THE BASICS #3: EQUITY

If you don't want to go into debt to finance the store, you could sell a "slice" of your "company cake" (a piece of equity ownership) to someone instead. That person could be a professional investor, friend, family member, etc. That slice would be called an equity stake, and it would entitle the new owner to that percentage of your company's current and future value.

Your company's value is based on its assets and profitability. If the business continues to grow and earns more profit, then the value of the entire company would grow too. That growth potential is called upside in the investment world. If the value of the entire company increases, so does the value of the slice. 

What does that mean? 

  • Let's say the friend you hired has the $50k you need to buy the store. She works for you, so she wants the business to succeed and keep growing. Therefore, rather than loaning you the money, she offers to give you the $50k in exchange for 20% equity in your company. In other words, she buys 20% of your business from YOU for $50k. That'd mean that she would own 20% of your cake business - she would be entitled to 20% of its assets and future growth.
  • Why would she do that instead of just loaning you the money? Why wouldn't she want to just get her money back with a little sugar on top? Because she believes that the value of that slice, her 20% stake, will be worth more in the long run than $50k plus interest. She sees more upside, or growth potential, in being an owner.
  • For example, let's say that owning the store allows you to double your business in five years. So your business is now worth twice as much as it used to be. If your friend still owns 20% of your company, then her slice of the equity cake is now worth twice as much too. She paid for $50k for the slice originally, so in this very simplified case, her slice would now be worth $100k. 

This type of equity financing happens all the time on a popular TV show. Instead of selling an equity stake to a friend, entrepreneurs offer to sell equity to a group of professional investors. If they reach a deal, the investor then owns that percentage of the entrepreneur's company and is entitled to that percentage of the upside

In either case, if the business keeps growing, good for the investor! The value of their initial investment increases. The negative for you as the business owner is that you no longer own 100% of your company. So you don't get to keep all of the potential upside for yourself. 

 

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