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Equity funding is used to help businesses raise funds by selling shares to an investor in exchange for a cash investment.
This means that the business receives the money it needs to grow whilst the investor owns shares in the business. The investor is then tied to the success of the company.
The investor will ultimately be able to cash out if the investment is successful by various methods which could include the sale of shares or a buyout. Depending on how the investment is made, the investor may also receive dividends.
This is very different to debt financing where the business borrows money but does not cede any control of the business. In contrast, the main advantage of equity funding is that there is no obligation to pay back the funds such as when taking a bank loan and there is no immediate financial burden on the company. A business may also not be in a position to access traditional debt funding due to not meeting the necessary requirements to successfully apply for a business loan.
Businesses of course want the equity funding to be a success and therefore provide the equity investors with a good return on their investment. However, raising equity funding means losing control of part of the business and usually means giving investors a say in how the business is run. On the flipside, the right equity investor can bring more than money to the table and help drive the success of the business.
For some businesses, the choice between equity and debt will be straightforward. For example, most early stage businesses do not opt for debt financing. However, for some businesses debt financing would be preferable whilst others would choose a mixture of both to help drive growth.
Raising equity finance is not an easy task and the business will need to identify and pitch potential investors. Businesses will need a solid business plan, including well-grounded financial projections. We use a forecasting software which calculates payment terms, VAT, depreciation, interest on funding and payroll calculations if you are looking for these. The type of equity finance a business seeks will take different forms depending on the age and type of business.
We have listed below some of the main forms of equity funding:
Friends and Family
One of the most common forms of funding for very early stage business ventures is via friends and family. This can typically be by way of either an investment or a loan. This can be easier and quicker than traditional methods.
However, there are issues to be considered especially involving interpersonal relationships if things go wrong. It can be hard to treat the arrangements in the same way as a professional business relationship.
These issues can be offset somewhat by making the arrangements more official and drawing up a formal written agreement for the benefit of both parties. SEIS and EIS tax reliefs can also make the investments more attractive and reduce the financial risks of failure making the emotional aspects less of an issue.
Angel Investors and Angel Networks
Angel investors are typically high net-worth individuals who choose to invest directly in start-up companies. Angel investors provide not only financing but also usually offer their skills and experience to help grow a business in the early stages.
Investment from an angel investor would typically be the first source of investment funding a start-up will secure before moving onto a venture capital round or other funding sources. Angel investors typically invest from £10,000 - £250,000 in return for equity in the business.
Angel investors play a vital role in supplying smaller amounts of capital to companies that have not reached the minimum required level required by venture capitalists.
Angel investors sometimes work together as part of an angel network. This can allow multiple investors to work together offering the opportunity to maximise investing capacity and reduce risk.
There are a number of online investment platforms that are designed to help businesses raise small investments from a large number of investors, known as crowdfunding. Crowdfunding refers to multiple people providing smaller amounts of money rather than one or two major investors.
This type of funding can typically help new early-stage businesses to gather enough funds to start in business. In many cases investors do not receive any equity in the business for investing but may be offered a reward of some sort.
If the investment is in an equity-based crowdfunding scheme then the investor will receive a stake in return for making an investment. These investments are risky and there is also a risk that the crowdfunding platform itself may go bust. However, equity crowdfunding allows investors to diversify risk and represents a way to invest small amounts in new businesses.
Venture capital is a type of financing that investors typically provide to early-stage, innovative small businesses that are believed to have excellent long-term growth potential. This can be an essential source of finance for both the business owners looking to raise funds and the investors they attract. For many new high growth businesses this can be one of the only ways of raising capital.
Venture capital typically provides finance and advice for businesses usually (but not exclusively) in technology-based sectors such as cybersecurity, fintech, AI, educational technology, life sciences and medical technology.
Venture capital can come from a wide range of investors including high net worth individuals, investment banks and other financial institutions.
The risk the investor takes on is reflected in the equity they receive alongside the potential for an excellent return on their investment if the business develops as hoped.
Many venture capitalists want to be able to protect their investment and will want a say in how the business is run. Venture capitalists also tend to have specific niche expertise that can help accelerate business growth. It is therefore usually the case that the business will have an active venture capital investor on the board in an executive or non-executive position.
Early-stage companies often raise money in ‘rounds’ - Series A, B, C etc - which will see further investment from either the same investors and/or new ones to support the company as it grows. Finding investment can be a laborious process and it can typically take 3-9 months to raise and close a VC round.
Private equity groups are normally formed by a number of investors who combine their assets to provide investment into companies, often which are usually struggling or in distress. Private equity investors commonly take a majority share in the business to help drive growth and return the business profitability.
Private equity investors typically target businesses at a later stage than venture capital investment although there can be crossover especially for some technology investments.
The investors usually hold a medium-term view and hope to sell their stake 3-5 years after making an investment in return for a significant profit.
At Key Business Consultants, we provide unrivalled expertise and advice on raising capital, including VCTs, SEIS and EIS. Get in touch with us today to discuss any of the issues raised within this article or call us directly on 02037 282 848.