Understanding Equity Financing
Which type of funding is best for my business, debt or equity? Should it come from banks, angel investors or venture capitalists? Equity Financing
What is Equity Financing?
Equity financing requires that the business sells a portion of the business in exchange for capital. The biggest problem with obtaining equity financing is often finding investors willing to buy into the business. The second limiting factor is wrestling with the fact that you must turn at least some of the control of your business over to the equity investor.
Of the 500,000 start-ups each year, only 500 receive venture capital investments. The MAJOR source of equity for a new business comes from friends and family. Ninety percent of the investment outside of friends and family comes from angel investors.
Angel investments are similar to venture capital (discussed below) in that they are equity investments, however Angels tend to invest smaller amounts and tend to invest in younger companies than do VC’s. Angels also tend to invest close to home and can be difficult to locate.
The Angel Capital Association provides a list of angel networks across the country on their website (http://www.angelcapitalassociation.org/), but is not an actual source of equity itself.
The desired investment profile for an Angel:
- A novel (new) or disruptive business concept
- A realistic business plan
- Technological Superiority
- Realistic Valuation
As with venture capital and loans, a solid business plan must be presented to potential angel investors.
Venture Capital firms tend to be specialized in specific industries and tend to only invest in those industries.
Companies should not look for VC if they are only seeking a one time cash infusion into the business. The time horizon from introduction to funding is typically at least 12 weeks and often can take 6 months or even a year and companies interested in VC should be realistic about this. The VC firm wants to get to know the management, learn the product, understand the management team’s personalities and abilities, as well as the companies “feel” before they are ready to make an investment. VC firms see these types of deals as a marriage, not as a transaction.
VC’s are not interested in investing in companies for the sake of maintaining a current level of operation. VC’s want to invest money in companies that can realistically expect high rates of growth, 20% or more, for at least several years. Financing receivables and paying off existing debt therefore are not things that VC’s would be interested in funding. VC’s look for a long-term relationship in their investments, typically three to seven years. They take partial ownership in the business, and therefore expect to have a say in how the business is operated.
VC firms rarely invest in deals that come to them “off the street”. That is to say, they usually look more seriously at deals that are referred to them by people they know and whose opinions they trust. If a company is seeking VC, they are best off looking for an introduction from someone whose opinion the VC firm would hold in high regard (Business consultants, attorneys, CPA’s, etc).
Small Business Investment Companies (SBIC)s are venture capital firms that receive loans from the Small Business Administration to make equity investments in small businesses. Venture Capital firms do not have to be regulated, but must submit to regulation if they want to be an SBIC.