Business Funding – Equity financing explained
Equity Financing
Equity financing requires that you sell an ownership interest in the business in exchange for capital. The most basic hurdle to equity financing is finding investors who are willing to buy into your business; however, the amount of equity financing that you undertake may depend more upon your willingness to share management control than upon the investor appeal of the business. By selling equity interests in your business, you sacrifice some of your autonomy and management rights. The effect of selling a large percentage of the ownership interest in your business may mean that your own investment will be short-term, unless you retain a majority interest in the business and control over future sale of the business. Of course, many small business operators are not necessarily interested in maintaining their business indefinitely, and your personal motives for pursuing a small business will determine the value you place upon business ownership. Sometimes the bottom line is whether you would rather operate a successful business for several years and then sell your interests for a fair profit, or be repeatedly frustrated in attempts at financing a business that cannot achieve its potential because of insufficient capital. Here are the most common small business options for equity financing:
Venture Capital: Venture capital (“VC”) firms supply funding from private sources for investing in select companies that have a high, rapid growth potential and a need for large amounts of capital. VC firms speculate on certain high-risk businesses producing a very high rate of return in a very short time. The firms typically invest for periods of three to seven years and expect at least a 20 percent to 40 percent annual return on their investment.
Venture capital firms are located nationwide, and a directory is available for $125 through the National Association of Venture Capital http://www.nvca.org , 1655 N. Fort Meyer Dr., Arlington, VA 22209, (703 524-2549). In addition, other sources for venture capital can be found through bankers, insurance companies, and business associations.
Small Business Investment Corps.: The federal government sponsors its own public venture capital organization through the Small Business Investment Corporation (SBIC) program. An SBIC is a privately owned and operated small business investment company that partners with the federal government to provide venture capital to small business. Using a combination of private funds and funds borrowed from the federal government, the SBICs provide equity capital, long-term loans (up to 20 years, with a possible 10-year extension), and management assistance to eligible small businesses. Loans and securities for less than five years are unusual and the cost of money on loans and debt securities is regulated by the Small Business Administration.
Private Investors/Business Angels: A less-formal source for external equity financing is through private investors, called “angels,” who are seeking new business investments for a variety of economic and personal reasons. Angels can be a very good source of money if you are looking for outside investors but you are not interested in, or not a likely target for, a venture capital firm. Although angels tend to be less demanding in their financing terms than venture capital firms, you should still exercise great caution in ensuring that your “angel” financier doesn’t turn out to be a devil in disguise. Some angels may offer loans at very low interest rates simply to help a new business or the community; others may expect specific rates of return on an equity investment.
**The US Small Business Administration helps you find funding to start or grow your small business.**
Initial Public Offerings: You may have read about how some small company became an overnight success story by deciding to “go public” through an initial public offering (IPO) of its stock. Going public simply means that a company that was previously owned by a limited number of private investors has elected, for the first time, to sell ownership shares of the business to the general public. The public sale of ownership interests can generate funds for working capital, repayment of debt, diversification, acquisitions, marketing, and other uses. In addition, a successful public offering increases the visibility and appeal of your company, thereby escalating the demand and value for shares of your company. Investors can benefit from an IPO not only because of the potential increase in market value for their stock, but also because publicly-held stock is more liquid and can be readily sold if the business appears to falter or if the investor needs quick cash.
Nevertheless, IPOs largely remain a financing option limited to rapidly growing, successful businesses that generate over a million dollars in net annual income. The use of IPOs is limited primarily because: (1) there is a very high cost and much complexity in complying with federal and state laws governing the sale of business securities (the cost for a small business can run from $50,000 $500,000); (2) offering your business’s ownership for public sale does little good unless your company has sufficient investor awareness and appeal to make the IPO worthwhile; and (3) management must be ready to handle the administrative and legal demands of widespread public ownership. Of course, an IPO also means a dilution of the existing shareholders” interests and the possibility of takeovers or adjustments in management control are present.
Alternatives to Going Public: While many small businesses sell interests in their companies that are “securities,” as defined by federal or state laws, the transactions are often exempt from registration regulations because the offerings are sufficiently small in dollar amount, and they are restricted to a limited number and/or type of investors. These exempt offers of securities are called “limited private offerings” and they can avoid much of the cost and delay of a public offering. Unfortunately, to qualify for any of the exemptions, you must fit the criteria for both federal and state security laws.
Franchising: “Franchising” is the transfer of the right to sell a trademarked product or service through a system prescribed by a “franchisor,” who owns the trademark. Franchising has been one of the fastest growing areas of new business development during the last 15 years and there are currently over half a million franchise businesses in the U.S. While traditional franchise businesses such as gasoline stations, auto dealers, and soft drink bottlers continue to grow, the most rapidly expanding industries for franchises are service businesses involving recreation and leisure activity and business services. Franchise arrangements are usually either: (1) product and trade name franchises or (2) business format franchises. The former involves product distribution arrangements within a specified geographic territory. For example, a gas station can be a product and trade name franchise. A business format franchise includes not only a product and trade name, but also operating procedures such as facility design, accounting and bookkeeping procedures, employee relations, quality assurance standards, and the overall image and appearance of the business. For instance, restaurants and convenience stores are often business format franchises.
ESOP’s: You may be able to find equity financing within your own company if you have employees and you are willing to share some ownership control with them. An Employee Stock Ownership Plan (ESOP) is a qualified retirement benefit plan in which the major investment is securities of the employer’s company. In an ESOP, employees can purchase shares of stock in the company by paying cash or by agreeing to reductions from salary or benefits. The employees become part owners of the business and you have additional funds for other business purposes. In addition, the company contributes to the ESOP by either making an annual cash contribution to the plan for the purchase of company securities or by directly contributing stock to the plan. Either way, the company’s contribution results in the cash price of the stock being returned to the company. The company gets a tax deduction for the ESOP contribution while effectively retaining the cash.