Advantage & Disadvantage of Equity Capital

Investors provide equity with expectations for returns down the road.

Investors provide equity with expectations for returns down the road.

Capital is simply the funds you have to invest in growing your business and buying assets for use in long-term business operations. Equity is one of two common sources you may use to acquire funds for your business. The other is long-term financing. Equity capital is raised by offering investors a percentage of ownership in the business in exchange for their investment. This has advantages and disadvantages relative to lender financing.

Repayment Obligations

One significant advantage of equity capital versus financing is that you have no obligation to make regular payments to investors. This allows you to use more of your incoming cash flow to operate and grow the business. Loans have monthly payment obligations as you repay the debt over time. This makes it much more difficult to keep up with your overhead and variable costs to operate.

Shared Risks

Investors typically take on the risks of the business in exchange for access to its profits or the opportunity to earn money from an increase in their ownership value. By sharing the risks, you do not have to bear the full burden if the business fails. You usually have no repayment obligation to the investors if the business goes under. Plus, taking on investors with expertise can, in certain situations, add credibility and value to your business.

Diluted Ownership

The counter-effect of sharing the risks of ownership is that you also give up some of the opportunity to profit. Each investor and new round of investment means you give up more ownership. In a partnership or corporation, your share of current and future earnings is dependent on the number of shares, or percentage of the business, you own. In some instances, the costs of giving up some of the profit may outweigh the money you save on loan interest.

Loss of Control

Relying on a small amount of equity capital usually means you get to retain most of the ownership and authority in the business. However, when you take on significant equity investment, you may have to turn over some level of control. Some investors require consultative involvement in business decisions. Others insist on having representation on your business board as a caveat for their investment. If retaining control of decisions is important to you, significant equity investment may not make sense.

 

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