Introduction
Equity finance is a way of raising funds by selling company stock to financial organizations, the general public, or institutional investors. The purchasers of shares are considered shareholders since they have obtained an equity stake in the business (Metrick, & Yasuda, 2021). Equity financing is a way of meeting an organization’s financial needs by selling its stock in return for cash. The shareholder’s stake in the company will determine how much of the share they get.
When a firm seeks equity financing to satisfy its funding requirements for diversification or development, it must prepare a document containing the company’s financial information (Bruton et al., 2015). Additionally, the business must indicate what it intends to accomplish with the cash obtained. Companies raise capital because they may have a short-term demand to repay debts or a long-term objective requiring funds for growth investments. As its development progresses, a prosperous startup will undergo multiple cycles of equity financing. Since a startup usually attracts various types of investors at various phases of its development, it may utilize different equity methods to finance its operations. This report will discuss three methods in detail; Bootstrapping, The Small Business Administration (SBA), and convertible financing. This report will clearly state the required information, advantages, and disadvantages of each method.
Convertible Financing
Convertibles are equities, typically securities or ideal shares, which can be turned into common stock. Convertibles are most frequently correlated with convertible bonds, which permit shareholders to convert one’s creditor position to an individual shareholder at an agreed amount (Dutordoir et al., 2014). Convertible note financing allows a corporation to easily raise finance without negotiating a company valuation. Investors acquire a convertible written contract in return for their money, which transforms into stock at a future stage with a stock price, equal opportunity, and control privileges determined by the investors’ money. Convertible noteholders do not own shares or even enjoy voting privileges before conversions.
There are validated and largely acknowledged styles for this type of financing, including Techstars, KISS, and SAFE. The essential differentiation is between debt and equity convertible financing templates. In an equity transaction, the note has no maturity period or cost of borrowing. There are extra shareholder conditions in a debit transaction, such as an interest rate of 6% and a maturity period of 2 years, so the shareholder has recourse if the business fails to raise successful funding round. It implies that by taking on convertible debt, entrepreneurs have to pay a huge amount at the maturity of the lease (principal and interest) if the conversion does not occur.
The discount and valuation cap are two important conditions in most convertible bonds, whether debt or equity. These function to compensate early shareholders. The valuation cap places an upper limit on the firm’s future pricing to estimate the number of shares the shareholder will obtain upon note conversion (Metrick, & Yasuda, 2021). This benefits initial shareholders if the company’s valuation exceeds the cap in the subsequent financing round. A discount (20%) is a proportional discount on the cost of each equity share paid by stockholders in the next financing round.
Convertible financing has the following advantages: this is a swift means of bringing capital money into a business since legal paperwork is light and avoids the negotiating process surrounding business valuation (less legal costs). The method permits for “high-resolution funding,” it has widely accessible discount and valuation market comparables on AngelList. It enables the delays of the dilution of founders’ control and ownership and the valuation event allowing a business to keep issuing low-cost alternatives.
Despite being one of the most effective methods for raising capital, conversion results in a dilution of control and equity. At the maturity of the notes, a substantial amount of cash will be required, and if share conversions are not initiated and shareholders call the debt, the maturity will be shortened, and the chance of default will increase. Lastly, this method creates “technical debt,” which means that the next financing cycle will be more difficult and expensive.
Bootstrapping
Bootstrapping refers to when a businessperson sets up a business with little investment, depending on personal funds other than external investments (Lam, 2010). An investor is considered bootstrapping as they attempt to start and develop a business using individual funds or the operating income of the startup entity.
Startups that bootstrap finance the business with individual money (mostly savings and credit cards). The objective of this method is to establish the brand, introduce it to the market, and ultimately use the revenue to develop the company without giving up shares to investors. Numerous businesses begin by self-financing but later realize they need to consider loans from relatives and friends, bank loans, venture financial investments, or investment firms.
Using this method to start a business is advantageous because it does not dilute the founders’ equity ownership or control. With bootstrapping, functioning lean necessitates extra diligent decision making because the business is operating on its funds (Lam, 2010). It ensures that founders remain focused on the business and not on raising funds, and it makes the business more appealing to prospective investors by demonstrating its determination and credibility.
Using this method to launch a business could result in a lack of capital and cash flow. Depending on the founder’s financial situation, bootstrapping may limit the growth rate due to a lack of capital, which may place an additional burden on the business. It may not allow founders to receive a wage, as the company is not self-sustaining if income is not quickly generated. Finally, this is not a good method for starting a business because there is no risk-sharing.
Small Businesses Administration (SBA)
The Small Business Administration (SBA) is a government institution whose mission is to stimulate economic development by aiding the nation’s businesses. The SBA’s primary function is to advise people who wish to launch and expand their enterprises (Yallapragada, & Bhuiyan, 2011). It offers a variety of resources for new and ongoing businesses. SBIC is a program licensed and regulated by the SBA that offers enterprise equity funding to new enterprises. The purpose of venture capital firms is to pool investors’ funds to spend money on new, potentially high-risk businesses. Such venture capitalists may be investment firms, pension scheme funds, or rich individuals. An investment company may have a large number of businesses and projects contending for finance at any particular time.
The SBA’s lending programs are among the institution’s most visible services, and they feature longer debt payment terms for smaller firms. Excluding loans for emergency aid, the organization does not issue loans. Instead, SBA-backed or assured loans are approved directly by lending institutions that adhere to the agency’s guidelines. SBA-guaranteed loans make it easier for small business owners to be eligible for financing (Yallapragada, & Bhuiyan, 2011). The agency also permits business owners to make smaller instalments over a prolonged period of time.
SBA loans include several benefits for business owners, including reduced interest rates, more flexible payback conditions, and bigger loan amounts. The SBA guarantees most small business loans and establishes a maximum credit rate at which creditors can charge borrowers. The SBA’s rates are linked to the federal prime rate. SBA loan rates are often better than interest or charges paid on other financing choices, given that the SBA’s actual interest rate is related to the federal prime rate. The terms of the loan are beneficial. Durations can be negotiated with the lender and are normally determined by the business strategy for which the funds will be used, but most SBA loans have longer terms than other financing sources. Finally, greater borrowing amounts are available. The SBA provides loans based on the company’s particular requirements.
Lower rates and extended periods are enticing benefits, but they come with tight underwriting criteria, substantial documentation, and lengthy application timeframes, among other disadvantages. SBA loans have some of the most stringent lending standards for small business people (Yallapragada, & Bhuiyan, 2011). Each lender has its own application procedure and authorization criteria. Most firms do not fulfil the lender’s or the SBA’s stringent lending conditions, putting many smaller firms in doubt about getting funds to continue to thrive and expand. Small business owners submit a lengthy request and substantial supporting documentation. It can take lenders weeks or even months to approve a loan request. This is a disadvantage for businesses that require immediate capital.
To sum it up, equity finance is a way of raising capital because it may have a short-term demand to repay debts or a long-term objective requiring funds for growth investments. This report entails three methods of raising equity for businesses. The Small Business Administration (SBA) guarantees most small business loans. Convertible financing implies that by taking on convertible debt, entrepreneurs take the chance of paying a huge amount at the maturity of the lease if the conversion does not occur. With bootstrapping, a businessperson sets up a business with little investment, depending on personal funds other than external investments. The mentioned methods are all important to a startup business. The SBA method is far superior for an individual when starting a business of the three methods. The approach provides businesses not only with a loan but guarantees it from the lenders. In addition, it provides businesses with strategies and plans to enable the smooth running of the business.
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