All About Equity Financing

What is Equity Financing?

Equity capital generally is composed of funds that are raised by a business in exchange for an ownership interest in your company. This interest can be in the form of ownership of common or preferred stock or instruments that convert into stock. In addition to taking an ownership interest in your company, equity investors may also participate as a member of the company’s board of directors and take an active role in managing your company. However, in comparison to debt financing, which must be repaid over time, equity financing does not have to be repaid.

Equity capital can be raised from family or from friends. However, it is most often raised from high-net worth individuals investors, commonly known as "Angel Investors" or from venture capital or private equity firms, also known as "Venture Capitalists (VC)." Generally, both angels and venture capital firms are looking for: early stage companies that can’t yet obtain bank financing; a return on their investment of at least 30-40%; and a clear strategy to be able exit the investment within 3-7 years and obtain this return.

What makes a company attractive for equity investment?

Industry – Typical companies that receive equity investment are high-growth companies, with the potential for a high rate of return, in the technology industry. These companies generally have the ability to be a market leader and often to capitalize on the "first mover advantage" – being first in a growing marketplace or industry sector.

Clear Exit Strategy – Angel investors and venture capitalists are attracted to companies that have a clear exit strategy, allowing them to obtain the return on their investment. Often known as a "liquidity event", this includes an initial public offering; private placement, acquisition or merger with another company or management-led buyout. In general, investors are looking to exit an investment within 3-7 years.

Financial Return – Equity investors are attracted to companies that clearly demonstrate the likelihood of significant financial returns. In general, these investors would like to see profit margins of more than 50%.

What do Venture Capitalist Look for?

Venture capitalists analyze business performance measures and generally evaluate future projections based on the management team.

Venture capitalists and angel investors may analyze some of the same issues as lenders when reviewing whether of not to invest in a business. These factors include a company’s past performance, the intended use of requested funds, the viability of a projected market and the quality of future projections. However, venture capitalist and other equity providers look much more closely at the features of a proposed product and the size of the market than do commercial banks.

Banks are creditors and are looking for service or product to provide sufficient cash flow and sales to ensure repayment of a loan. By contrast, equity provides are owners, holding an equity interest in a company. Their investment decision is made on the basis of whether of not a company can grow rapidly, with the potential to generate significant sales and result in large profits. They will be most interested in companies with new products or business models with the potential to see appreciation of at least 300-500 percent within seven years. Most venture capitalists make investments in the $250,000 - $1.5 million range. Investments are rarely made under this level, as it can cost several thousand dollars to undertake a preliminary review of possible investments and smaller investments often are not cost-effective.

The following are the factors venture capitalists often consider:

Management Skill – Most venture capitalists will focus on the experience and skill of the company’s management team. Venture capitalists often "bet the jockey, not the horse" – focusing on management capability, often more than products or services. In general, venture companies are looking for companies with experienced senior management, with defined roles and responsibilities and with a clear understanding of the market.

Competitive Advantage – Most venture capitalists are looking for a unique characteristic in a company’s business plan – something that provides the company a clear competitive advantage, either through the product, market or business process.

Performance History – Venture capitalists also will look at the performance history of the company making the proposal. While some equity providers look at companies that are just starting out, many more are interested in existing companies moving into new markets or expanding their services or products.

Types of Venture Funds

There are different types of venture funds, including:

Partnerships – These funds are typically established as partnerships that invest the money of their institutional limited partners. The partners typically include corporate pension funds, government pension funds, private individuals, foreign investors, corporations and insurance companies. These include venture capital funds that are focused on investing in minority businesses or minority markets.

Investment Banking Firms – These funds are usually traded in established securities, but will form investor syndicates to fund venture proposals.

Manufacturing Companies – These funds are typically designed for smaller companies as a means of increasing their research and development.

Small Business Investment Companies and Specialized Small Business Investment Companies – These funds licensed by the Small Business Administration and provide management and technical assistance as well as financing.

Mezzanine Financing

Mezzanine financing is a hybrid of debt and equity financing. It is generally used to finance the expansion of existing companies. Basically, it is debt capital, with current repayment requirements, but with rights to convert to an ownership or equity interest in a company. It is generally subordinated to debt provided by senior lenders (such as a bank) and is referred to as subordinated debt. Mezzanine financing is advantageous in that, on the balance sheet of a company, it is treated like equity and may make it easier to obtain standard bank financing.

Mezzanine financing, being a hybrid of debt and equity financing, is generally not collateralized. Often, there is a repayment obligation with mezzanine financing. It may also be riskier than debt financing and therefore is not generally available with standard commercial lenders. Mezzanine financing is typically found with venture capital companies and/or alternative lending institutions seeking a higher rate of return. Most companies providing mezzanine financing are looking for returns of 20% or higher.

To attract mezzanine financing, companies usually must demonstrate:

• Track record in the industry, with established reputation and product;
• A history of profitability, or, at a minimum, breaking even;
• A viable expansion plan for the business, whether through acquisition, broader penetration of the market, etc.

What Steps are Necessary to Find Financing?

How to obtain venture capital

Once you’ve determined that your business is a likely candidate for venture financing, the key to finding this financing is through networks. The vast majority of companies that eventually obtain equity do so through networks into the venture capital or angel community. If you do not have networks into these communities, then it is critical to begin research to identify the most likely funding sources for your business.

To begin, you must first identify the venture companies that are financing businesses in your industry sector or stage (seed financing, second or expansion financing), geographic area, etc.

Identify individuals who can assist you in your search for venture companies in your community. These often include lawyers, accountants, and entrepreneurs who have previously financed businesses. These individuals often have formal and informal networks into the venture community.

You must become actively involved in the venture networks in your community. Good sources for networking include:

Venture capital forums. There are a growing number of forums providing training and opportunities to meet venture capitalists in your local communities or on a national basis.

Regional or local venture capital organizations. These are organizations of venture capitalists in your local area. They often have networking events and/or opportunities for entrepreneurs to "pitch" their concept.

Universities with programs on entrepreneurship.

Established angel networks. These are organizations of individual investors who meet regularly to review and discuss investment opportunities.

Professional organizations, such as trade associations of lawyers and accountants .

In addition, you can obtain information on local venture capital companies in your area through trade organizations, such as the National Association of Investment Companies (firms focused on investing in minority markets) www.naichq.org and the National Venture Capital Association (trade organization for venture capitalists) http://www.nvca.org. In addition, the Small Business Administration licenses Small Business Investment Companies (SBICs), which are companies investing in small businesses; information on individual SBICs, including their sector focus, can be found at http://www.sba.gov/gopher/Local-Information/Small-Business-Investment-Companies

Requirements for obtaining Equity

In general, most companies that obtain equity are in high-growth, technology sectors that promise a high rate of return. Because equity investments are not collateralized and are riskier than debt, equity investors are looking for a high return on investment to justify their risk. These investors will generally look to new and growing market sectors or to business models with large growth potential within existing market industries.

If your business is a likely candidate for venture capital, you must prepare certain information to sell your idea. This includes a very short oral presentation; an investor-oriented business plan and executive summary; and documentation for any due diligence analysis.

Oral Presentation.In searching for venture capital, you will have to pitch your idea to potential investors, often in informal settings. To do this, you must present your business concept and reasons for a high return in a short, concise (no more than two minute) presentation. If you are then invited to make a formal presentation to a venture capitalists or group of angel investors, these presentations generally last between 5-10 minutes.

Business Plan. You must prepare an investor-focused business plan that remains current based on market or business model changes. This business plan must include the following:

• Executive Summary
• Description of the Company
• Analysis of the Marketplace
• Discussion of Products and Services
• Marketing and Sales Activities
• Discussion of Management and Ownership
• Organization and Personnel
• Funds Required and their Use
• Financial Data
• Exit Strategy

Due Diligence.

Any company looking for venture capital should anticipate and prepare for the due diligence analysis that will be undertaken by any investor. In general, investors will want to see support for the assumptions and projections that are made in your business plan and presentation and to assess any liabilities. They will review financial statements, tax liabilities and any other potential legal liabilities. They will also want to test any technology and review any licenses, patents or documentation required to operate your business. In general, if you are seeking venture capital, you should obtain assistance from an accountant or lawyer to ensure that these materials are in order.