UNDERSTANDING EQUITY
What is Equity Finance?
Equity finance refers to the sale of a percentage of ownership in your business in order to raise funds for business purposes. 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).
There are different types of equity investors – each has a preference for the stage of business growth they prefer to invest in, as shown in the diagram below:
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 (this is a thorough investigation of your business, its record keeping, business plan, research and documents) 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. Let’s explore this a bit further!
Seed Funding
This refers primarily to Angel Investors and a few selected Venture Capital lenders who provide money to businesses that are about to start or have just started. This is probably the most risky type of investment given that the decision to lend money is based only on a business idea and a detailed business plan.
Remember that these investors are hoping that the money they invest in a business will earn them even more money when they exit! Most investors will work closely with the business owner to provide support when it is needed.
What seed funders look for
- An innovative business idea. If the business idea is in a newly emerging sector (for example clean technologies) or will disrupt how an existing sector operates (for example Uber), then this will catch their interest. A disruptive business changes how that sector operates – think of how internet and mobile banking has changed how we pay our bills or how Uber is currently disrupting the taxi industry.
- An idea that they can legally protect (through a patent, copyright, trademark etc.)
- A business that can show that their research indicates a large market need for the product or service.
- A business that clearly understands their potential customers and has done enough research to convince the investor that the market needs this product or service.
- A strong business leader and team capable of building the business.
- A business that can quickly gain market share (often referred to a traction). This means they need a clear plan on how the business will acquire its customers.
- Seed funding varies in the amount that investors are prepared to lend and can range from a few thousand to a couple of million Rands.
Early stage funding
This describes a business that is registered with the CIPC, has developed a prototype of its product or service and has at least a few clients that have tested the product or service. The business is now ready to grow and needs finance in order to do this.
Venture Capitalists are the primary source of funding at this stage of business growth, although a few Angel Investors may be prepared to help. They will expect a seat or two on your board of directors and may also provide additional support to the business owners when required.
What early stage funders look for
- Proven, existing market need
- Proven client base that is hungry for the product
- Well researched markets that need the product or service
- Well researched and thought-out business plan detailing how the business will grow
- Strong leadership and an excellent management team with the experience and capabilities to quickly grow the business
- A detailed plan of how the money will be spent to achieve the growth
- Returns of at least 25% on the investment within a 3 to 7 years period. This means they would like to be paid the capital amount plus 25% compound interest!
- Early stage growth usually attracts a much high investment than seed funding and may range from R1 million to R10 or even R15 million.
Mid-expansion funding
As you can see from the diagram above, the funders of mid-expansion growth are Venture Capitalists and Private Equity companies. By now this business must be able to show that it has a strong and profitable trading history and is ready to expand its markets, preferably internationally.
Mid-expansion funding usually starts at a minimum of R10 million, but many of the private equity funders are only interested in businesses that need at least R20 million and upwards. Of course, as the amount of money they lend increases, so do their expectations. They will definitely sit on your board of directors to ensure input into the overall growth strategy.
What mid-expansion funders look for
- A Profitable company
- They often only invest in specific sectors
- Strong leadership and highly experienced and capable management team
- Sufficient resources capable of quality delivery
- Well researched markets and an acquisition plan
- Excellent governance and legislative compliance
- Businesses capable of giving them an excellent return on their investment
- Some private equity companies focus on funding highly successful family businesses that are now looking to expand
Late Mezzanine and Exit funding
Mezzanine funding is a useful form of finance for a well-established, growing business. Mezzanine capital is typically used to fund a growth opportunity, such as an acquisition, new product line, new distribution channel or plant expansion or in private business for the company owners to take money out of the company for other uses or to enable management to buyout company owners for succession purposes. Although it makes up a portion of a company's total available capital, mezzanine financing is critical to growing companies and in succession planning in recent years.
Typically mezzanine
investors are looking for between 15% and 25% return on their investment. Mezzanine funding is more expensive than bank funding, but it is not as rigid and therefore provides a flexible funding mechanism. They typically provide funding for a period of between 5 and 8 years.
What Mezzanine funders look for
- A profitable company capable of growth and providing between 15% and 25% return on their investment
- Suitable growth opportunities - These can include acquisitions, new product development, new markets, management buy-outs and so on
- Strong leadership and a capable management team
Terms associated with Equity Finance
Term Sheet - A document that sets out the terms and conditions for the investment.
Due Diligence - A thorough examination of the financials and business plans of the business. This is usually conducted by external auditing firms.
Preference Shares - This type of share is often allocated to equity shareholders. Preference shares have a fixed price and in the case of liquidation, these shareholders receive payment before that of ordinary shareholders.
Liquidation - The forced closure of a business that is in trouble. In this instance the creditors (businesses that are owed money) will receive only a small portion of the monies owing to them, as creditors are rated and employees have the first claim to be paid.
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.
Management involvement
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.
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.
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. It is important to have an experienced person guide through the first equity deal to make sure that you understand the term sheet and that the evaluation of the business is fair.
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 really 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
- Cost for an advisor to assist you to prepare the documents required by the investor
Next steps:
- Return to Different Types of Finance
- Read the Summary of Government Funds
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