What Are the Advantages & Disadvantages of Selling Stock to Raise Funds for a Small Business?
Many companies get their start with capital contributed by friends, family, and people close to the company who may provide capital in exchange for ownership in the company in the form of stock. As a business matures and begins operations, some of its capital requirements may still be met by additional sales of stock. There are several important advantages and disadvantages of using stock sales as a source of capital.
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Advantages
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Selling stock has the advantage of raising capital without incurring a corresponding debt that will have to be repaid. The investor is receiving ownership interest in the company as consideration for the investment. The purchasing shareholders are counting on the value of their ownership increasing so that when the investors need their money back, the shares can be sold at higher price..
Variable
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In order for a company to sell its stock, the stock must first be registered with the U.S. Securities and Exchange Commission. However, if the company qualifies for one or more of the exemptions from registration offered by the SEC, its shares can become available for sale in a few days to a few weeks with very little cost. The exemptions have been engineered for small businesses, which, according to the 2006 Final Report to the SEC by the Advisory Committee on Smaller Public Companies, make up nearly 80 percent of American businesses.
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Disadvantages
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In the absence of one of these exemptions, the registration process requires the company to submit extensive paperwork and disclosures which are reviewed and then commented on by the SEC. This process can take six months or more and requires the company to engage auditors, accountants and lawyers, making the process not only time-consuming but also prohibitively expensive for raising small amounts of capital.
Dilution
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Another disadvantage is the potential for dilution of the existing shares. Whenever additional shares are issued, the percentage of the prior shareholders' ownership is diminished. This is referred to as dilution. If additional shares are issued and the overall value of the company remains the same, then the value of the stock owned by the original shareholders lessens. Needless to say, this is not in the best interest of the shareholders.
Bottom Line
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Selling the company's common stock to raise capital can be an effective method of capital formation if the company qualifies for one of the three exemptions from registration offered by the SEC, and if the increase in the overall value of the company resulting from the application of that capital exceeds the loss in value to the original shareholders resulting from the dilution.
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