If you can’t bootstrap your business and fund it from your own money, you’ll need to attract investors to provide the necessary capital. For some startups, equity financing could be the key.
Equity financing can unlock serious investment in your business. With a brilliant idea, a sound business plan and passionate leadership, your startup could be an attractive proposition for investment. According to the British Business Bank a record £5.9bn was invested in small businesses in 2017 – an increase of 89% over previous years.
What is equity financing?
Equity financing is fairly straightforward. Investors buy a stake in your business, giving you cash in return for shares.
Unlike a loan, equity financing doesn’t have to be paid back, nor do investors have a right to interest or capital repayments. Instead, investors are betting that your company will grow to be highly profitable. For investors, it’s a long game: years after they’ve initially invested they can either cash out – sell their shares in your business for more than they paid for them – or reap a share of the profits.
How equity financing works
The first step is to value your business. You can’t pluck a figure out of the air and hope for the best. Investors will want to understand how you arrived at the value of your business. Tot up the value of assets and business activity, such as future orders and income, and then subtract liabilities and debts to get a value. You can also value your company based on its potential, such as forecasting profitability based on growth.
You need to value your business competitively to woo investors but it’s important to strike the right balance. Undervaluing your start up means sacrificing too big a share of future profits. Overvalue it and investors will be reluctant to put money into your business.
For example, by valuing your startup at £200,000 you could offer a percentage – say, 25% – in exchange for £50,000 of investment. Convince an investor that your business is potentially worth more – say, £400,000 – then you’d get £100,000 for the same 25% stake. Once your business starts making a profit, the investor will receive 25% of profits for as long as they hold their share of equity.
Why choose equity financing
The biggest advantage of equity funding is that the money doesn’t have to be paid back, only a share of profits. If your business fails, you won’t have to repay investors.
Equity financing is useful when other funding avenues are impractical or the amounts too small. If you can’t bootstrap or the business requires lots of money simply to get off the starting blocks, then equity funding is a viable option.
Types of equity financing
Equity financing ranges from selling parts of your business to family and friends, to attracting investment from private equity firms and angel investors.
Seed capital – This is often the first type of equity funding, usually in the £10-£30k range. Seed capital is typically given by early stage investors, such as family members, who believe in your business idea.
Equity crowdfunding – You can list your business on a crowdfunding platform such as CrowdCube and Seedrs. This lets individuals make micro investments, each buying a tiny amount of equity in your business. Together the investments all add up to a larger amount of capital investment.
Angel investors – Usually wealthy individuals, angel investors typically invest at the start of a business or in more established SMEs looking to expand. Angel investors can bring contacts, expertise and support to the table in addition to providing funds.
Private equity – Sitting between angel investors and more expensive venture capital, private equity tends to invest in small-to-medium businesses looking to grow and capitalise on their success.
Venture capital – Investors and investment firms that invest in more established businesses. Investments can be sizable, and the expectations on the business in terms of profitability and growth significant.
Get the best from equity financing
The biggest challenge with equity financing is to convince investors that your business is worth their money. Make sure you have a watertight business plan, including financial forecasts, and a firm handle on costs, income, market trends and challenges. Have a clear idea for the future of your business. For example, is the plan to grow the business and then sell it?
For investors, equity financing is a risky game. The more faith they have in your plan, your team and your operations, the more likely they are to invest. They’re also looking for big rewards, so make sure your business has the potential to scale into a highly profitable enterprise.
Thinking of starting a business? Check out our free online courses in partnership with the Open University on being an entrepreneur.
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