A company can finance its operation by using equity, debt, or both. Equity is cash paid into the business—either the owner's own cash or cash contributed by one or more investors. Equity investments are certified by issuing shares in the company. Shares are issued in direct proportional to the amount of the investment so that the person who has invested the majority of the money in effect controls the company. Investors put cash into a company in the hope of sharing in its profits and in the hope that the value of the stock will grow (appreciate). They can earn dividends of course (the share of the profit) but they can realize the value of the stock again only by selling it.
Cash obtained by incurring debt is the second major source of funding. It is borrowed from a lender at a fixed rate of interest and with a predetermined maturity date. The principal must be paid back in full by the fixed date, but periodic repayments of principal may be part of the loan arrangement. Debt may take the form of a loan or the sale of bonds; the form itself does not change the principle of the transaction: the lender retains a right to the money lent and may demand it back under conditions specified in the borrowing arrangement.
The dynamics of investing cash in a business—be it the owner's cash or someone else's—revolve around risk and reward. Under the provisions of bankruptcy law, creditors are first in line when a business fails and owners (including investors) come last and are therefore at a higher risk. Not surprisingly, they expect higher returns than lenders. For these reasons the potential outside investor is very interested in the owner's personal exposure in the first place—and the exposure of other investors secondarily. The more the owner has invested personally, the more motive he or she has to make the business succeed. Similarly, if other people have invested heavily as well, the prospective new investor has greater confidence.
The liquidity of the investment is another point of pressure. If a company is privately held, selling stock in that company may be more difficult than selling the shares of a publicly traded entity: buyers have to be privately found; establishing the value of the stock requires audits of the company. When a company has grown substantially and thus its stock has appreciated, pressures tend to build to "take it public" in order to let investors cash out if they wish. But if the company pays very high dividends, such pressures may be less—the investors hesitant to "dilute" the stock by selling more of it and thus getting a smaller share of the profit.
If the company also used debt as a way of financing its activities, the lender's perspective also plays a role. The company's ratio of debt to equity will influence a lender's willingness to lend. If equity is higher than debt, the lender will feel more secure. If the ratio shifts the other way, investors will be encouraged. They will see each of their dollars "leveraging" a lot more dollars from lenders. The U.S. Small Business Administration, on its web page titled "Financing Basics," draws the following conclusion for the small business: "The more money owners have invested in their business, the easier it is to attract [debt] financing. If your firm has a high ratio of equity to debt, you should probably seek debt financing. However, if your company has a high proportion of debt to equity, experts advise that you should increase your ownership capital (equity investment) for additional funds. That you way won't be over-leveraged to the point of jeopardizing your company's survival."
For the business owner control is an important element of equity dynamics. The ideal situation is that in which 51 percent of the equity invested is the owner's own—guaranteeing absolute control. But if substantial capital is needed, this is rarely possible. The next best thing is to have many small investors—another difficult condition for the start-up to create. The larger each investor is the less control the owner may have—especially if things get rocky down the ways.
ADVANTAGES AND DISADVANTAGES
For the small business the chief advantage of equity is that it need not be paid back. In contrast, bank loans or other forms of debt financing have an immediate impact on cash flow and carry severe penalties unless payments terms are met. Equity financing is also more likely to be available for startups with good ideas and sound plans. Equity investors primarily seek opportunities for growth; they are more willing to take a chance on a good idea. They may also be a source of good advice and contacts. Debt financiers seek security; they usually require some kind of track record before they will make a loan. Very often equity financing is the only source of financing.
The main disadvantage of equity financing is the above-mentioned issue of control. If investors have different ideas about the company's strategic direction or day-to-day operations, they can pose problems for the entrepreneur. These differences may not be obvious at first—but may emerge as the first bumps are hit. In addition, some sales of equity, such as limited initial public offerings, can be complex and expensive and inevitably consume time and require the help of expert lawyers and accountants.
SOURCES OF EQUITY FINANCING
Equity financing for small businesses is available from a wide variety of sources. Some possible sources of equity financing include the entrepreneur's friends and family, private investors (from the family physician to groups of local business owners to wealthy entrepreneurs known as "angels"), employees, customers and suppliers, former employers, venture capital firms, investment banking firms, insurance companies, large corporations, and government-backed Small Business Investment Corporations (SBICs). Start-up operations, seeking so-called "first tier" financing, must almost always rely on friends and "angels," private persons, in other words, unless the business idea has real explosive, current, fad-appeal.
Venture capital firms often invest in new and young companies. Since their investments have higher risk, however, they expect a large return, which they usually realize by selling stock back to the company or on a public stock exchange at some point in the future. In general, venture capital firms are most interested in rapidly growing, new technology companies. They usually set stringent policies and standards about what types of companies they will consider for investments, based on industries, technical areas, development stages, and capital requirements. As a result, formal venture capital is not available to a large percentage of small businesses.
Closed-end investment companies are similar to venture capital firms but have smaller, fixed (or closed) amounts of money to invest. Such companies themselves sell shares to investors; they use the proceeds to invest in other companies. Closed-end companies usually concentrate on high-growth companies with good track records rather than startups. Similarly, investment clubs consist of groups of private investors that pool their resources to invest in new and existing businesses within their communities. These clubs are less formal in their investment criteria than venture capital firms, but they also are more limited in the amount of capital they can provide.
Large corporations often establish investment arms very similar to venture capital firms. However, such corporations are usually more interested in gaining access to new markets and technology through their investments than in strictly realizing financial gains. Partnering with a large corporation through an equity financing arrangement can be an attractive option for a small business. The association with a larger company can increase a small business's credibility in the marketplace, help it to obtain additional capital, and also provide it with a source of expertise that might not otherwise be available. Equity investments made by large corporations may take the form of a complete sale, a partial purchase, a joint venture, or a licensing agreement.
The most common method of using employees as a source of equity financing is an Employee Stock Ownership Plan (ESOP). Basically a type of retirement plan, an ESOP involves selling stock in the company to employees in order to share control with them rather than with outside investors. ESOPs offer small businesses a number of tax advantages, as well as the ability to borrow money through the ESOP rather than from a bank. They can also serve to improve employee performance and motivation, since employees have a greater stake in the company's success. However, ESOPs can be very expensive to establish and maintain. They are also not an option for companies in the very early stages of development. In order to establish an ESOP, a small business must have employees and must be in business for three years.
Private investors are another possible source of equity financing. A number of computer databases and venture capital networks have been developed in recent years to help link entrepreneurs to potential private investors. A number of government sources also exist to fund small businesses through equity financing and other arrangements. Small Business Investment Corporations (SBICs) are privately owned investment companies, chartered by the states in which they operate, that make equity investments in small businesses that meet certain conditions. There are also many "hybrid" forms of financing available that combine features of debt and equity financing.
METHODS OF EQUITY FINANCING
There are two primary methods that small businesses use to obtain equity financing: the private placement of stock with investors or venture capital firms; and public stock offerings. Private placement is simpler and more common for young companies or startup firms. Although the private placement of stock still involves compliance with several federal and state securities laws, it does not require formal registration with Securities and Exchange Commission. The main requirements for private placement of stock are that the company cannot advertise the offering and must make the transaction directly with the purchaser.
In contrast, public stock offerings entail a lengthy and expensive registration process. In fact, the costs associated with a public stock offering can account for more than 20 percent of the amount of capital raised. As a result, public stock offerings are generally a better option for mature companies than for startup firms. Public stock offerings may offer advantages in terms of maintaining control of a small business, however, by spreading ownership over a diverse group of investors rather than concentrating it in the hands of a venture capital firm.
Entrepreneurs interested in obtaining equity financing must prepare a formal business plan, including complete financial projections. Like other forms of financing, equity financing requires an entrepreneur to sell his or her ideas to people who have money to invest. Careful planning can help convince potential investors that the entrepreneur is a competent manager who will have an advantage over the competition. Overall, equity financing can be an attractive option for many small businesses. But experts suggest that the best strategy is to combine equity financing with other types, including the entrepreneur's own funds and debt financing, in order to spread the business's risks and ensure that enough options will be available for later financing needs. Entrepreneurs must approach equity financing cautiously in order to remain the main beneficiaries of their own hard work and long-term business growth.
Benjamin, Gerland and Joel Margulis. Angel capital; how to raise early-stage private equity financing. John Wile & Sons, 2005.
"The Capital Gender Gap: Despite the health and proliferation of female-owned businesses, women use less commercial credit." Business Week Online. 26 May 2005.
Carter, Michael. "Private Equity Capital Update." Fairfield County Business Journal. 27 September 2004.
Nakamura, Galen. "Choosing Debt or Equity Financing." Hawaii Business. December 2005.
Nugent, Eileen T. "Join the Club." International Financial Law Review. April 2005.
U.S. Small Business Administration. "Financing Basics." Available from http://www.sba.gov/starting_business/financing/basics.html. Retrieved on 24 March 2006.