Equity Investment Agreement: Everything You Need to Know
An equity investment agreement occurs when investors agree to give money to a company in exchange for the possibility of a future return on their investment.3 min read
2. When Does Equity Fundraising Make Sense?
3. Pros and Cons of Equity Investment
Updated November 9, 2020:
An equity investment agreement occurs when investors agree to give money to a company in exchange for the possibility of a future return on their investment. Equity is one of the most attractive types of capital for entrepreneurs, thanks to wealthy investor partners and no repayment schedule. However, it does require the most effort to find it. Fundraising with equity means that investors offer money to your company in exchange for a stake in the business, which presumably will become more valuable as your company gains success.
How Does Equity Fundraising Work?
During the initial stage of fundraising, you'll determine a specific valuation of your company. In other words, you'll decide what your business is worth at that time. According to your company's valuation and the amount of money an investor gives to your company, they will own a percentage of stock in it. Once your company goes public or sells, they will receive back compensation in the same proportion that they invested.
For example, say the founders of Magnificent Puzzles have chosen to transform their small business into an international chain, and they are seeking $500,000 in equity investments. The company has been valued at $2 million. The venture capitalist firm Equity Excitement decides to invest $250,000, which means they will earn 12.5 percent equity in Magnificent Puzzles. In the future, when Magnificent Puzzles doubles in value, the value of Equity Excitement's initial investment will have doubled as well. Equity Excitement's investment is now worth $500,000.
When Does Equity Fundraising Make Sense?
Under some circumstances, equity fundraising makes the most sense. In other circumstances, it is the only realistic option for a business. A few of these situations include:
- Your company needs a long time to establish itself. Not every company will start producing income as soon as it's launched. Some might spend a couple of years in the negative before generating income. That doesn't necessarily mean the company isn't viable. If you need a large chunk of operation cash to run your company before it begins turning a profit, equity investments are the type of capital that makes the most sense.
- Your company has zero collateral. Lenders require borrowers to offer something of value as collateral in case they are unable to pay back their debt. If you are unable to offer a lender that security, your best fundraising option is to locate equity investors who agree to take a chance with your company. If the business fails, they will have lost their investment.
- You can't bootstrap. Most investors expect you to launch your business before you invest, even if it's just from your garage or spare bedroom. However, some companies (a private yacht line, for example) require massive funds just to start.
- Massive growth is imminent. Equity capital investors tend to invest in companies and industries that have the potential for huge growth and exponential returns. Your local bookshop may be successful, but it lacks the potential to become the next Fortune 500 company. However, if you intend to build the next Barnes and Noble chain and your plan and vision support that type of growth, investors may very well be interested in jumping on board.
Pros and Cons of Equity Investment
Like all forms of fundraising, equity investment has both advantages and disadvantages. One of the most beneficial characteristics of equity investment is that unlike regular bank financing, it does not require any regular payments. Investors look forward to a future opportunity to cash out their share of the profits. Another advantage is that equity investors (especially those known as "angel investors") can offer valuable advice and guidance that will support the growth of your business. Also, it's often easier to acquire early investments from your family and friends because they share your excitement in your success.
On the other hand, accepting investment funds from family and friends may create tension in the relationships, especially if you are unable to offer a return on their investments. Locating the right investor may also take much more time and effort than applying for a loan. Long-term business complications may also exist when you take equity investment. If you hand over a large chunk of equity in your company, you give up your exclusive control over both current and future business decisions.
If you need help understanding an equity investment agreement, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.