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.
For the purposes of this discussion, short term equity financing is defined as capital that is acquired in exchange for a portion of ownership that will be paid back in 5 years or less with the original ownership being restored in the process.
This type of equity financing approach is best suited for growth companies with good margins that can afford to pay the higher cost of capital associated and can in turn secure the capital they need to effectively grow and scale their business.
Too often business owners are hung up trying to find high risk debt that will require debt servicing which can drain cash flow and cause implosion if things don’t go exactly as planned.
At the same time, its also understandable why business owners are apprehensive about selling off part of their business and potentially giving away too much of their future.
The business financing solution to high growth, high margin situations where there’s a good probability that the plan to grow will succeed, can be satisfied by equity investors or forms of convertible debt financing that share the same objectives as the business owner, only in reverse.
For the short term equity investor, the goal is to put funds into a company in exchange for ownership and have the company execute its plans and generate the expected return in the shortest time possible at which point the money invested is paid back with a healthy return and ownership sold back to the original owners.
Short term equity investors are looking for opportunities to flip their money in and out of a business and double it or better in three to five years. They are not interested in long term ownership and the risk and administrative complexity that can entail.
Some business owners may feel that paying an investor back double what they put in as an excessively expensive form of financing. But when confronted with this opposition, I will paint the picture of the business owner sitting on some sandy beach 10 years from now, after reaping the success of getting their business scaled up to its potential as quickly as possible, and revisiting this decision to use short term equity capital. Will they really be saying to themselves, dam I gave away too much in cost of capital 10 years ago to build my wealth? Not likely.
The long term benefits can far out weigh the costs, provided everyone goes into the equity financing arrangement with a well defined beginning and end to the relationship.
When business owners are looking to raise capital through equity financing, they are planning to sell off a portion of the ownership of their business to someone else in exchange for a cash payment. This sale of ownership can be of a controlling or non controlling nature, but unlike debt financing where you pay back the money borrowed, ownership can have very long term connotations.
That’s one of the reasons why many people equate equity investing to marriage in that you’ve got to plan whether you want to be in the relationship for an extended period of time and under what conditions.
And while marriage agreements can be made going into the relationship in the form of prenuptial agreements, business financing scenarios involving equity capital should go one step further and have both an entry and exit agreement in place.
Especially for small businesses, it makes very little sense to take on an equity partner with no clear exit strategy for either partner. Many businesses get trapped in a situation where either a owner wants to leave the ownership group or the owners can’t get along anymore and someone needs to buy out the other.
Without an upfront agreement as to how an owner can exit, the process can be grueling to complete and financially damaging to both parties, but particular to the trusting and naive that get taken advantage of by the remaining owner or owners.
While any equity investment will clearly outline what you get for the cash you’re paying, it also should have its own form of prenuptial agreement and states exactly how things ARE going to end. There is no misconception here that everyone’s in it until death do us part, and even if that was the case, what happens to the ownership shares on passing? Failure to plan out the end right at the beginning is a bad idea in virtually any situation I’ve come across.
But in the hast to secure financing and the excitement of getting going or getting things back on track, the exit strategy is many times over looked or over simplified.
And the exit strategy you’re prepared to consider will also better align you with sources of financing that are better fits for what you’re looking for. For instance, there are many equity investors out there that want to double their money in three to five years and then get all their money back along with the required gain. This speaks to a very specific exit strategy that has to work for both sides at the outset of discussing the deal.
For investors that want to ride the wave of opportunity there should still be an exit plan to really protect both sides as the longer the relationship goes on the more likely something is going to happen with respect to ownership and ownership objectives.
The other part to keep in mind is that the more sophisticated the investor or investor group, the more the exit plan is going to be stacked in their favor, taking advantage of the entrepreneurs financial ignorance or sheer desperation.
So, yes equity financing is very much like marriage, but with a contract going in and one going out with the divorce or funnel preplanned.
When seeking equity financing for an existing or future business, its important to make sure you have a clear understanding of what you’re getting into.
Many times business owners are either in too much of a rush or pressed against a wall to consider the pros and cons of any equity financing options they are considering, being more inclined to take what they can get. Even if there is more time available to consider the “goodness of fit” of a potential investor into the business operation, the key issues and considerations can still be easily overlooked or glossed over.
The primary thing to remember is that taking on an investor is like marriage. You could be involved with this new person or person for a long time, and breaking up the relationship at a future point in time may not be very easy or even possible to accomplish under terms you can live with.
That being said, one of the first tenants when considering taking on an equity investor is start with the end in mind.
The reality is that anyone who gives you their money is going to want it back, so it only makes sense that the ending of any proposed investor marriage is clearly lined out from the outset in a manner that is acceptable for both parties.
From the business owners point of view, the goal may be to be able to buyout the investor at a specific point in time for a clear dollar amount, or at least for a dollar amount that is calculated by an acceptable formula.
This creates a structure where both sides can size up the value to each other of getting involved in a transaction in the first place as well as providing some level of protection to both parties.
Selling off part of your company without doing this is dangerous to say the least. Everything can seem nice and light at the start of the business relationship, but things can change radically in a very short period of time.
And regardless if the business is ahead or behind on its financial projections created at the time equity financing was secured, there is a defined process for either party to deal with any changes in circumstances or expectations.
Once the honeymoon is over, its hard to predict where the relationship will go so it only makes sense to provide both sides with a way out that doesn’t potentially kill the business in the process.
Its been written many times over that selling shares in your business and taking on equity capital in return is many ways like marriage… long term potential commitment, relationship challenges, the difficulties in breaking up, and so on.
I’m not going to recycle this analogy. Instead, I want to focus on the preamble and courtship that comes prior to the union and I want to look at it from both sides of the courtship.
From the point of view of the business owner seeking capital, the process can be many times drawn out and rather grueling. Any interest that does surface can easily be mistaken as love at first sight due to the stressed out and/or desperate nature of the those seeking capital.
Like any courtship, there should be a dating process whereby several meetings take place over a period of time to see if there is a worthwhile relationship to develop or not. Those seeking capital can develop tunnel vision over the physical (money) attributes and overlook other characteristics and flaws that should be evaluated as well.
Regardless of how tired or desperate your search for capital has become, a proper courtship should still be undertaken before jumping into bed with a potential investor. Every investor has a history, a past, a lending portfolio and strategy that one would be well advised to learn about before cashing any checks.
From the investor side that provides equity capital for an interest in a business, the same need for courtship also applies.
Investors, for the most part, are more courtship oriented, especially those that have previous investments notched in their belt and have likely seen a lot of what can happen when there is a Las Vegas type wedding ceremony between the parties soon after meeting.
An investor is far better served by playing a bit hard to get and being prepared at the outset for an old fashioned courtship. As mentioned previously, the business seeking capital is too often in a hurry and wants to get funding in place as soon as possible. These capital seekers can provide well polished presentations and convincing arguments why they should be the ones chosen to receive equity capital.
The interesting thing about courtship is that many times the applicant for capital can’t provide any great level of substance after the flurry of the initial presentation and first few dates. If an investor can find an opportunity with some real staying power over several meetings as well as being able to hold up to some background checks and story verifications, then there may be a serious relationship in the making.
While both sides can feel the pressure of outside competition competing for the others affections, in the end, goodness of fit is more of a courting process than an intense weekend fling.
For those couples that take the time to put each other through their paces, the resulting opportunities will be far more rewarding if further pursued and far less regrettable if the process of courting equity capital reveals significant blemishes and warts lurking beneath the surface that otherwise would have been overlooked or gone unnoticed until after the wedding.
Lets make a slight qualification to this post before going any further. Obviously, investors will focus their attention on opportunities that meet their criteria for industry, technology, profit potential, and so on. But after they pre-qualify the opportunity to be in the ball park so to speak, what is the most significant criteria there after that most equity investors and their advisors will apply against potential opportunities?
Answer… Strength of the management team.
And even to get more specific, the presence of some one or a team of some ones that has been involved with a similar opportunity in a similar industry with at least one other company at a similar stage in its life cycle, and successfully led these past organizations to not only meet the expectations after capital investment, but also were able to orchestrate a profitable exit strategy.
Most investors are looking to get in and get out in 5 years or less and at least double their money in the process to provide the minimum return expectation. So not only do they want someone at the controls that knows how to get things done right off the start, but also someone who knows how to cash out profitably in a reasonable amount of time.
So basically, investors are looking for a tangible financial score card that clearly shows what the key personnel have delivered in the past, and hopefully delivered more than once. Sure, holding high senior positions in profitable companies and having an impressive set of academic and professional credentials can help build the case for competent management, but if there isn’t proof of making things happen and delivering returns directly from their leadership efforts, then investors are likely to pass.
There are a number of reasons why this makes a lot of sense.
First, there are all kinds of senior managers out there that may be highly skilled at what they’re area of expertise is, but have no real experience of managing in a more raw and non linear start up or growth environment. And the business landscape is littered with all kinds of examples of high priced executives that flamed out on ventures funded with other peoples money.
Second, there is a definite learning curve to managing a fast moving venture with high expectations and lots of moving parts that have to come together quickly or fall apart. There are many executives that are capable of moving into an existing position and improve upon it or take it to the next level. But its not the same experience as building something from nothing.
And here’s something else to consider. Not only is the past management track record the most important equity financing criteria, but in many cases its at least 70% of an investors decision to proceed with the opportunity or not.
So before you spice up your presentation for the next group of equity investors you want to get an audience with, make sure that you’ve got someone you can bring along that has the type of track record to close the deal.
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.
When seeking any type of business financing for any sized business, small or large, there are four and only four uses or applications of capital. I’m going to go over each of them and why this is important to know and understand.
First of all, why is this at all important? Identifying the exact use of capital creates greater relevance in the capital procurement process.
OK, I’ll speak English. Locating suitable capital funds, either debt financing (business loans), equity financing(investor capital), or a combination of the two, will depend to some degree on how the funds will be applied in your business.
Lenders and investors can be very specific in deals they will seriously consider funding and one of their key criteria will be how the funds will be applied.
Certain applications of funds will completely remove certain lenders and investors from the mix. By understanding this at the outset, you can create greater relevance in your search to secure capital by screening out the sources of money that will automatically not be interested in your deal.
This doesn’t mean the deal is good or bad, its just not going to be relevant to certain sources of business financing. So you can save yourself a lot of time and aggravation focusing on relevant sources. There are of course other criteria that helps determine relevance, but for today let’s stick with use of funds.
So what are the 4 uses of debt financing and/or equity financing?
– Start Up. The start up of a new business venture.
– Acquisition. The acquisition of an existing going concern business.
– Expansion. The Expansion of the assets of an existing business for the purposes of growth.
– Debt Consolidation/Reorganization. The repackaging of existing and potentially new debt into a modified or new debt instrument or instruments. This predominately relates to businesses in some distress or downturn that need to either inject more capital into the business to cover losses or move short term debt to a longer term debt instrument to improve the balance sheet and security position of lenders.
Within each of these uses, there are even more specific sub uses such as:
– working capital to finance day to day operations
– short term capital to purchase and add value to inventory
– short term capital to finance accounts receivable
– longer term capital to acquire other tangible assets like equipment, buildings, and land.
– capital to acquire intangible assets
If you are seeking business financing for a start up venture, there are many sources of capital that don’t fund start ups. Identify them, and don’t waste your time asking them for money.
If you’re looking to acquire an existing business, don’t seek funds from someone providing trade credit related to working capital type assets only.
As I alluded to earlier, there are other twists to this as well as certain lenders and/ or investors will consider expansion funding, but have other criteria to determine if the deal is relevant to them (amount of funding, industry, debt to equity ratio of the balance sheet, debt service coverage, assets to be acquired, security ratio, etc.)
Each lender will have their own criteria set for each application of funds they will seriously consider. I say seriously consider because most lenders state at the outset they will look at virtually any deal to maximize their marketing efforts, but in reality, they all have a pretty narrow focus.
That’s why its important to understand how to accurately describe the business financing you seek and then qualify the universe of funding sources so that you’re only spending time with a relevant list.
But more in depth lender qualifying is a topic for another day. Stay tuned.