Equity Financing Application

“When Should Equity Financing Be Considered As A Source Of
Business Capital”

First of all, lets get clear as to what we mean by equity financing.

Equity financing occurs when ownership in a company is sold in exchange for an agreed upon purchase price.

The purchase price becomes new capital in the business and is recorded as such on the balance sheet.

In the business financing world, there are basically three general forms of financing…debt financing, equity financing, and some combination of debt and equity.

Equity financing, in many situations, occurs when a business or company can not qualify for debt financing.

Part of the reason for not being able to qualify for debt financing may be a lack of equity on the corporate balance sheet. Once this has been corrected through an equity investment, the business entity may immediately be eligible for different types of debt financing programs.

When a business is in a startup and development mode and has not generated revenues nor is cash flow positive on a monthly basis, then an equity investor is typically required to provide the cash flow necessary to complete the development process and get to a cash flow positive position.

Higher rate forms of asset based lending that provide financing debt to equity ratios higher than conventional lenders, will say that they are renting equity to the business due to the high level of debt and risk that the business is covering.

All things being equal, most business owners will prefer to debt finance their business needs as it comes at a lower cost than and equity investment in most cases, and the business owner retains ownership and control of the company.

That being said, debt financing can be difficult to manage, especially when you are working with more than one lender where the risk of being offside with some lender covenant is going to be that much higher. Debt financing sources can also demand repayment at times for no reason or wrong doing on the part of the business, potentially leaving the business owner or manager scrambling to manage cash flow.

Because equity financing is connected to ownership, its typically not always straightforward how an owner will be able to sell their shares and exit the business. Most corporations have shareholder’s agreements that outline this process, but it can still take considerable amount of time to exit and there is no guarantee that the initial investment will be reclaimed.

Equity financing in many cases is considered to be a more patient form of capital as its placement is usually connected to the future earnings potential of a given business versus existing financial returns.

The higher risk associated with speculating on future returns also demands a higher risk which is going to be expected by most any equity investor.

More and more often, we are seeing business financing solutions with both debt and equity elements where the investor/borrower is only looking to be in place for a period of three to five years, exit the business, and make a high rate of return on the capital provided upon exit.

For most start up business situations, the entrepreneur is first utilizing their own equity to get the business going, leverage debt to grow the business, and then use third party equity financing to scale out the business in order for it to reach it market potential.

So depending on where you are at in your business cycle, there can be different debt and/or equity financing solutions that are going to be more relevant to you.

The key point here is that each situation is unique and as a result most business financing solutions are customized towards available sources of debt and equity that are available and relevant at the time of need.

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Equity Financing Comes In All Shapes And Sizes

There Are Many Equity Financing Sources Out There.. Which One’s Best For Your Business?

First off, lets focus our discussion around equity financing objectives, not the exact form whether it be angel, or venture capital group, or institutional fund, or whatever.

Regardless of the form of equity financing source, what’s more important is the investor requirements or intents.

Too often small and medium sized business owners or entrepreneurs start seeking equity financing for a business venture because they either realize that they can’t borrow enough debt financing, or they need more equity in the business to leverage more debt financing.

So, effectively they’re backing into the need for equity financing in the first place, out of necessity.  And because most types of business financing capital hunts are unplanned, the business ownership group is usually in a rush due to some time pressure, perhaps even in an early stage panic mode.

As a result, the business owners are not perhaps as selective as they should be, or they don’t start the equity financing process with their objectives clearly outlined.

This is where all the different shapes and sizes of equity capital come in.

Like the business owner trying to secure capital, the investor is trying to place capital.  Each investor is going to have their own profile of industries they like, returns they expect, level of risk, business stages their interested in, and so on.

My question to the business owners looking for money is are they presenting an investment opportunity for investors they want or don’t want?

If you’re in a rush, which most entrepreneurs are, many will answer that they don’t care about the profile or reputation of the investor, they just want the money.

While this mind set and approach can create the desired results, its unlikely that the results will be optimal for the initial business owners that were trying to get equity funding, but its much more likely that things worked out just fine for the investor, especially if they are a well seasoned equity capital provider.

Let me explain.

The more of a rush you’re in and the less thought through your strategy and implementation plan are, the more likely you’re going to attract very opportunistic investors that understand their superior bargaining position and will take full advantage.  If they inject money, they will likely command a large ownership stake, likely a large controlling interest, board control, and every other kind of control their lawyers can think up.

But again, there are all sorts of variations around this theme.  The key point is, unless you know what you want and are in a good bargaining position to get it, you’re likely to see very one sided investor offers that may very well give you the money you’re looking for, but ask for close to your soul in return.

When a business ownership group or individual is seeking equity financing, they need to consider two questions before starting their courtship with potential investors.

Question 1:  How much of the company (and in what ownership form and conditions) am I prepared to offer for the capital I seek?

Question 2: Am I looking to sell off an interest in the business for the long term or for the short term only?

Question 1 has a lot to do with your bargaining power which will relate to what business stage you’re at (pure start up, pre-commercial, early stage, growth, etc.), what types of assets you own and their ability to appreciate in value and generate cash flow, your management team and their related experience to what you’re trying to do, how much capital you’ve put into the business, the related time line for making use of the capital to be invested and the payback period, and so on.

Question 2 is critical to your ability to build out your business over time according to your vision and strategy.  For example, a business ownership group or individual may be prepared to relinquish a large portion ownership, perhaps even a controlling interest, if the original group or owner has the ability to buy back the interest at some predetermined time in the future for some predetermined price or price calculating formula.

Without this sort of objective, the equity capital you raise can very well get into the be careful what you wise for category.  For example, its not at all uncommon for very opportunistic investors to aggressively buy into a company with great potential with the underlying goal of getting rid of all the original owners and managers within a few years in order to take complete control of the venture.

There are also investor financing groups who are only looking for short term investing opportunities which in many cases are no more than 5 years in length.  They typically will require a certain amount of minimal return with some upside potential based on the performance of the business.

The key here is to clearly understand what you have to negotiate with and what you’re prepared to live with before seeking equity financing.

That way you’re more likely to get something that can work for both sides and if you have to compromise, at least you’re doing it with you eyes wide open.