Equity financing can be a good way to raise cash but there are disadvantages

by • September 11, 2020 • SME LoanComments (0)126

Equity finance is way to raise capital through the sale of shares in a business, can sometimes be more appropriate than other sources of finance, eg bank loans – but it can place different demands on you and your business.

Advantages of equity finance

Raising money for your business through equity finance can have many benefits, including:

  • The funding is committed to your business and your intended projects. Investors only realise their investment if the business is doing well, eg through stock market flotation or a sale to new investors.
  • You will not have to keep up with costs of servicing bank loans or debt finance, allowing you to use the capital for business activities.
  • Outside investors expect the business to deliver value, helping you explore and execute growth ideas.
  • Some business angels and venture capitalists can bring valuable skills, contacts and experience to your business. They can also assist with strategy and key decision making.
  • Like you, investors have a vested interest in the business’ success, ie its growth, profitability and increase in value.
  • Investors are often prepared to provide follow-up funding as the business grows.

Disadvantages of equity finance

However, there are drawbacks of equity finance too. It’s worth considering that:

  • Raising equity finance is demanding, costly and time consuming, and may take management focus away from the core business activities.
  • Potential investors will seek comprehensive background information on you and your business. They will look carefully at past results and forecasts and will probe the management team. However, many businesses find this process useful, regardless of whether or not any fundraising is successful.
  • Depending on the investor, you will lose a certain amount of your power to make management decisions.
  • You will have to invest management time to provide regular information for the investor to monitor.
  • At first you will have a smaller share in the business – both as a percentage and in absolute monetary terms. However, your reduced share may become worth a lot more in absolute monetary terms if the investment leads to your business becoming more successful.
  • There can be legal and regulatory issues to comply with when raising finance, eg when promoting investments.

Besides equity financing, there are a range of financing options available when starting up or running a business. The most suitable finance option for your business will depend on many things. This includes, how much funding you need, what stage your business is at, and whether you are willing to sell a percentage of your business in return for investment.

Venture capital is type of equity finance for business

What does a venture capital investor look for? Well, it’s a bit different in focus from a lender. Venture capitalists do not want to be around forever in your business – they generally want to see an exit strategy that will see them out in about 5 years, with a high return on their investment.

The two usual exit paths are sale to another company or “going public” with an IPO [initial public offering]. Either of these paths are facilitated when your company shows good revenue growth and profitability. Unlike lending, the venture capitalist does share in profit growth.

Venture capitalists are interested in both high technology and various other industries, and they will look for a balanced management team – technology, finance, marketing, etc. – since it will take this type of management team to produce the revenue and profit growth that will drive increases in value and thus high returns.

Venture capitalists fund very few of the huge number of potential businesses that contact them every year, and most that are funded are not start-ups – they are already launched and have probably reached profitability. The venture capitalists will also probably be much more attracted to a company that includes management that has already had one or more successful launches – for the obvious reason that they know how to manage the growth for returns.

Angel investor is another type of equity financing for business
The angel investor or accredited investor is a special type of venture capitalist. Usually an individual with substantial net worth and income, he provides capital to startup companies and takes a personal stake in your venture. He might accept less control and a slower return on investment than other venture capital firms, but his investments share the high levels of risk and a potentially large return on investment so his investment criteria are similar.

Meeting angel investors and venture capitalists and matching them with investment opportunities can be difficult for 2 reasons – the sheer number of opportunities and investors, and qualifying or matching to get a good fit between investor and suitable opportunity.

Going public [IPO] may be yet another way of equity financing for business

Going public with an IPO is a complex and massive undertaking so it’s not a primary method of equity financing a business. The criteria for going public is market capitalisation of up to $300 million, excellent growth potential and an ongoing need for large amounts of capital.

Going public became a primary way of financing a large business, where profitability and growth potential are required. The actual process can take a year and consume huge amounts of two valuable resources – money to pay for all the fees and commissions, and executive time. It can be a real drain and distraction to senior management so it works mainly for companies that have established and deep management capability to “run the show” while others “ride the IPO”. If you are short of operating funds, don’t even think of IPO as a way to finance your family business out of a tight corner.

Government and other grants
Besides the usual sources for equity financing a business – debt and equity – there is the government and other grants. [A grant is different from a loan in that a grant does not have to be repaid]. Much information on these, including so-called information books and lists, is available on the Internet.

It can be a quagmire, and difficult to know if you will qualify or how much you will get [depends on program funding availability, decision of some bureaucrat, etc.] so it’s not such a reliable source, but if you have some time, you might get the seed funding you need. Like anything else with government, read and study the program criteria and make sure that your application is letter-perfect and addresses the goals of the program to which you are applying.

One of the most difficult aspects of equity financing a business is choosing just which approach is best for you. fortunately, there is lots of help available.

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