The recently passed JOBS Act makes it easier for entrepreneurs to raise equity from outsiders by facilitating crowd funding, a process of raising money from a large number of people through social networks. But that doesn’t mean small-business owners should necessarily try to sell shares in their companies.
Seeking equity from others only makes sense if entrepreneurs stand a reasonable chance of getting it. A business owner’s scarcest resource is time. Yet, many entrepreneurs waste time trying to raise equity even though their businesses are inappropriate for such investment. External equity makes sense only if a business has the potential to generate a sizable return on investors’ money.
The returns offered need to be at least as good as investors’ other alternatives on a risk-adjusted basis. Consider the following: If investors can buy a stock mutual fund with a long-term return of 7 percent per year, and only one in five start-ups succeeds, then entrepreneurs need to provide investors with at least a 35 percent per year annual rate of return to interest them (35% X 20% = 7%).
Equity investors also want to know they can cash out someday. That means the business has to have a plan to go public, be acquired, or sell shares back to management. Furthermore, the business must provide enough information for investors to assess whether the company will be successful or not.
Most businesses lack these characteristics. Research done on behalf of the Office of Advocacy of the U.S. Small Business Administration estimated that only one in 20 companies seeking external equity is a good fit for such financing.
Even if entrepreneurs have what it takes to get an equity investment, they still should think twice. Using your own money or money generated from your business’s operations is cheaper than getting capital from outsiders, who will charge a risk premium. Similarly, debt usually costs less than equity.
Borrowing money is also better than selling equity because it doesn’t require giving up control. Equity holders don’t just get a share of a company’s profits; they also get some level of control. Debt holders, in contrast, only get the right to an agreed upon interest rate and the return of their principal.
Debt is also much easier to obtain than equity. That’s because some lenders have a strong incentive to make loans. Suppliers are the classic example. Because companies often can’t get customers to buy their products without offering them credit, nearly three-quarters of small businesses receive trade credit, a 2009 survey by the Gallup Organization found. Contrast that with Census Bureau estimates that only about 1 percent of businesses less than five years old have received an external equity investment.
Debt is also easier to obtain because it’s less risky. Not only do debt holders have a priority claim on assets in the event of bankruptcy, but the loans also can be designed to minimize the risk. Banks, for example, will readily lend money to entrepreneurs who borrow personally or personally guarantee the loans. The claim on the entrepreneur’s own earnings reduces repayment risk. In fact, Federal Reserve researchers have found that 56 percent of small-business debt is personally guaranteed.
In short, although the JOBS Act might make it easier for entrepreneurs to raise equity capital, most will still be better off sticking with debt financing.