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Understanding the Challenges of Equity Financing

At some point, every small business owner must raise capital. Whether to support existing operations or fund business expansion, most companies will require more capital than their operating cash flow. And of the available options, equity financing can be the most problematic.

The simplest definition of equity financing means finding one or several investment partners. These are individuals that receive a claim on the firm's net assets and operating earnings in return for capital. Depending on the company's legal structure and type of ownership, equity investors either impact decision-making or have no control over company management and operations.

The first challenge when raising equity capital is to determine what rights and responsibilities equity owners will have.  The easiest way to handle this issue is to incorporate the business prior to raising capital.  For example, a general partnership usually sells equity positions to limited partners who have the right to provide contributions and receive distributions. Corporations, on the other hand, sell stock that gives owners a percentage ownership and the ability to vote on certain business decisions.  In the absence of a legal structure, legal documents must be prepared to outline how an equity owner interacts with the business.  This is extremely important since without it partners may make outrageous demands on management leading to shareholder litigation.

Since equity financing entails selling stock, members or partnership interests, it is important to not give control to investors and to comply with the state and federal statutes regulating sales. For example, in order to avoid external partnerships, you might want to sell stock to only friends and family. However, you can't just sell stock to anyone and must comply with federal securities regulations, even if your business is just starting up.

One of the most crucial regulations affecting equity financing is the need to find accredited investors. According to federal guidelines, an accredited investor has accumulated at least $1 million in net assets in the last 3 years or has has earned over $200,000 per year if single or $300,000 if married.  Unaccredited investors are allowed to invest after completing a considerable amount of documentation.

As far as ownership is concerned, the firm cannot sell equity shares to more than 35 unaccredited investors.  Regardless of the number of unaccredited investors, to sell to them requires the creation and distribution of a private placement memorandum (PPM) and audited financial statements.  Because of these additional regulations, equity financing costs more if most of your stockholders are unaccredited.  The cost of cresting a PPM and having the financials audited can cost upwards of $10,000.

For a startup or younger company that does not require an inordinate amount of capital the best and least expensive investor is an accredited one. Having amassed a substantial amount of assets, these partners usually have the resources and knowledge to make rational investment decisions.  However, even though a PPM and audited financials are not required, many accredited investors may ask for similar types of documentation before making the decision to invest.

Although selling a piece of your company may seem like it should be an easy thing to do, there are many regulations and considerations that make equity financing the most expensive and challenging way to raise capital.  It is the most expensive since, unlike debt financing, you must share profits with partners in the amount of their equity ownership.  For these reasons, most small business owners prefer to avoid equity financing.

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