Guide: Introduction to Equity Investing
Practical information for entrepreneurs on equity investing.
What is Equity?
Equity financing is raising finance for your company by selling a share in your business to an outside party. This outside party can be a venture capital fund or venture capitalist, but also an informal investor (also called business angel or angel investor).
In the most straightforward type of equity, you as an entrepreneur do not pay an interest rate. Instead, in return for supporting your firm with capital, the investor (whether an individual or an institution) becomes a shareholder.
The financial return on equity finance for an investor either comes from dividends, i.e.: a share of your firms’ profits depending on the share and profits re-invested. Or from selling the share in your company to another investor at a higher price than the buying price. This is also called the “exit opportunity”, which usually takes place 3 to 7 years after closing the initial deal.
Private equity is capital invested in companies that are not listed on the stock exchange. This sort of capital is called “risk capital” or “venture capital”.
This difference between an angel investor and a venture capital fund is that an angel investor typically invests less than a venture capital fund: USD 150,000 on average and unlikely to make investments exceeding USD 1 million. Venture capital funds usually invest above USD 200,000.
An angel investor's involvement with a business is likely to be more informal and active than that of a venture capital fund. A venture capital fund manager is mainly a professional whose job it is to represent the investors and manage their money.
Experts support fund managers by assessing the performance of each individual business in the portfolio. Not surprisingly, the share owned in the company is usually larger in the case of venture capital funds.
The 'Price' of Shares
There is no exact way to determine the price or the value of your shares. It is up to the 'market' (i.e. up to the investors) what they will pay for it and for how much the entrepreneur agrees to sell the share in the company. The value of the shares depends on the total current market value of your company. That means 100% of the shares equals the total value of all assets - including intangible assets, minus the total of liabilities (debt). The market value of an asset, tangible or intangible, is subject to the value that an investor assigns to that asset. Thereby the market value is never an objective concept. The consequence is that investors and entrepreneur negotiate on the price.
Depending on how much capital is needed to invest, or how much shares you want to sell, you decide on a price for X % of the shares.
An example:
If your company’s assets, tangible and intangible, currently have a market value of 120,000 USD (not objective as explained) and you have liabilities (short term + long term loans) of 20,000 USD in total, your company is worth 100,000 USD. This is also called the ‘net worth’ or the total equity.
You need an extra 40,000 USD to do the necessary investment. After this investment your company’s net worth will be 100,000+40,000= 140,000 USD of which 100,000 is yours and 40,000 of the external investor. Thereby the external investor gets (40,000/140,000) 29% of the shares. The remaining (100,000/140,000) 71% is still yours.
Please note that what is explained above is a very theoretical explanation. Usually, all will be subject to negotiation.
Debt to Equity Ratio
The debt to equity ratio measures how much money a company should safely be able to borrow over long periods of time. It does this by comparing the company's total debt/loans (including short term and long term liabilities) and dividing it by the amount of owner's equity.
When seeking money for a business, an entreprenuer should consider the company's debt-to-equity ratio. The more money owners have invested in their business, the easier it is to attract financing.
New or small businesses may find it difficult to get debt financing so they turn to equity funding. Most businesses have a mix of debt and equity financing. Too little equity could prevent you from securing or repaying loans, while carrying little or no debt could indicate that you are too risk-averse, and that your business might not grow as a result. Check with your industry association to find the average debt-to-equity ratio for your sector.
Why Equity?
Why would you consider equity investment?
- You do not pay back the capital or any interest to the investor. The investor has the same motivation as you: make your business grow. The more successful your business, the higher are the profits for you and the investor. No debt/loan payments means more cash on hand. Moreover, if no profit materializes, you aren’t obligated to pay back equity contributions.
- Access to finance you would not have through conventional channels, such as expensive loans from banks, or issuing public securities.
- Independence from self-financing or finance from your friends and family, your suppliers or customers.
- After getting more equity in your company, a loan might be easier to obtain and might also be cheaper. See 'debt to equity ratio'.
- Very often an entrepreneur benefits from know how and experience of the investor.
Are there disadvantages?
- You are no longer the full owner of the business. You may have to get used to the idea that an external investor will become involved in the operation and/or management of your business. When it comes to decision making on a specific issue, you may have conflicting interests and perspectives. Valuation of very young start-up companies can also be difficult. The relationship between you and the investor should be built on 100% trust in each other.
BiD Network & Equity
What does BiD Network do to provide access to equity for entrepreneurs?
BiD Network invites you to present your plan here: www.bidnetwork.org/presentyourplan
If your plan is approved by us, we will ask your permission to present your business on Angelsoft. Angelsoft is a web-based platform connecting entrepreneurs and investors. We will guide you through this process and will try our best to find you a suitable investor and raise the necessary amount of equity. We also provide general assistance throughout the negotiation process. We aim to connect you to our local representatives as much as possible. Through BiD, you can reach out internationally, but solve potential issues locally.
What does BiD Network not do?
Although we try our best, we cannot guarantee we will find you an investor. This also depends on your flexibility and openness to different opportunities. Nor can we assure that the investment you receive will automatically lead to growth of your business.
Obtaining Equity
Once your business plan is approved and you are presenting yourself on Angelsoft, these are normally the next steps, with assistance from BiD Matchmaking:
A. Think of what you are looking for
Try to formulate for yourself what it is that you are looking for. Are you only looking for finance, or also in search of advice on, for example, management, strategy or marketing? It will help you, and the BiD Matchmaking team, if you identify your minimum requirements beforehand and if you clearly state this in your business plan.
B. Identification
The matchmaking team will seek suitable investors for your business. If an investor is interested, the matchmakers will introduce you to the investor. At the same time, you also approach investors for your business. You pitch your plan, check their interest, verify their credentials, choose the one you find most suitable and finally start negotiating.
C. Negotiation
Discuss the business plan and the role of both you and the investor in executing the plan. Decide on a term sheet or letter of intent in which you and the investor come to a conditional agreement. This includes the valuation. The valuation is the price that an investor is paying for the stock in your business. BiD Network recommends that the entrepreneur will always keep the majority of the shares.
D. Verification and due diligence
Before an investor will decide on any investments, he/she wants to verify the exact status of your business, the capabilities of the management and all other aspects to get convinced of actually investing in a promising business. Likely components of these checks are on the following:
• financial audit (development in income statement, accounts receivables/payables, financial statements, cash-flow, portfolio of orders, forecasts, and checking contracts with clients)
• management team (background, education, experience, expertise, skills, efficiency of combined team)
• corporate and capital structure
• legal contracts and intellectual property (checking the company registration documents, fixed assets contracts, employment contracts, loan agreements with employees and contracts of ownership)
• material agreements
• analysis of liability, claims and risks
• interviews with the management, suppliers and clients/customers
At the same time it is important that you assess the investor. Make sure you know about the following:
• details of the fund used for investment in your business
• motivation and expectations of the investor
• other investments made by investor (previous and current)
• usual form of interaction between investor and previous/current investees
• attitude towards other (co)investors
E. Deal closure and contracts
After the verification process, the term sheet or the letter of intent will be reviewed and can then be converted into a shareholder agreement, which includes the final valuation. The agreement also shows how the investor(s) and entrepreneur will work together.
F. Investing the capital
Once both parties have agreed with the shareholder agreement, the investor’s legal representative will in many cases make financing documents. These are based on the starting points agreed upon in the term sheet; however, they continue to specify the rights and obligations of each party. The entrepreneur’s legal representative will further review this. Once both parties agree to sign it, the investment can be made. There is a possibility that the investor will not transfer the full value of the stock at once, but after each “milestone”; after the occurrence of a progressive step forward or event.
G. Realizing Growth; Management and Clear Mechanisms
Because it is in the interest of both the investor and the entrepreneur, that the entrepreneur maximizes his growth potential, the investor is likely to desire involvement in the management of the business. This can take various forms, so it is important that the parties agree upon a cooperation that runs smoothly for both. Typically, the investor is on the Board of Directors. Important in this process is that clear mechanisms are agreed upon, i.e. with respect to financial decisions, (marketing) strategy of the business and the sharing of profits.
H. Exit: selling the shares
In order to ensure financial returns to the investor(s), an exit opportunity is likely to take place within 3 to 5 years. It is likely that the investor will first ask you, the entrepreneur, if you have any particular preferred buyer. In general, the shares in your company can be sold in various ways:
• general public sale (IPO)
• private sale to a current shareholder
• private sale to a third party
• private sale to the owner of the business
Glossary
Angel financing: is usually equity finance, sometimes debt financing, offered by ‘angel investors’ or “informal investors” for financing of - usually – early stage companies.
Angel investor or business angel: a wealthy person, usually a former entrepreneur, who provides equity finance (occasionally debt finance) to very early-stage businesses. Angel investors can usually add value through their contacts, experience and expertise.
Business plan: is a document that describes the entrepreneur's idea, the market problem, proposed solution, business and revenue models, marketing strategy, technology, company profile, competitive landscape, as well as financial data for coming years. The business plan is used to ‘sell’ the business to financiers.
Committed capital: capital committed to specific fund, but not necessarily invested yet.
Convertible loans: A convertible loan is first and foremost a loan - plain and simple. It involves borrowed money that has to be paid back with interest. Typically, the conversion feature gives the lender an option to convert all or a portion of the outstanding amount of the loan into some form of an equity position in the borrower's company.
In its most basic form, the lender has reserved the right to exchange his or her creditor position with the company to become an owner in the company. The borrower is willing to provide the lender that option in exchange for securing more favourable terms on the loan.
Deal flow: the pipeline of investment opportunities that an organization reviews in any given period.
Debt financing: a form of financing by means of debt (loans) rather than equity. A firm raises money for working capital or capital expenditures by taking out a loan from a bank or other financial institution. In return for lending the money, the individuals or institutions become creditors and receive a promise from the borrower to repay principal amount and interest on the debt within a certain time period.
Diversified funding: The process of spreading investments among various different types of securities and various companies in different fields. The aim being to reduce risk.
Dividend: Dividends are payments made to shareholders. The amount of these payments depends on the underlying earnings of the business.
Entrepreneur: the person who has possession over a company, enterprise, or venture and who thus assumes the (financial) risk of beginning and managing a new business venture.
Equity financing: raising finance for a company by selling a share in the business to an outside party. In return for supporting the firm with capital, the individuals or institutions become co-owners or “shareholders”. The financial return of equity finance comes either from dividends, a share of the firm's profits, or from selling the share in the company at a higher price than the buying price.
Equity investors (venture capitalists, funds, informal investors) typically look for SMEs with high growth potential.
Exit: is the moment that an investor/shareholder sells its share in the firm. In other words, the exit strategy is a way of "cashing out" an investment. The exit is the way most equity financing generates a return on investment. Private equity investors generally receive their principal returns via a capital gain on the sale or flotation of investments.
Exit strategies can include an initial public offering (IPO), being bought out by a larger player in the industry, a share repurchase by the company or its management, etc. You can think of the exit strategy as the first opportunity to trade an illiquid asset (shares in a private firm) for a very liquid asset (cash).
Fund manager: The person who oversees the allocation of the money present in a fund.
Grant: money given to an Small and Medium Enterprise (SME), usually for a specific project and for specific results. A grant generally does not have to be re-paid. It is often offered by (non)governmental organizations or foundations.
Incubator: An organisation designed to nurture business concepts or new technologies to the point that they become attractive to investors. An incubator typically provides both physical space and some or all of the services- legal, managerial, or technical - needed for a business concept to be developed. Incubators often are backed by venture capital firms, which use them to generate early-stage investment opportunities.
Invested capital: capital actually invested by a specific investor as opposed to the funds committed for future investment.
Investment committee: the committee of a venture capital fund that decides which investment opportunities will or will not be invested in.
Internal Rate of Return (IRR): the annualized effective compounded return rate which can be earned on the invested capital; also called the yield on the investment. A project is a good investment proposition if its IRR is greater than the rate of return that could be earned by alternate investments (investing in other projects, buying bonds, even putting the money in a bank account). Thus, the IRR should be compared to any alternate costs of capital including an appropriate risk premium.
Loan: an advance of money from a lender to a borrower over a period of time. The borrower is obliged to repay the loan either at intervals during or at the end of the loan period, usually together with interest.
Mezzanine financing: see quasi-equity
Micro Finance: is often debt finance (loans) to individuals for loan amounts commonly not exceeding USD 5000.
Minimum IRR: the minimum total return expected by the investor on each investment.
Minority share/interest: A significant but non-controlling ownership of less than 50% of a company's shares by either an investor or another company.
Private Equity: A form of financing that enables unlisted (thus are not listed on a public stock exchange) private companies to obtain the equity needed for their development. Private equity is generally illiquid and thought of as a long-term investment. As the companies are not listed on an exchange, any investor wishing to sell securities in private companies must find a buyer in the absence of a marketplace. In addition, there are many transfer restrictions on private securities.
Quasi-equity financing: (also known as mezzanine financing or subordinated debt): typically involves a mix of debt and equity financing. This is generally considered debt but having characteristics of equity capital, e.g. flexible repayment, expected higher rate of return and for the most part unsecured.
Quasi-equity financing is often more attractive to companies with more limited growth potential and/or companies that prefer not to relinquish full or partial control of the business by selling shares. It is a form of financing frequently used by SMEs.
Return on Investment (ROI): the profit or loss resulting from an investment transaction, usually expressed as an annual percentage return. ROI is a return ratio that compares the net benefits of a project versus its total costs.
Risk capital: [see also venture capital]
Rounds of financing: indicates the stage of financing of a start-up company. The usual progression is from start-up to first round to mezzanine to pre-Initial Public Offering. May be referred to as first, second and third rounds or ‘A’, ‘B’ and ‘C’ rounds.
Royalty Finance: is done by selling the rights to a percentage of revenue of a product or service in advance of the revenue being earned. Traditionally this type of finance has been common to investors in the mining and energy sectors. Recently it has become more common within technology companies. Royalties are also called income notes.
Secondary investments: A private equity secondary is the acquisition of one or more limited partnership interests or direct investments from the original investor. Such transactions are called ‘secondaries’ because the purchase and sale of the asset is occurring a second time following its original issuance.
Seed money or seed capital: the first round of capital for a start-up business. Seed money can take the structure of a loan or equity investment. Seed money provides startup companies with the capital required for their initial development and growth. Angel investors and early-stage venture capital funds often provide seed money.
Shareholder: Same as a stockholder. A shareholder/stockholder is co-owner of a business. Depending on the value of the business at the point of investment, the shareholder invests money in the business in return for an X percentage of the shares and thereby of and X percentage of the profit made during his/her co-ownership.
SME: Small and medium sized enterprises, so, excluding micro and survivalist enterprise.
SMME: Small, medium and micro enterprise.
Venture capital (also called risk capital): refers to capital invested into small and young companies in return for equity ownership. Generally speaking, venture capitalists or angel investors supply capital to companies that are small, may be start-ups, are high risk, and which could not get the funds by listing on the stock market or borrowing from banks. In return for taking the extra risk, the venture capital provider often looks for substantial equity stakes, or a seat on the managing board of the SME. Sometimes, they provide management and financial support to their investee companies, as well as just money. They will look for an exit of the company within 2-5 years, but venture capital can be invested for periods of up to 10 years in some developing countries.
Literature
Hallmark, J.B., Fernando Gonzalez Nieves, L., Pardo, S. and Hryck, D.M. Entrepreneur’s Guide to Private Equity in Mexico. Law and Business Review of the Americas. Volume 9, May 12, 2005. Retrieved online on July 28, 2008 through www.lavca.org/lavca/allpress.nsf/0/B18D52E6AD6C7BF7862572F900731735.
Lighthouse Consulting. An Entrepreneur’s Guide to Raising Private Capital. Strategy, Process, and Tools for Maximizing Success and Maintaining Focus. 2001. Retrieved online on July 28, 2008 through www.lighthouse-consulting.com/entrepreneurs_guide.pdf
Online glossaries on venture capital such as www.vcexperts.com, www.smallbusinessnotes.com, www.vcaonline.com and www.finance-glossary.com.