Equity 101: How It Works

  • By The Able Team
  • Published 12/24/2016

An age-old question in small business finance is whether you raise equity or take on debt. But before you can begin to answer that, you have to know what equity is.

That’s what this article will address.

What Is Equity

So what is equity?

In a technical sense, equity is the value of ownership, calculated as the difference between your assets and your liabilities. So for instance with a house, your homeowner’s equity is the difference between the value of your house and the amount of your mortgage.

In common usage, though, equity just means “ownership.” It’s typically used interchangeably with stock/membership interests. So for instance, if you’re selling an interest in your company, you’re “selling equity.” If you’re raising money from investors, you’re “raising equity.”

How It Works

In broad strokes, equity is simple: you sell a certain percentage of your company in exchange for money. So if you own 100% of your company, and the company’s worth $10 million, you might sell 10% of it for $1 million to an investor to raise funds for an expansion project.

How do you do that?

You have an “offering.”

Because of past abuses, selling equity is one of the most heavily regulated areas of human activity. There are very strict rules about who you can sell to, how you can sell to them, what you have to disclose (and what you don’t), and what duties you owe to them after you sell. And if you mess up, expect heavy fines, nearly irreparable damage to your ability to raise more money, and, in some instances, jail time.

The basic rule is it is illegal to publicly/generally offer securities to unaccredited investors (also known as “retail investors”) without properly registering them first.

So you have four basic options:

  • Register your securities for a public offering
  • Have a private offering to only people you know
  • Have a public offering limited to “accredited investors” (rich people)
  • Small business equity crowdfunding

Let’s take each of these in order.

Public Offering

Public offerings are heavy-duty affairs. They typically involve an investment bank, a law firm, and a few million dollars of transaction costs. Smaller companies get by with less stringent registration in some circumstances, but even here, the costs tend to be prohibitive for most businesses.

Expect several months (at least) between when you start the process and when you get the money.

Private Offering

As the name suggests, private offerings (also known as “private placements”) are offerings made only to select investors. There are a variety of private offerings, but the most common is a Regulation D (“Reg D”) offering, specifically a 506(d) offering.

For 506(d) offerings, the general rule is you need to know the person before you offer to let them buy securities. You can sell to a mix of accredited and retail investors (with the number of retail investors capped at 35), though all investors need a certain level of financial sophistication.

Historically, 506(d) offerings have been the workhorse of most small-business equity raising. You’ll definitely need an attorney, but transaction costs will be lower. The process is simple: identify the people you want to ask, secure any introductions you need, explain your company and why you’re raising money, and then ask for a commitment.

Make sure to talk to your lawyer first, though. There are lots of traps for the unwary.

Expect about 1-2 months from term sheet to close.

506(c) Private Offering

506(c) offerings are relatively new, having come about as a result of the JOBS Act. They’re private in the sense that not just anyone can get in on them: you need to be an accredited investor (remember: rich). But since you’re only allowing comparatively sophisticated investors into the round, you can advertise them widely (even on Facebook!) in a way you can’t with other types of private offerings. There are even platforms springing up dedicated to 506(c) offerings.

That said, there are a lot of hidden legal issues with a 506(c) offering, so if you’re considering one, get a lawyer first.

Small Business Equity Crowdfunding

The newest kid on the block, small business equity crowdfunding is exactly what it sounds like: using crowdfunding to raise equity for your small businesses. Specifically, you can raise up to $1 million in a given 12-month period from a lot of investors (retail or accredited).

The basic idea is you go to a small business crowdfunding portal, and after some basic diligence, you can register your offering and start raising money. If you don’t have a robust personal network to connect you with accredited investors, small business equity crowdfunding can be a good option.

But it isn’t a panacea. Small business equity crowdfunding comes with some heavy duty reporting and disclosure requirements (including audited financials in some cases).

A Note of Valuation

How do you determine the valuation of the company and how much to sell?

Well… that’s a good question. And there’s not a great answer to it. The valuation of most companies is very much a transaction-by-transaction thing. There’s been a lot of ink spilled about how to value a company, but the real answer is that the value of the company is whatever you can get a buyer to pay.

For a deeper discussion of valuations, we recommend checking out Get Backed, a book by one of our cofounders about the art of the raise.

Pros and Cons

Pros

  • Very flexible repayment terms. You pay investors out of profits and proceeds from a sale. There are no monthly payments, typically the investors can’t “call” their money, and you are in the driver’s seat when it comes to payouts.
  • Low risk. If your business fails, you and your investors lose their money, but that’s usually the end of it. Equity investments are not personally guaranteed, and the risk (and reward) ends with the business.
  • Easier to early stage companies. It’s much easier for early stage companies to raise equity than raise debt. With equity, they’re selling an idea. With debt, they’re selling results.
  • The ”wow” factor. Raising equity has a certain mystique about it. It’s often a newsworthy event that says to the world “investors believe in me, and so should you.” It can make your company seem more legitimate, even if it’s held together with duct tape and bubble gum.

Cons

  • Hard to value. With debt, it’s pretty easy to know you’re getting the best deal you can. Provided you do your homework, most lenders will offer you the same basic price (based on your business strength and credit profile). That’s much less true for equity, especially when dealing with professional buyers. You might get a good deal, or you might sell your company for a song.
  • Permanent high interest rate. With equity, your investors are on your cap table, meaning you’ll be paying dividends to them forever (unless you buy them out, typically after a hefty price).
  • Control issues. With debt, your lender typically has some control over your business in the form of leverage… but only if things aren’t going well. With equity, your investors always have some control over your business—even if they’re minority shareholders.
  • Reporting and disclosure obligations. You owe equity investors duties of reporting and disclosure. They own the company, just like, and have a legal right to know what’s going on.
  • Transaction costs. Transaction costs tend to be fairly high for raising equity. Even simple raises can run five figures. Venture raises can easily run six figures.

Best Uses

Equity is best used for early-stage companies or outsized expansions plans. In other words, equity is a good choice for projects where the debt load would be unaffordable (or you can’t find a lender to take the risk), and you’re willing to give up more of the upside in the form of a partial sale of your company.

Summary

When you raise equity, you’re selling part of your company. As you can imagine, this is a very complicated process, but if debt isn’t an option, it is a great way for early-stage or venture-backed companies to raise the money they need to expand.

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