Equity Financing - Piece of the pie

Equity Financing: The Advantages and Disadvantages of Each Finance Option

A brief overview of the different types of equity financing options available to business owners and the advantages and disadvantages of each option, including venture capital, private equity and angel investors.

Equity Financing involves selling shares of your company to investors in exchange for capital. In contrast to debt-financing, you don’t have to make regular repayments or repay the full amount borrowed and the risk to you can be lower than debt financing.

The biggest disadvantage of equity financing is that you dilute your level of ownership of the company, and you lose a lot more control over your business and decision-making.

At the very least you will be expected to produce regular management reports for investors, but often you will have to create a seat on your Board for the investors to keep an eye on your progress.

The amount of control and ownership you give up will depend on the type of equity financing you choose.

Here is a brief overview of the different types of equity financing options that are available to business owners and the advantages and disadvantages of each option…

Institutional Investor

Associated Companies

One option to quickly raise finance for your business is simply to find an institutional investor who is willing to buy some of your equity in return for capital.

As a business owner, you don’t have to sell all your company shares to realise a return – you can sell a proportion of your equity and maintain control of the business.

As you’ll see, there are many ways to finance your business by selling equity, but the simplest option is to find an individual investor to buy a portion of your company.

There’s a misconception that ‘Angel Investors’ are only for start-ups, but there are many institutional investors looking to buy stakes in mature businesses.

Angel Investor

Questions

This involves selling shares in your early-stage company to a wealthy individual (or individuals) who is willing to provide capital in return. For many early-stage businesses, an angel investor can be the only way to gain large amounts of funding.

One of the main advantages of getting finance from an angel investor is that they often provide valuable expertise, advice, mentorship, and valuable connections to the business beyond just their financial support.

An angel investment can also validate your business idea and increase your credibility with other potential investors. There are also tax incentives available to angel investors to encourage this type of equity financing.

It’s also true that angel investments are often less structured and less demanding than venture capital investments.

But angel investors are not charities! They will want to see fast growth, performance targets achieved and a return on their investment. And as with most equity financing options, taking on an angel investor means giving up some ownership and control over your company.

The angel investor is likely to want a say in how the company is run and will expect regular updates and management reporting from the business owners. This can be time-consuming for an early-stage business owner, although good management reporting is crucial with or without an angel investor.

As far as possible before an investment, the angel investor and business owner need to ensure that they have a shared vision for the future of the company and that their goals are aligned because when these are not aligned, there is a high potential for conflict.

Venture Capital

Reviewing Performance

Venture Capital fundraising involves selling equity in your business to a venture capital firm in return for capital.

Venture capital firms typically make investments in companies in the early stages of development but with very high growth potential and clear scalability. Risk is high to the venture capital firm, but so is the potential reward.

Venture capital firms will usually bring in sector experts to your business and have an extensive network of contacts, so as a business owner, you gain valuable resources, strategic advice, management support and connections as well as funding. This can help to minimize your risk, increase your chance of success, and help you to avoid many of the mistakes that early-stage businesses make.

You may also benefit from the venture capital firm’s reputation in the market when undertaking additional funding rounds.

But the venture capital firm will expect high growth and a significant return on their investment, and with this growth expectation comes a large amount of pressure on the owner and management team.

You will also lose a significant amount of control over your business, as venture capitalists typically take an active role in the companies they invest in and may want to make major decisions about the direction and strategy of the business.

You may also have to give up a larger proportion of your business than you want, and if you need to raise additional funding in the future, your ownership stake could be diluted significantly more.

Private Equity

This is another form of equity financing where you give away significant equity in your business to a private equity (PE) firm, in return for large amounts of capital.

In contrast to venture capital, private equity investors typically invest in well-established, more mature businesses that are looking to grow to restructure their operations. This means their investments are often less risky than venture capitalists.

The focus of a PE firm is usually on buying out existing shareholders, improving operations, quickly increasing the value of the company, and selling the company for a profit.

As a business owner, you will have to give away significant amounts of control and equity. PE investors usually want to take a majority stake in the business, whereas venture capitalists will typically only want a minority stake.

One primary advantage of private equity financing is that you don’t just gain funding, you gain a network of advisors to support you and your management team, and your chances of further success are greatly improved.

Selling to private equity also enables you to realise the value of some of your shareholding.

The biggest disadvantage of PE funding is that you must give up a significant amount of control over your business and must agree to strict terms and conditions. A PE investor’s primary objective is to make your company worth more than it was when they bought it, and many business owners struggle with the short-term outlook of a PE firm rather than the long-term strategic view they may have taken prior to the PE firm’s involvement.

PE firms will also expect to take an active role in the companies they invest in, and usually they will expect a seat on your Board. They may also take control over major decisions, including the direction and strategy of the business. At the very least you’ll be expected to provide detailed reporting about your performance against rigorous targets.

Initial Public Offering (IPO)

This form of equity financing involves selling shares in your company to the public, raising significant amounts of capital for the business to spend on growth and other strategic initiatives, and providing liquidity to existing shareholders.

As well as raising large amounts of capital, an IPO can significantly increase the public awareness of your brand. It can also increase the credibility of your company, as you will have gone through a rigorous process of regulatory scrutiny in order to list publicly.

However, an IPO is not to be considered lightly. Going public is a complex and expensive process. You will also need to spend significant amounts of money on accounting, advisory and legal fees which will continue once your stock is listed publicly.

Once you become a public company, you will also have to comply with many regulatory requirements and financial reporting obligations which you don’t have to do as a private company. You will also be expected to disclose operational and financial information to the public which you might have wanted to keep private.

As an owner, issuing shares to the public also means you lose a significant amount of control over the company.

The value of your shares will be impacted by market volatility and fluctuations that will often be out of your direct control. Finally, many public companies develop a short-term focus, driven by quarterly earnings expectations, rather than a long-term strategic planning focus.

Employee Stock Ownership

Management team meeting

An Employee Stock Ownership Plan (ESOP) is a type of equity financing arrangement in which employees of a company are given the opportunity to buy shares in their company in return for capital.

Beyond the opportunity to raise finance, the main advantage of employee stock ownership is that owner-employee interests become aligned with those of the company.

When employees have a financial stake in the business (beyond just a salary or bonus), they develop a sense of ownership, and the company gains a more productive, highly motivated, and loyal workforce.

Company culture also improves as employees have a shared purpose and an increased sense of community. There are also some tax incentives for employers and employees using an employee stock ownership plan.

However, the downside of an ESOP is that they are often costly, complex, and time-consuming to administer with specific legal and accounting requirements.

As the business owner, when your employees have a feeling of shared ownership, it can be hard to maintain control and continue to exert the same level of influence and authority.

An ESOP is also a good option when the company is performing well, but if performance starts to fall, it can have a negative impact on employee motivation and company culture.

Download our free guide: How to Raise Finance for your Business

This article is taken from our free guide “How to Raise Finance for Your Business” which you can download below:

Leonherman’s Corporate Finance Services

If you’re looking to raise finance for your business then our corporate finance advisors can help you to choose the best option for your business and circumstances.

Our team of corporate finance advisors, led by Jerry Scriven, regularly help business owners with business planning, financial reporting, fundraising, management reporting and valuations and we’d be delighted to have a conversation with you to find out about your specific needs and ambitions.

On the other hand, if you are an investor or lender and you are looking for a trusted advisor to undertake due diligence, valuations or other advisory work before and after a finance deal, then we would be delighted to speak with you. Call us on 0161 249 5040 or email: partners@leonherman.co.uk.

Important Disclaimer

This material is published for information only. It provides only an overview of the regulations in force at the date of publication, and no action should be taken without consulting the detailed legislation or seeking professional advice. No responsibility for loss occasioned by any person acting or refraining from action as a result of the material can be accepted by Leonherman.

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