Hello and welcome to FYI.
This week, we bring you the fourth installment of a five part series on business finance. It’s about equity financing as an external source of funding and continues from previous posts on bootstrapping and debt finance.
So what is equity financing?
Simply put, equity is a stake in a business; a claim to both profits and losses. Equity financing therefore translates to raising money by trading a slice of the business in exchange for financial investment. These investors agree to a permanent partnership that can only be liquidated by the sale of their stake to the original owners or other new investors. As such, equity funds are not repayable and do not attract interest payments.
What are the sources of equity financing?
During the start-up process, family and friends in some instances would want a share of ownership as opposed to granting a loan. The fund received under these terms is classified as equity finance because they inevitably become shareholders in the business. It is important to note though, that once again the absence of drawn agreements and shareholding structure has led to lots of problems with equity investments from family, especially during future refinancing stages of the business.
The second source of equity financing is Angel Investors. These are usually business-savvy, wealthy individuals that bring networking opportunities in addition to interest-free leverage in exchange for a part of the business. They are the most sought after type of investors and can come in during the early stages of the business life cycle. They not only share risk, but also increase the probability of success through their personal experiences and relationships. They are however difficult to find and demand considerably higher stakes than family and friends.
A third source of equity financing is Venture Capitalists. These are the big money investors that fund high growth businesses in a bid to sell off or go public. They also bring networking opportunities, interest-free leverage, and a wealth of industry knowledge in exchange for a part of the business. They base their decisions on the competitiveness of the management team and sometimes insist on installing theirs. They also usually require an exit strategy that is achievable in not more than 5 years.
Another source of equity finance is Government Grants. These are highly competitive funds that are sponsored by Federal or State Governments in exchange for small stakes in the business. They usually carry single obligor limits and are directed towards growing small and medium enterprises in strategic sectors of the economy. A typical example of an equity grant is the type available to entrepreneurs under the YOUWIN programme in Nigeria.
For businesses that become highly successful brands with established profitability, stable management and growing public demand for goods and services, Initial Public Offerings (IPOs) provide further equity financing opportunities. These are however guided by Government regulations and are in most cases very expensive. It is also an important part of the exit strategy for other private equity financiers such as Venture Capitalists and Angel Investors.
And how do you decide on equity financing or the source to pick?
Any decision on equity finance must be based on the understanding that while traded equity provides leverage that doesn’t carry the weight of interests nor needs to be repaid, it slows down the decision making process, reduces your control of the business and share of profits in the long run. It is for this reason that equity finance is considered by some to be more expensive than debt in the long run. However, entrepreneurs in fast growth industries, where economies of scale are crucial, understand that total ownership of a small business will not compare to a smaller slice of a larger one. For example, a 100% stake of N1million compared to a 25% stake of N100million.
For investors, the high risk of incurring losses means investments will only be tempting if the possibility of high returns exists. Businesses seeking equity finance must therefore prepare comprehensive business plans that show rapid profitability and feasible exit strategies. These strategies can range from buyouts from existing shareholders of the company, to mergers and acquisitions that target other businesses, IPOs that target the general public, and even liquidation. Venture capitalists and Angel Investors particularly pay close attention to this aspect of the business.
If you haven’t considered these exit scenarios and the other funding options discussed are not favourable for your business, we still have one last part of the series to go. So just follow our social media page(s) and get notified.
In what other ways have you used equity to finance your business so far?
Abubakar Abdullahi is Managing Principal at The Front Office NG. He tweets @ab_bakr
Editor’s Note: A version of this article first appeared in The Business Hub on 2nd September 2014.