Equity financing refers to the sale of a percentage of ownership in your company in order to raise funds for business purposes. Obviously this is a big step for any entrepreneur and needs to be carefully thought through before signing such an agreement. It is recommended that you seek professional advice before signing an equity agreement as there will be many new aspects of shareholding that need to be understood and you also need to be aware of how it will impact on the day to day running of your company.
Equity financing can differ tremendously in scale and scope: For example, a small business owner may sell shares in his/her company to raise anything from a few thousand Rands to a couple of million Rands, whereas a listed corporation will sell shares to investors (companies and individuals) to raise billions of Rands (for example, Google or Facebook).
Equity Finance to match your needs
Ambitious small companies that grow into successful businesses will often have several rounds of equity finance investments during their growth. There are many different types of equity financiers: most have a distinct preference for the type, size and sector focus of the companies they invest in.
How Equity Finance works
In general, businesses start by using the business owner’s savings, often with help from friends and family. Then the business reaches a stage where they need finance in order to grow; and it is at this point the business owner looks for early stage equity finance partners.
Equity financiers who invest in early stage businesses, often called Angel Investors, are really picky about who they’ll invest in. They have a lot to lose since such a high percentage of small businesses fail in the first 5 years. Equity financiers also expect to exit from the deal at some point. This is called an exit strategy.
Very few equity finance companies are willing to invest permanently in your company. Invariably the deal is structured to include an exit clause that dictates the terms of how they will exit from the ownership of your company, how they will be paid as well as the length of time they want to invest. Payment options can include the owner buying back the shares that had been sold to the equity partners - at the price specified in the agreement. Sometimes payment for the exit of the first round of equity partners can be made when a second round of investment happens. Either way, the terms and price guidelines for exit will be clearly set out in the shareholding agreement.
Equity financiers will want to keep a close eye on the progress of the business. Expect them to at least sit on your Board and at most to be quite active in the management of the company. Again, the level and type of involvement you are willing to work with should dictate the type of equity funder you select initially.
Some of the government agency equity financiers automatically assign mentors to smaller businesses that they have invested in. Business owners have to cooperate with the mentorship program as part of the equity deal.
Types of Equity Finance
Type 1: Angel Investors and private individuals
This type of investment comes from private individuals, private companies or family and friends who are prepared to risk their money on start-ups and/or early stage businesses.
Your investor might be willing to invest in you because you already have a relationship that involves trust. However, in the case of private individuals and companies that provide seed funding for start-ups they will want to examine your business more thoroughly and insist on a due diligence before formalising the investment offer. Some investors like to be actively involved in what happens in the business, in which case your company will benefit from their expertise. Others prefer to take a back seat and let you run with it provided they receive regular feedback on financial progress. How much they invest in your business, and the shareholding structure, depends on available funds, their perception of your business and its growth opportunities and how you negotiate the deal.
Things to think about
Deciding to sell shares in your business is a big deal. Like all major decisions, you need to weigh up the positives and the negatives before making the final decision. It is also critical that you carefully select your equity finance partner to make sure that whoever will co-own your business brings additional value and business acumen that can help grow your business.
Type 2: High growth Equity
Some equity financiers only invest in high growth companies. They are looking for a 20% to 25% upwards return on their investment.
Many of these investors have minimum amounts that they will invest, this is usually in the region of R10 million to R20 million but varies from fund to fund. The assumption is that you need money for gearing and that you are on the brink of a big breakthrough. In South Africa, there are few funds that would invest this type of equity in start-up businesses, unless they believe you have a groundbreaking business concept and a strong management team. It’s just too risky.
Type 3: Equity Finance for ordinary businesses
There are equity financiers that balance their portfolio of investments to include investments in the following types of businesses:
- Sustainable small businesses that are profitable but will probably never be high growth businesses
- Lifestyle businesses
- Businesses that have a slower, but steady growth path
Generally, equity finance for ordinary businesses is more available. These investors are looking for regular, steady returns on their investment and some specialise in specific sectors as well.
Whichever investment option suits you best, it is useful to take expert advice to make sure you understand the terms and conditions of the investment and that it is fair and does not unduly prejudice you.
The cost of Equity Finance
Whilst equity finance may not cost you that much in the beginning it could be costly if your business does very well. That is, costly in the sense that you would be sharing your profits with the investors. However, you would also need to acknowledge that the growth probably wouldn't have happened if they hadn't taken the risk of investing in your company!
Costs you should be prepared to finance in order to conclude an equity finance deal include:
- Legal fees for a lawyer to assist you in structuring the equity shareholding agreement
- Costs for an accountant to perform a due diligence and also help you to value your company