EQUITY FINANCING
Equity financing is a strategy for obtaining capital that involves selling a partial interest in the company to investors. The equity, or ownership position, that investors receive in exchange for their funds usually takes the form of stock in the company. In contrast to debt financing, which includes loans and other forms of credit, equity financing does not involve a direct obligation to repay the funds. Instead, equity investors become part-owners and partners in the business, and thus are able to exercise some degree of control over how it is run.
Since creditors are usually paid before owners in the event of business failure, equity investors accept more risk than debt financiers. As a result, they also expect to earn a higher return on their investment. But because the only way for equity investors to recover their investment is to sell the stock at a higher value later, they are generally committed to furthering the long-term success and profitability of the company. In fact, many equity investors in startup ventures and very young companies also provide managerial assistance to the entrepreneurs.
ADVANTAGES AND DISADVANTAGES
The main advantage of equity financing for small businesses, which are likely to struggle with cash flow initially, is that there is no obligation to repay the money. In contrast, bank loans and other forms of debt financing provide severe penalties for businesses that fail to make monthly principal and interest payments. Equity financing is also more likely to be available to concept and early stage businesses than debt financing. Equity investors primarily seek growth opportunities, so they are often willing to take a chance on a good idea. But debt financiers primarily seek security, so they usually require the business to have some sort of track record before they will consider making a loan. Another advantage of equity financing is that investors often prove to be good sources of advice and contacts for small business owners.
The main disadvantage of equity financing is that the founders must give up some control of the business. If investors have different ideas about the company's strategic direction or day-to-day operations, they can pose problems for the entrepreneur. In addition, some sales of equity, such as initial public offerings, can be very complex and expensive to administer. Such equity financing may require complicated legal filings and a great deal of paperwork to comply with various regulations. For many small businesses, therefore, equity financing may necessitate enlisting the help of attorneys and accountants.
In the Small Business Administration publication Financing for the Small Business, Brian Hamilton listed several factors entrepreneurs should consider when choosing a method of financing. First, the entrepreneur must consider how much ownership and control he or she is willing to give up, not only at present but also in future financing rounds. Second, the entrepreneur should decide how leveraged the company can comfortably be, or its optimal ratio of debt to equity. Third, the entrepreneur should determine what types of financing are available to the company, given its stage of development and capital needs, and compare the requirements of the different types. Finally, as a practical consideration, the entrepreneur should ascertain whether or not the company is in a position to make set monthly payments on a loan.
As W. Keith Schilit pointed out in his book The Entrepreneur's Guide to Preparing a Winning Business Plan and Raising Venture Capital, small business owners must keep in mind that the more equity they give up to investors, the more they are working for someone else rather than themselves. Some entrepreneurs tend to think of equity financing as a free loan, but in fact it can be quite an expensive way to raise capital. For a small business to make equity financing cost-effective, it must be able to command a fair price for its stock. This entails convincing potential investors that the business has a high current valuation and a strong potential for future earnings growth. Schilit recommended that entrepreneurs proceed cautiously and try to use more than one form of financing to ensure business growth. They should also compare the cost of equity financing to that of other financing options, as well as consider the ramifications of equity financing on company's current and future capital structure.
SOURCES OF EQUITY FINANCING
Equity financing for small businesses is available from a wide variety of sources. Some possible sources of equity financing include the entrepreneur's friends and family, private investors (from the family physician to groups of local business owners to wealthy entrepreneurs known as "angels"), employees, customers and suppliers, former employers, venture capital firms, investment banking firms, insurance companies, large corporations, and government-backed Small Business Investment Corporations (SBICs).
Venture capital firms often invest in new and young companies. Since their investments have higher risk, however, they expect a large return, which they usually realize by selling stock back to the company or on a public stock exchange at some point in the future. In general, venture capital firms are most interested in rapidly growing, new technology companies. They usually set stringent policies and standards about what types of companies they will consider for investments, based on industries, technical areas, development stages, and capital requirements. As a result, formal venture capital is not available to a large percentage of small businesses.
Closed-end investment companies are similar to venture capital firms but have smaller, fixed (or closed) amounts of money to invest. These companies themselves sell shares to investors, then use this money to invest in other companies. Closed-end investment companies usually concentrate on high-growth companies with good track records rather than startup companies. Similarly, investment clubs consist of groups of private investors that pool their resources to invest in new and existing businesses within their communities. These clubs are less formal in their investment criteria than venture capital firms, but they also are more limited in the amount of capital they can provide.
Large corporations often establish investment arms very similar to venture capital firms. However, such corporations are usually more interested in gaining access to new markets and technology through their investments than in strictly realizing financial gains. Partnering with a large corporation through an equity financing arrangement can be an attractive option for a small business. The association with a larger company can increase a small business's credibility in the marketplace, help it to obtain additional capital, and also provide it with a source of expertise that might not otherwise be available. Equity investments made by large corporations may take the form of a complete sale, a partial purchase, a joint venture, or a licensing agreement.
The most common method of using employees as a source of equity financing is an Employee Stock Ownership Plan (ESOP). Basically a type of retirement plan, an ESOP involves selling stock in the company to employees in order to share control with them rather than with outside investors. ESOPs offer small businesses a number of tax advantages, as well as the ability to borrow money through the ESOP rather than from a bank. They can also serve to improve employee performance and motivation, since employees have a greater stake in the company's success. However, ESOPs can be very expensive to establish and maintain. They are also not an option for companies in the very early stages of development. In order to establish an ESOP, a small business must have employees and must be in business for three years.
Private investors are another possible source of equity financing. A number of computer databases and venture capital networks have been developed in recent years to help link entrepreneurs to potential private investors. A number of government sources also exist to fund small businesses through equity financing and other arrangements. Small Business Investment Corporations (SBICs) are privately owned investment companies, chartered by the states in which they operate, that make equity investments in small businesses that meet certain conditions. There are also many "hybrid" forms of financing available that combine features of debt and equity financing.
METHODS OF EQUITY FINANCING
There are two primary methods that small businesses use to obtain equity financing: the private placement of stock with investors or venture capital firms; and public stock offerings. Private placement is simpler and more common for young companies or startup firms. Although the private placement of stock still involves compliance with several federal and state securities laws, it does not require formal registration with Securities and Exchange Commission. The main requirements for private placement of stock are that the company cannot advertise the offering and must make the transaction directly with the purchaser.
In contrast, public stock offerings entail a lengthy and expensive registration process. In fact, the costs associated with a public stock offering can account for more than 20 percent of the amount of capital raised. As a result, public stock offerings are generally a better option for mature companies than for startup firms. Public stock offerings may offer advantages in terms of maintaining control of a small business, however, by spreading ownership over a diverse group of investors rather than concentrating it in the hands of a venture capital firm.
Entrepreneurs interested in obtaining equity financing must prepare a formal business plan, including complete financial projections. Like other forms of financing, equity financing requires an entrepreneur to sell his or her ideas to people who have money to invest. Careful planning can help convince potential investors that the entrepreneur is a competent manager who will have an advantage over the competition. Overall, equity financing can be an attractive option for many small businesses. But experts suggest that the best strategy is to combine equity financing with other types, including the entrepreneur's own funds and debt financing, in order to spread the business's risks and ensure that enough options will be available for later financing needs. Entrepreneurs must approach equity financing cautiously in order to remain the main beneficiaries of their own hard work and long-term business growth.
FURTHER READING:
Barr, Stephen. "Where Cash is Anything but Trash." CFO: The Magazine for Senior Financial Executives. February 1998.
Gladstone, David. Venture Capital Handbook. Prentice Hall, 1988.
Hamilton, Brian. Financing for the Small Business. U.S. Small Business Administration, 1990.
Kelting, John. "Innovative Financing Solutions." Acquisitions Monthly. October 1999.
Schilit, W. Keith. The Entrepreneur's Guide to Preparing a Winning Business Plan and Raising Venture Capital. Prentice Hall, 1990.
Timmons, Jeffrey A. Planning and Financing the New Venture. Brick House Publishing Company, 1990.
SEE ALSO: Capital Structure ; Debt Financing