Raising the capital to finance a business is one of the biggest challenges entrepreneurs face. With many banks playing hardball, equity investors are increasingly becoming a preferred source of business financing. According to a Global Private Equity and Venture Capital report compile by Preqin, a leading source for alternative assets data and intelligence, about $551 billion (1,062 deals) was raised by private capital funds in 2015.
Yet, unlike bank loans and other forms of debt financing, entrepreneurs who want to secure capital from equity investors must give up a share of their business. Shark Tank, the popular American television series aired on ABC is probably the poster child for equity investing. Budding entrepreneurs pitch their companies to six equity investors and ask for money in exchange for equity. In true shark aggressiveness, the investors scramble for the ideas they like and very often succeed to secure more equity than the entrepreneurs were offering.
Equity investing, like any other funding option, has its pros and cons. As an entrepreneur, it is your job to evaluate both sides and determine whether the method is ideal for your business.
First, though, here are some basics you should grasp before hunting for equity investors.
The Basics of Equity Financing
Get Your Business Structure Right
From the onset, you must understand that when you give up equity, you are essentially inviting new owners into the company. The business structures that give room for equity investors include:
- General partnership – In general partnerships, all partners conduct the business jointly and they are wholly and equally liable for the financial obligations of the outfit. If the company falls into debt, the partners have no ability to protect their personal assets. It’s a simple arrangement that doesn’t cost much to set up.
- Limited Partnership – In a limited partnership, there is one (or more) general partner who runs the day to day affairs of the business, and another (or more) who doesn’t participate in its operations. General partners have unlimited liability for the debts of the business while the liability of limited partners only extends to the level of their participation.
- Limited Liability Company or Private Limited Company – An LLC or PLC is a business structure that legally protects the owners from any liability. The company is recognized as a (legal) person, and is thus responsible for its debts and obligations.
- Corporation – Like LLCs, corporations are legal persons that can enter into contracts, hire staff, pay taxes and reach out to potential equity investors. The shareholders who are not involved in running the company are free of liability.
Your structure can affect your ability to attract potential equity investors. If you want to form a general partnership with an equity investor, for instance, you may find a hard time finding one, because the arrangement makes investors personally liable, should the enterprise fail. Many investors prefer pumping money into LLCs and corporations.
Understand Securities Laws
Do you need to learn securities laws if you have ownership interests in a partnership, LLC or corporation? Generally, these laws regulate the registration and trading of shares and other financial instruments on various public and private stock exchanges. They also ensure accurate financial reporting by traded companies, seek to eliminate fraudulent activities such as insider-trading and proxy solicitation, and ensure transparency in the ownership and management of companies. If your company is an LLC or a corporation, it is advisable to understand securities laws, and it is even more imperative to do so if you intend to take it public.
Pros of Equity Investors
Provide Access to Vast Growth Capital
Equity investors are typically high-net worth individuals who have an interest in rapidly steering startup companies to success and then selling their stakes. If your business has a high-growth potential, you stand a higher chance of securing enough capital from equity investors while retaining a substantial amount of equity in the company. It is common practice for business owners to approach their existing equity investors to request for more funding for purposes such as expanding operations and financing the inventory. As long as your investors are certain the business is on an upward trajectory, they won’t have a problem buying more shares or even extending you a line of credit at lower interest rates than the current market rate.
Bring Expertise and Connections into the Business
Lack of sufficient management expertise is one of the reasons why new businesses fail. Driven by the desire to achieve a dream and become overnight millionaires, many entrepreneurs make ill-advised decisions that cost the business down the line.
When investing in a venture, equity investors know very well that they stand to lose their money should the things go south. To prevent this from happening, they typically provide management expertise to the companies they invest in. Sometimes they do so personally, and other times they send over professional managers to provide support.
Beyond the expertise and experience, equity investors bring in an extensive network of industry connections. In Shark Tank, we see the sharks promising entrepreneurs that they will get their products on stores that are otherwise unreachable to the average person. In some cases, the fact that a business is associated or backed by a well-known investor is enough to give it a head start in the market. In short, equity investors can open countless doors of success to a business.
Reduced Pressure to Make the Business Profitable
Business debts must be repaid, regardless of whether the enterprise is making a profit or not. When you default, the lenders won’t hesitate to move in and claim your assets. To avoid such scenarios, business owners are under immense pressure to earn profits and meet their financial obligations. With equity financing, the situation is a bit different. Although it is in the best interest of everyone that the enterprise succeeds, there is little pressure to grind out a profit, since you have no obligating to pay the shareholders until the business is profitable. If the business fails, your investors won’t come knocking on your door asking for their money. Everyone counts their losses and moves on.
The Cons of Equity Investors
Possibility of Losing Ownership
There are real stories of business founders who no longer own even a piece of the companies they built from scratch. This is a likely result of equity financing. Strapped for cash, some entrepreneurs keep dishing out equity in their companies until they are left with none, or so little that they can’t influence the business. There is probably nothing as painful as losing ownership of a company that you are passionate about; a company that you probably started in a backyard.
When you choose to go the equity financing way, you should be a competent negotiator. Know the value of your company, give away as little equity as possible to each interested investor and always strive to keep majority ownership. Sometimes, though, a reduced shareholding isn’t necessarily loss of value. Owning 1 percent of a potential billion-dollar company is more valuable than owning 51 percent of a $1 million company that has little prospects of further growth.
Too Many Captains
Even if you retain majority of your ownership, your investors have a right to influence the day to day operations of the company. You can no longer hire personnel for key positions or enter into contracts without getting their nod. In fact, they have a right to vote to elect a board of directors and you must keep them updated on major business events.
This is perfectly okay. As long as you and your investors are on the same page regarding the general direction the business should take, problems shouldn’t arise. However, when you deal with way too many investors, it becomes more difficult to agree on various issues. Having too many captains in the cockpit of your business gives rise to conflicts of interests, and those who feel their views aren’t being considered can sue you or the company. The best way to prevent this is to give away larger equity stakes to a small pool of investors, instead of dishing out small bits to everyone who shows interest in the company.
Need for Through Background Scrutiny
Successfully pitching your business to prospective equity investors or venture capital firms isn’t an easy task. You must justify your valuation of the company and answer a truckload of questions. And when you finally land one, he or she will require an extensive scrutiny of your past business activities, as well as your personal background. This can be quite time consuming and demanding.
As you already know, equity financing, whether private or public, is regulated by securities law. These laws vary from jurisdiction to jurisdiction and are often complex in nature, so you may need to secure the services of a securities lawyer to guide you through various compliance issues. Violating security laws can lead to costly lawsuits, fines and even jail term.
Finally, equity financing can be a double-edged sword depending on your choice of investors. They can lead your business to massive growth and make you a millionaire or billionaire in the process, or they can aggressively buy into your company leaving you with a small piece of the cake or nothing at all. Be smart and always advise your potential investors to check with their advisers to evaluate the risks involved in the investment.