Raising Equity Investment

Raising business financeA provider of equity is putting their money into the business in return for a share in its ownership and therefore both its profits and future value.

If you seek other equity investors in to your business (such as backing from a VC firm), you will therefore be selling part of the ownership of your business to these investors, and as a result reducing (diluting) your own percentage holding in the business and in the process your control over it as well as your share of its present and future value.

Click here for specific information on raising turnaround equity.

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Financial Promotions

But before considering raising any sort of equity from any third party you do need however to be aware of the levels of regulation that surround this, as failing to comply can lead you into considerable problems.

Contacting people to discuss the possibility of investing in your business is defined as a ‘financial promotion’ under the Financial Services and Markets Act (FSMA). The rules under the FSMA are intended to protect investors from being enticed into putting their cash in to fraudulent or excessively risky schemes. So unless your approach falls under one of a number of exemptions set out in the Financial Promotions Order (FPO), it will need to be issued by an authorised person, which is generally someone regulated by the Financial Services Authority (FSA).

The underlying message is therefore to seek appropriate professional advice if you are looking to raise equity.

What Issues Do You Need To Consider?

In all cases where you are bringing in outside investors you will need to consider:

How much control you are handing over, what percentage of your business you will be selling and how actively involved will the investor then want to be in the business

How long it will take to raise the money, as all investors will have to go through some form of process to decide whether to invest, before which you will have had to go through some form of process in drawing up a business plan or proposal to interest them in investing

How certain you are of getting the cash, as you are ultimately reliant upon an investor deciding to risk their money; and

The costs involved in attempting to raise cash which can be substantial as a proportion of the cash raised (and to what degree your advisors will require an upfront payment or will work on success only fees).

How much your business will be worth to an investor and therefore how much of it will an investor require in return for the cash you are looking for.The most commonly used basis of valuation in dealing with small owner managed businesses is the multiple of earnings approach.  This values the business at a multiple, which will depend on the attractiveness of the business, times the sustainable levels of profits it is generating. If a business is in distress however, the multiple approach is normally not applicable and values tenmd to be based on an assessment of the net equity in the assets after liabilities (if any).

You therefore need to be realistic about the value of your business as this will determine the share of the company that someone is going to need in return for the investment you are looking for.

Sources Of Equity Finance

Potential sources of equity for your business fall into two broad camps. These are:

Informal sources, people or businesses who may be interested in investing in your business for a variety of reasons, but who are not set up to act as professional investors, or are actively looking for investment opportunities. These can include you, family and friends,employees; or trade partners.

Formal sources, which are people or institutions who are professional investors that are actively looking for opportunities to invest and where making such investments is one of their principal business activities, such as business angels and venture capitalists

Informal Sources

The first informal source of finance for your business is of course you, as you can invest your own cash or cash that you have raised by borrowing against your other assets (for example by raising a mortgage against your house) into the business.

The advantage of this approach is that if you are providing all of the equity funding, you will retain full control and ownership of your business. The disadvantages however can be that you may find:

  • you may not have sufficient resources to fund the business properly to the level required; and that
  • your personal assets (and personal financial health) are now mortgaged to the success of the business.

The second group of people that you might turn to are people with whom you have a personal connection, sometimes dismissively referred to by finance professionals as the 3Fs of family, friends and fools. However it is wrong to do so as this type of funding has been vital for the start-up of thousands of businesses over the years.

Through your personal network you may have direct access to people who may be able to provide cash. What’s more you can do so without incurring the significant costs of trying to access this type of cash through more formal means; and you will also have some idea as to whether they are actually likely to invest or not whereas as discussed below, some formal sources may be much more uncertain.

However, you should think very carefully about the implications of using such money and how these relationships will be affected by the arrangement because of the serious issues it can raise if there is not absolute clarity at the outset as to what the arrangment involves.

With any investor, formal or informal you should always have a shareholder agreement which spells out their interest in the business and the overall arrangement to avoid as far as possible any later disputes.

As people intimately connected with the business, your employees can be a source of funds, but more often employees’ share schemes are set up as a tax efficient way of incentivising and retaining key staff.

You could also think about whether there are any potential trade partners who might be interested in a stake in your business or in helping to fund a project in some kind of joint venture (JV). This has the advantage of dealing with somebody who already knows your business and to a degree, your market but needs to be balanced against the commercial impact such an arrangement can have on your trading.

Formal Sources

Formal sources of investment broadly comes either from business angels or Venture Capitalists.

Business Angels

Business angels are usually successful business people who have made sufficient money to have retired or sold their own business and are now interested in investing in small businesses, often both as a way of making money and continuing to be involved in business.

They are therefore usually interested in investing in small businesses with potential for high growth where by taking equity they can look to become involved, while potentially obtaining a high return on their investment.

Business angels therefore bring not only cash but usually significant business experience and often a good network of business contacts. The downside for the entrepreneur can be that they will often seek to be actively involved in the direction of the business which can lead to conflict, so it is important to see how hands on they want to be and how you feel about this.

For most businesses looking to raise less than say £250,000 (such as for a start-up or seed development money), Business angels usually offer the only realistic option (other than some smaller specialist regional venture capitalists). Some business angels are prepared to invest quite small amounts, say from £10,000 upwards whilst at the top end of business angel investment, over £500,000 may be possible although this would usually be through a syndicate of such investors rather than a single individual. The typical business angel investment is however generally reckoned to be somewhere between £75,000 and £100,000.

Some business angels invest on their own, while some work as part of clubs. There are a number of networks around the country which have been set up to enable prospective businesses to be put in touch with such investors, for example by circulating a regular digest of opportunities to a database of investors or by running investment fairs where candidate companies seeking funding can take stalls and offer presentations on their proposals.

Venture Capitalists

For sums larger than can be raised from Business Angels you need to approach Venture Capitalists (VCs). These are businesses that exist to raise funds, mainly from institutional investors such as pension funds, which they are then looking to invest to provide them a higher return than they can achieve from other sources.

A venture capital firm (VC house) therefore regularly goes through a cycle of:

  • raising a fund and investing the cash raised;
  • managing a portfolio of investments for the life of the fund which might typically be seven to ten years;
  • before then selling off its investments in order to realise a capital gain, and pay back their investors capital together with a sufficient return to attract investors for their next round of fundraising.

This structure obviously puts pressure on the VC house to get a good return so as to make its next round of fund raising easier which will be passed on to you. But it also puts pressure on the VC house to exit from its investments by the target date and investments that are still held by a closed fund can find themselves under pressure to achieve a sale.

VCs will therefore be looking to:

  • invest in unquoted companies with high growth potential and ambitious, experienced management
  • be more willing to commit a material amount of their own money into the venture
  • are prepared to sell a realistic stake in the business for the funding required and the risk the VC is taking
  • expect to be able to sell their investment on within say three to seven years which will mean the:
  • sale of the shares back to the company
  • sale of the company; or
  • a flotation; and
  • obtain a return on their investment by way of a capital gain on their exit of say over 20% to 30% a year.

This means that before considering venture capital (or business angel) investment your business needs to be an entrepreneurial one that is looking for a high rate of growth, rather than a lifestyle business which gives you a decent standard of living but which is unlikely to provide the financial returns to make it worth an outside investor risking their money in the business.

Dealing with a VC as a potential investor has some advantages over dealing with a business angel in that a VC house will have a process of investment appraisal which is likely to be extremely tough, but you can at least rely that if you pass the high hurdles set, they are likely to invest and will not suddenly get cold feet and put their cheque book away as business angels can do.

Another advantage for many business owners of VCs over business angels is that a VC will not generally become involved in the day-to-day operations of your business as the management the business will remain your responsibility, whereas business angels will often actively seek a role.

The VC firms’ approaches differ but they will normally want a seat on the board and may also wish to appoint chairman of the board to both provide guidance to the business and act as the VC’s eyes and ears.

There are some exceptions to this general rule, most notably the VC houses specialising in turnarounds, which because of the nature of the situations they are investing in, will become very actively involved in the hands-on management of the business.

Of course the information contained in an article like this can never be a full statement of the legal position as the relevant laws are complex and liable to change. This article can only therefore be a general guide as to the issues involved and as these can have serious implications you should always seek appropriate professional advice on your own particular circumstances before taking any action.

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