Hi, fellow entrepreneurs! If you’re thinking about starting your own business, or if you’re in the beginning stages of planning your finances, it’s important to understand the different types of funding that are available and commonly used. You have a few different options when it comes to raising capital for a business, but the two fundamental elements of funding (or “capitalizing) a business are through the use of debt and equity. Almost every business utilizes a combination of both, and there is quite literally an ideal debt-to-equity ratio for every firm based on the goals and structure of the business at a given time. Debt is a more familiar term (credit cards! loans!) but “equity” is often tossed around and I realized that the meanings and uses of the word weren’t always clear. So, we’re diving into the concept of equity today with a primer designed to make the topic approachable and easier to navigate. Today, we’ll go over the private and public components of equity and define their key differences.
Private equity is an umbrella term referring to the practice of institutional or accredited individual investors using capital to buy companies, make them better, and then eventually sell them. I like the way @getxipi put it simply, “Private equity is really just a complicated way of saying that a bunch of people put their money together to invest in a business. This money usually comes from high net worth individuals or funds of people. Private equity firms pool this money together and make these investments.” Venture capital is a good example of private equity—more on that here!
Public equity is essentially the opposite of private equity. It’s what we know as stocks (you might have a portfolio with “shares” of Coca-Cola, Alphabet, or more recently – Slack!) which are traded on publicly visible exchanges, like the New York Stock Exchange. In general, public equity investments are seen as less risky and are more readily available for all types of investors. The biggest difference is an investor could log online to their money market account at an institution like Schwab or Fidelity, and place a trade. Private equity is harder to access and requires specific relationships in order to invest in a company that is not available on a public exchange. Another benefit to investing in public equity is its liquidity, as most stocks that are traded publicly are available and can be easily traded through public market exchanges.
Perhaps an easier way to think about public and private equity is to think about it in terms of the companies you know and love. Pepsi is a public company whereas Sarah Flint is private, Delta Airlines is public, but Away Luggage is private. A company must conduct an IPO to transform from a private company (with private funding) to a public company (with funding from “the public” via transactions on publicly-accessible exchanges, like the New York Stock Exchange).
When starting a company as an entrepreneur, your funding options are either debt (like a credit card, or a loan from a person or bank – if your business has revenues) or a form of private equity. SO…
We’ll discuss the role debt plays in raising capital for a business in the next post, but if you’re at all lost on the difference between equity and debt, this will help: Equity is the ownership of shares in a business, which can increase in value over time (like a stock!) and they can of course decrease in value. Debt is simply a loan, and lenders make money from interest.