Starting or expanding a business requires a lot of effort and funds. It is often recommended that new or expanding businesses must refrain from utilising their personal funds for business purposes. So, most businesses turn to either debt financing or equity finance loans to meet their financial needs. Today, in this article, we will look at equity loans and how they can help your business in detail.
What is an Equity Loan?
Equity loans, also known as equity financing or equity funding, is a source of finance for businesses in which an entrepreneur exchanges a percentage of their company ownership in return for a certain amount of money. To understand the equity loans meaning in a better way, let's use an example.
Assume you run an XYZ company and require Rs 10 lakh in cash. Mr A, one of the firm owners, appreciates your business plan and is willing to give you the necessary finances in exchange for a 30% equity stake. If you agree to this offer, then Mr A will become a partial owner of the company.
How Does Equity Finance Loan Work?
It is difficult to obtain a loan from a
financial institution for businesses that are not operating well owing to funding limits or for a start-up business that does not have business assets or is financially established. In such a scenario, they turn to equity loans. Equity funding can be obtained from a variety of sources including friends, the general public, venture capitalists, and large business owners.
The steps of closing a deal for equity finance loans differ from one investor to the next. In the case of public or private companies that are raising funds from the public through IPO, the process is complex and is regulated by a concerned regulatory body. Under this type of financing arrangement, you are not required to pay EMI or interest rate.
However, when your business makes a profit, you need to distribute the portion of it to the investors and may also declare dividends.
Advantages of Equity Financing
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Low Risk
In the context of a borrower, a loan against equity is less risky. This is because, under this arrangement, investors are given shares and stakes in addition to a set percentage of ownership. As a result, even if the business fails and you lose all of the stakeholders' money, there are no repayment obligations. Remember that equity is highlighted in the asset column, not the liability column.
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Resolves Cash Flow Issues
Under this source of finance for business, investors do not take away your company's funds. You are neither required to repay monthly instalments for such funding nor are you liable to pay interest. As a result, equity loans are known for boosting a company's cash inflows.
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Network Building
Equity loans imply the onboarding of powerful investors who are directly or indirectly involved in business operations. Investors assist firms in providing strong business networks so that the company's growth and expansion can double their investment. These investors can also help you grow by providing mentorship and sharing their vintage experience if you are a start-up.
Also Read: Financial Tips to Set Up a New Business Disadvantages of Equity Finance Loans
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Sharing of Ownership
When you raise funds through an equity loan, you allot some share or stake to the investor. The number of shares or the percentage of stake reflects investors' ownership. As such, if a single investor provides significant funding, there may be a conflict of interest because ownership is distributed proportionally among several individuals.
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Increased Accountability
When you have investors on board, you must keep them up to date on all business decisions. Investors require regular and accurate reporting on the performance of their vested funds. They also require regular insights into the activities of the organisation. However, this is not the case when it comes to borrowing from financial institutions. Lenders are primarily interested in whether or not you pay on time.
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Profit Sharing
When your company makes a profit, you must distribute it to the investors in proportion to their stake in the company. You must also pay the stockholders a dividend over time.
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Investors' Opinion Matters
When you raise funds from investors, they are directly or indirectly involved in your company matters. In most companies, the big investors/ shareholders are given a seat on the board of directors. Any decision that was to be executed in the corporation had to be approved by the board of directors. As a result, every shareholder who disagrees with your viewpoint has the right to vote against you.
Business Loans vs. Equity Finance: Which is Better?
Debt financing vs. equity financing is a topic of debate among many business owners. These two funding choices are vastly different from one another. To learn more about the significant differences, look at the table below.
Sr.No | Parameters | Equity Financing | Business Loan |
| 1 . | Meaning | Entrepreneurs raise money from investors in exchange for a percentage of their company's ownership. | Financial institutions lend money to businesses without asking them for any ownership rights. |
| 2 . | Assets/ Liability | An equity finance loan is regarded as a company's own funds and is an asset for businesses. | Since business loans must be repaid over time, they are shown in the company's liability column. |
| 3 . | Duration | Equity loans are often for a longer period of time, and the length of time varies widely depending on the profile. | Business loans are usually short term loans and are available for the maximum tenure of three years. However, other kinds of business financing apart from term business loans might be available for a longer tenure. |
| 4 . | Lender's Status | Investors that provide equity loans are recognised as shareholders and owners of the company. | When it comes to debt financing, financial institutions are just lenders. |
| 5 . | Risk | In the context of investors, equity financing is considered a risky investment. | In the context of a lender, debt financing possesses a low risk. |
| 6 . | Types | Shares and stocks are some of the common examples of equity loans. | Different forms of debt financing include bank loans, loans from family and friends, lines of credit, credit cards, mortgage loans etc. |
| 7 . | Pay-off Approach | When a company makes a profit, the owner is compelled to pay dividends based on the number of shares held by investors. | The borrower repays the principal amount plus interest over the stipulated time. |
| 8 . | Nature of the Repayment /Return | Returns to investors are not guaranteed and are only paid out if the company makes a profit. | Under debt financing, the financial institution sets the EMI, which includes a percentage of the principal amount as well as the interest rate. |
| 9 . | Collateral | To get an equity loan, you will need a solid business plan. | To qualify for this loan, you must have excellent credit, business expertise, and a profitable financial statement. |
| 10 . | Suitability | Equity funding is suitable for start-ups, as, in addition to cash, they require proper guidance and business networks. | Unsecured business loans are ideal for established and vintage business owners. |
| 11. | Tax Benefits | Equity financing does not offer tax benefits to entrepreneurs. | The interest you pay on your business loan is subject to tax deduction under the Income Tax Act of 1961. |
As a business owner, if you consider the big picture you will see that business loans are far superior to equity financing. They are available at a reasonable
interest rate, and you don't have to share ownership with someone you don't trust.
Also Read: Everything You Need to Know About Getting A Small Business Loan Without Collateral To Sum it Up
Equity finance loans are not suitable for all types of businesses. Before considering this source of finance for business, you should undertake extensive research and consult with your team. This type of
business finance option is appropriate for early-stage companies, companies with funding requirements of a few crores, and a business owner looking to sell out his/her company.
