and fast rules to why some deals get invested in, so the “mating” process for investors and entrepreneurs simply takes time. Both parties need to get to know one another, set expectations, and of course settle on a deal that is equitable for both parties. None of those processes are particularly short.

That all assumes you actually find the right investor to begin with. It’s always possible that even if you find the right investor they decide that it’s not the right time to make an investment. Any of these factors can extend your timeline to get funding.

Types of Equity Investors

Equity investors fall into three primary categories – angel investors, venture capitalists, and private equity firms. As your company becomes more mature, you will graduate from one type of financier to the next.

Angel Investors. Professional angel investors (not your parents) tend to invest amounts as little as $10,000 to as much as $1 million in exchange for equity or convertible debt. They tend to be sophisticated individuals who have subject matter expertise around particular industries where they invest their capital and

Venture Capital. Venture capitalists don’t make a large number of investments, but they tend to invest larger amounts of capital, from as little as $250,000 to as much as $100 million. They typically invest after angel investors have already put money into a company.

Private Equity. Private equity investors look for “mature” businesses that have existing revenues but are either looking for expansion capital to grow the business or for the existing shareholders to take some money off the table personally in the form of a buyout.

Summary

The competition for equity capital is fierce, but that shouldn’t stop you. The benefits of getting a large infusion of capital that you don’t have pay back monthly (like a loan!) is a huge attraction for many entrepreneurs, which is why the waiting rooms of venture capital offices stay so busy!

Also see: Private Equity vs Venture Capital