Financing a start-up through its initial development and into the growth phase is a key concern for entrepreneurs. Finding the right type of funding, in sufficient quantity, when it's needed is one of the biggest challenges a new business faces.
Equity financing is the process of raising capital through the sale of shares in a business. It involves giving away part of the ownership of the company to an investor buyer who will be looking for a return on their investment, and takes a variety of forms.
Investors have a vested interest in the company and will not usually require regular payments until your business becomes profitable. This means you can invest all of your money when you really need it. Equity investors also bear the risk of the business failing; they may lose their entire investment. For these reasons, the UK legislative regime has protections for investors, meaning that raising finance is a complex legal and regulatory area.
Here, we consider the different types of equity finance and the relative pros and cons of each for start-ups.
FAMILY AND FRIENDS
Pros
Quick access to cash
Friends and family are unlikely to carry out the same level of due diligence as external investors and may not require such a detailed business plan to be in place before investing.
Flexible terms
Family and friends are in it with you, not solely for themselves. They may, for example, be willing to reduce their equity stake as the loan is repaid which may allow you to maintain or increase the all-important majority stake in your company. They are also unlikely to require certain veto rights and decision-making powers which external investors may insist upon.
Give confidence to future investors Evidence of emotional initial investments can be attractive to future funders; it shows a belief in the business and a belief in your abilities by the people who know you best.
Cons
Personal business relationships
Ensure that the terms of any finance from family and friends are explicitly agreed and documented. In particular, consider whether their shares will carry voting rights, which will allow them to take part in decision-making.
What if it fails?
Personal relationships may be soured if money
from family or friends is not well spent.
No expert advice or support
External investors often provide access to their networks and own industry knowledge. Unless your friends and family have a business back, ground, you'll only benefit from the money.
ANGEL INVESTORS
High net worth individuals who invest their own money in businesses of their choice in return for shares. Generally individual business angels invest between £10,000 and £500,000 at a time. Some organise themselves into angel groups or angel networks to share experience and pool capital (allowing investment figures to reach £2m).
Pros
Know-how and business network
Angel investors often share invaluable business networks, experience and know-how with companies they invest in, helping start-ups to avoid mistakes and to focus on the important steps
Follow-up funding
Angel investors often support businesses through the path to growth and exit over a long period. They may expect to invest further in future funding rounds to achieve the most potential from the business.
Cons
Having their say
A certain level of influence over the company's decision making powers (depending on the particular agreement) may be required and they may require veto rights for certain key decisions. Angel investors may also stipulate conditions for their investment.
Exit
As the company grows, unless a specified exit route is agreed at the outset, the angel investor will retain its shares. If your business has high potential it can be costly to buy out your investor to re-gain full control at a later date.
VENTURE CAPITAL
Venture capital (VC) and private equity (PE) firms partner with institutional investors (e.g. pension funds, insurance companies and family offices) to provide finance to companies with high growth potential, in return for an equity stake. The aim of VC and PE firms is to improve the companies in which they invest in order to sell them on at a profit (typically to a strategic buyer or by public listing), generating good investment returns for their own institutional investors. VC firms generally invest in promising start-ups which require growth capital and business expertise to take them to the next level, whereas PE firms tend to invest in established businesses which require a cash injection or new strategy to move them forwards.
Pros
Know-how and business network
VC firms will have a vested interest in the business and so, like angel investors, often provide strategic guidance and share their business networks, experience and know-how.
Long-term investments
VC firms are long-term investors, typically investing for three to seven years. They are committed to building sustainable value and may advance further funding at a later stage, if required.
Cons
Having their say
Similar to angel investors venture capitalists bear a high financial risk so they will usually want a say in company decisions
Investment timing
VC firms tend to fund young companies at a later point in their development than angel investors (who often accompany the very first steps).
Investor motivations
VC firms look out for businesses that promise the highest return on investment because they are not investing their own money. Raising VC finance may therefore involve a more rigorous due diligence process.
The Equity Gap
There is an 'equity gap' between f250,000 and f2 million, where it can be difficult to secure venture capital finance because of the amount of time and effort required to appraise an investment proposition by a venture capital firm
EQUITY CROWDFUNDING
Equity crowdfunding is a new and fast-growing type of equity financing, whereby a company markets its business on a website, or "crowdfunding platform", for a specified time and with a specified funding goal, in the hope that the "crowd" (ie. the public) invest their own money in its shares.
Pros
Potential to reach millions of investors around the world
Investors need only individually invest small amounts of money into a business or idea (low-risk for them) which can then be pooled together to reach the ultimate funding target.
Easy money
Crowdfunding is a relatively quick and easy way to raise finance. You have to work on a good presentation of your idea and then spread it around the community. Most crowdfunding websites won't charge you for publishing a pitch, but may take a commission when you reach your target
Profile raising
A well delivered pitch can help to raise awareness
of your new business or idea.
Innovative finance
Crowdfunding is a 21st century addition to the equity financing market, which makes it attractive to progressive minds.
Cons
Limited expert advice or support
Crowd investors are unlikely to offer any formal business advice and support in addition to their equity investment.
Don't pitch too early
If your marketing is unsuccessful, your pitch could fail. Be mindful of the damage this could have to business reputation, brand and morale.
Protect your IP
If you haven't adequately protected your business idea before launching your pitch, it could be copied.
Micro-shareholders
Having a large number of small shareholders can complicate future company decision making and increase the housekeeping burden. It can also affect future investment opportunities, as larger investors may be reluctant to get involved if there are too many shareholders in the company.
Kathryn Saunders