A Guide to Equity Investment
In our last blog, we discussed the primary ways that a business owner can finance the start or growth of their business. Ultimately, there are two major categories: debt or equity. The key difference between the two is that with equity financing you sell off a percentage of ownership of the company, while with debt funding you retain the ownership of the business and instead pay interest on the amount borrowed.
Within each category there are a variety of ways you can structure deals. For debt financing, the distinctions are mostly between the way the money can be borrowed, the repayment structure, and how interest is calculated. But for equity investment, the primary differences are who the investor is and how much control of the company they will receive.
While it's common to think of equity financing as a cash injection from an investor, in truth equity investment is a purchase of a portion of your company. It's important to think of it this way, because equity financing is a permanent choice with long term consequences for the company. The only way to get rid of an investor is to buy them out, usually at a significantly higher price than which they bought in.
So, what types of equity investments are available to a business owner?
SMALL BUSINESS EQUITY FINANCING
For small businesses, there are really only two types of equity financing available: Friends and Family, and Angel investment. The Friends and Family round is the most common way for a small business owner to raise startup capital, since those close to you are most likely to give you favorable terms, and are usually the easiest to convince of your business plan. However, like all equity investment, you are selling your friends and family a portion of your business, which means they will be around for as long as you own the business, or until you buy them out. When considering investment from friends or family, make sure you're comfortable with this person having a stake in your business over the long haul. As a general rule, try to give as little of your company away as possible in the beginning, since you will potentially have to sell off more as the company grows.
The other type of equity investment available to small business owners is Angel investment. Angel investors are wealthy individuals, or groups of wealthy individuals, who invest in early stage companies, with a plan to exit the business usually within 3-7 years. They tend to make investments of $25k-$500k, and are looking to get 3-7x on their money when they exit. So, if an Angel investor puts $25k into your business, they are hoping to be able to sell their shares for at least $75k in 3-7 years, usually to the next round of investors. Every Angel has a different risk tolerance, investment goal, and expertise level, so it's very important to understand where the investor is coming from before you sign on the dotted line. Most Angels are looking for a business with a solid business plan, proof of concept, and a clear path to the revenue and profit targets that will allow them to realize the investment return they're looking for. Therefore, you should have a business plan, pro forma financials, and pitch deck all ready before you start looking for Angel investors.
MEDIUM-TO-LARGE BUSINESS EQUITY FINANCING
If your business has annual revenue over $2m, you're likely looking for more than the $500k threshold of the average Angel investor, meaning you're going to have to look elsewhere for larger equity financing. Where early stage funding can be highly flexible, and subject to the whims of the individual parties, late stage funding is generally much more regimented and straight-forward. The two primary types of large equity funding (Venture Capital and Public Markets) tend to have strict investment guidelines and processes for completing equity purchases, which means the onus is on the business owner to "package" their business in such a way as to be attractive to these types of investors.
Venture Capital funds are funds dedicated to a specific investment prospectus, meaning they receive cash from individual investors or institutional investors (like retirement accounts, large institutions) and put that money toward investments in specific types of companies. They tend to make investments from $500k to $100m and are looking for specific types of companies, at certain stages, with a clear path to achieving their investment goals. Unlike Angel investors, Venture funds are usually very clear and upfront about their investment strategy (even posting it right on their website), which means you don't have to waste your time reaching out to funds that don't invest in your type of company. One thing to keep in mind when you're seeking Venture funding is that fund managers are usually very conservative and are tasked with protecting their investment above all, which means they can be very aggressive in seeking control of the company, or at least a voice in how things are managed. They usually want a significant portion of the company, and a seat on the board. This isn't necessarily a bad thing, since they often come with significant expertise on managing and growing medium-to-large businesses, and they're often just as invested in the growth and success of your business as you are.
The end of the line for equity investment is taking your company public through an Initial Public Offering (IPO). This means that shares of your company will be sold on a stock exchange and can be purchased by any interested party. This is an extremely complicated process that is usually managed by an investment bank and is highly regulated by the Securities and Exchange Commission (SEC), so going public is not a quick or simple option for raising capital.
Seeking equity investment for your business is rarely an easy process, and you always want to make sure that you're partnering with the right person or fund, so that you meet your goals and their's. If you'd like to know more about your small business' funding options, reach out to us for a free business evaluation.