if you're a young entrepreneur who owns your own business or wants to launch one, you have two basic ways to raise money: with debt and with equity. Debt financing means borrowing money. Equity financing means selling a piece of the company. One advantage to equity financing is that you don't have to go into debt. The equity investor becomes an owner just like you rather, than a creditor. If the business fails, he loses his investment and that's the end of it. Of course, if the business is a success, you don't get all the goodies for yourself. The equity investor gets a share, too.
When a company sells shares to other investors, it gives up a piece of itself as a way to raise money to finance growth. Small, privately held companies sell shares to private investors, who then hold equity in the company. Companies that are more ambitious open their shares up to the public. When a company goes public and sells shares of stock, it's selling many pieces of itself to whoever wants to buy. In most cases this is the quickest way to amass large amounts of cash to finance growth.
Young companies often need money for growth or for research and development, but they're not far enough along to sell stock. In such situations, they often look for help from venture capitalists, or VCs. These are professional investors who identify promising companies and sink money into them in exchange for a share of ownership -- and, often, a voice in the direction of the business. Venture capitalists are in it for profit. They expect to cash in their ownership stake when the company either goes public by selling stock or gets acquired by another company.
Taking on a Partner
If you're looking to open a restaurant or a small shop, you should understand going in that your equity financing options will be very limited. You might not get much interest from stockholders or venture capitalists because the risk might be too high and the return too low. One option is to turn to the oldest form of equity financing there is: taking on a partner. You might tell a couple of friends that if they each chip in $25,000, they will have equity in the business. In some instances, such as when everyone invests the same amount of money, you will be equal partners. In other cases you might want to retain a majority stake of the business and have partners control less than 50% of the business.
Convertible debt blends the features of debt financing and equity financing. In basic terms, convertible debt starts out as a loan, which the company promises to repay. If the company meets certain performance benchmarks, the unpaid balance on the loan converts to an equity stake in the company. Those benchmarks might have to do with reaching revenue targets, raising money from other sources, or gaining a specific market share. Convertible debt offers investors a measure of security: They start out with a promise that they will be repaid, which is not something that equity investors typically receive. Once the company demonstrates its strength by meeting benchmarks, that promise goes away and they become equity owners. At this point the company has usually shown it's a worthy investment.
- "Financial Accounting for MBAs," Fourth Edition; Peter Easton, et al; 2010
- Entrepreneur: Convertible Debt
- Harvard Business Review: How Venture Capital Works
- How to Calculate Rate of Return After Selling Shares
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