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Understanding Equity Capital in Small and Medium Sized Enterprises

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					Understanding Equity Capital in Small and Medium-Sized
Enterprises
by Siri Terjesen


Executive Summary
 •    Equity capital or financing is funding raised by a business in exchange for a share of the ownership.
 •    Equity financing enables firms to obtain money without incurring debt, or without needing to repay a
      specific amount of money at a particular time.
 •    There are four stages of equity investment: seed, early-stage, expansion, and late-stage financing.
 •    Equity capital sources differ in terms of timing, amount provided, type of firm funded, extent of due
      diligence, contract type, expectations of timing and payback, and monitoring of business decisions.


Introduction
Entrepreneurs may require both debt and equity financing, and often start their firms by financing growth
through equity. Equity capital is money invested in the venture with no legal obligation on the entrepreneur to
repay the principal amount or to pay interest on it; however, it requires sharing the ownership and profits with
the funding source, and possibly also paying dividends to equity investors.
After value has been built, entrepreneurs may consider debt financing, which involves a payback of the
funds (with interest) for use of the money. In short, debt places a burden of repayment and interest on the
entrepreneur, whereas equity capital forces the entrepreneur to relinquish some degree of ownership and
control.
The stages of equity financing are depicted in Figure 1. In the first stage, known as the seed stage,
entrepreneurs tend to raise capital from their own savings, though they may also seek informal investment
from family, friends, business angels, and public sources. Entrepreneurs may then choose to pursue formal
equity capital through rounds of early-stage, expansion, and late-stage financing. This may be followed by an
initial public offering (IPO) and, finally, raising of finance from public markets and banks. Summary details of
the financing stages are as follows:




Figure 1. The stages of equity financing
 •    Seed financing is the initial funding to develop a business concept, for example by expenditure on
      research, product development, and initial marketing to reach early-adopter customers. Companies
      that receive seed funding may be in the process of incorporation, or may have been in operation for a
      while.
 •    Early-stage financing is sought by companies that have completed the product/service development
      stage and test marketing but require additional financing to expand.
 •    Expansion financing is provided when the company is poised to grow rapidly. The funds may be used
      to increase production capacity, marketing, or product development, and/or provide additional working
      capital.
 •    Late-stage funding refers to pre-IPO investments to strengthen a company’s positioning and to gain
      endorsements from top venture capital (VC) firms as the company prepares to list.



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At any stage, equity investment can come from informal or formal sources. However, it is more usual to
access informal sources in the seed and early stages, and formal sources in the expansion and late stages.


Informal Equity Sources

Informal and Angel Investment
Informal investment refers to equity provided by individuals. In addition to accessing their own savings and
those of family, friends, and even neighbors, entrepreneurs seek informal “angel” investors who provide
financial capital as well as business expertise for running a company.
As shown in Figure 2, the rates of informal investment vary dramatically around the world, from a high of
13% in Uganda to a low of 0.5% in Japan. Business owners are approximately four times more likely to make
informal investments than are non business-owners (Bygrave and Hunt, 2005). As can be seen in the figure,
many informal investors have experience as owners/managers of their own businesses.




Figure 2. Rates of informal investment around the world. (Source: Global Entrepreneurship Monitor data)
Although the profile of angel investors varies, in developed economies, angels tend to have entrepreneurship
experience, be retired from their own firm or a corporation, and have net incomes in excess of US$100,000
a year. Most angels invest in companies within a two-hour traveling distance of their home, and therefore the
informal investment market is geographically diverse. On average, the angel capital market is approximately
ten times the size of the formal venture capital market. Indeed, small firms are eight times more likely to raise
finance from business angels than from formal institutions.
Business angels tend not to have any previous relationship with the entrepreneur, and are often more
objective. Angel investors can be passive (backing the judgment of others) or active (hands-on, with advice
or direct management input to help the business to establish itself). Angels tend to invest as individuals or
as part of a larger group, and generally as a part-time interest rather than as a full-time job (as is the case of
venture capitalists). In addition to financial goals, informal investors often seek other, nonfinancial returns,
among them the creation of jobs in areas of high unemployment, development of technology for social needs
(for example, medical or energy), local revitalization, provision of assistance to indigenous peoples, and just
personal satisfaction from the assistance they give to entrepreneurs.
Business angels prefer to fund high-risk entrepreneurial firms in their earliest stages. They fill the so-called
equity gap by making their investments in precisely those areas where institutional venture capital providers
are reluctant to invest. Angels may also prefer to fund the smaller amounts (within the equity gap) that
are needed to launch new ventures, and they invest in almost all industry sectors. Angels tend to be more
flexible in their financial decisions, and also tend to have different criteria, longer investment horizons
(“patient” money), shorter investment processes, and lower targeted rates of return than venture capitalists.
Business angel funding can make a firm more attractive for other sources of finance. However, business
angels are less likely to make follow-on investments in the same firm.


Formal Equity Sources

Venture Capital
Venture capitalists can be a valuable and powerful source of equity funding for new ventures, providing, in
addition to capital, help with a full range of financial services for new or growing ventures. These include
market research, strategy, management consulting, contacts with prospective customers/suppliers/others,

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assistance in negotiation and with management and accounting controls, employee recruitment, risk
management, and counseling on regulations. Venture capitalists tend to have ambitious expectations for
both the return on and the increase in their investment, as shown in Table 1.
Table 1. Typical returns on investment (ROI) and increase on initial investment sought by venture capitalists.
(Source: Terjesen and Frederick, 2007)

Stage of business                          Expected annual ROI (%)            Expected increase on initial
                                                                              investment
Seed                                       60+                                10–15 times
Early                                      40–60                              6–12 times
Expansion                                  30–50                              4–8 times
Late                                       25–40                              3–6 times
Turnaround situation                       50+                                8–15 times

The process of seeking venture capital financing includes the following four stages:
 •      Initial screening to assess the firm’s ability to meet the VC’s particular requirements.
 •      Detailed reading of the business plan.
 •      Verbal presentation to the venture capitalist.
 •      Final evaluation, including visiting suppliers, customers, consultants, and others; the venture capitalist
        then makes a final decision.
This four-step process screens out approximately 98% of all venture plans, with the remaining 2% receiving
some degree of financial backing. Venture capitalists reach a go/no-go decision in an average of 6 minutes
on the basis of the initial screening, and in less than 21 minutes on the basis of an overall proposal
evaluation. The main factors in their decision are the firm’s expected long-term growth and profitability,
although an entrepreneur’s background and characteristics are also taken into account.
Venture capitalists tend to agree on an exit strategy at the time of investment, with the following five main
mechanisms:
 •      Trade sale to another company.
 •      Repurchase of the venture capital shares by the investee company.
 •      Refinancing or purchase of the venture capital equity by a longer-term investment institution.
 •      Stock market listing.
 •      Involuntary exit.
Table 2 summarizes the differences between business angels and venture capitalists.
Table 2. Differences between business angels and venture capitalists. (Source: Terjesen and Frederick,
2007)

Differential factor                        Investor type
Business angel                             Venture capitalist
Personal                                   Entrepreneurs                      Investors
Firms funded                               Small, early-stage                 Large, mature
Due diligence done                         Minimal                            Extensive
Location of investment                     Of concern                         Not important
Contract used                              Simple                             Comprehensive
Monitoring after investment                Active, hands-on                   Strategic
Exiting the firm                           Of lesser concern                  Highly important
Rate of return                             Of lesser concern                  Highly important




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Initial Public Offering
As the firm grows, managers may consider an initial public offering (IPO), which is when a company’s shares
are first sold to the public. An IPO is often the first time people outside the company have the opportunity
to buy its shares; hence, IPOs are referred to as “going public” or “floating” the company. An IPO has
advantages and disadvantages. The advantages are:
 •    Amount and efficiency of capital raised: Selling shares is one of the fastest ways to raise large sums of
      capital in a short period of time.
 •    Liquidity: A public market provides liquidity for owners, who can readily sell their shares.
 •    Value: The market puts a value on the company’s shares, which in turn allows a value to be placed on
      the company.
 •    Image: Publicly traded companies are often perceived to be stronger by suppliers, financiers, and
      customers.
However, an IPO also has several disadvantages:
 •    Cost: IPO expenses are significantly higher than for other sources of capital due to fees for accounting,
      legal services, prospectus printing and distribution, and the cost of underwriting the shares. The cost
      can easily exceed $1 million.
 •    Disclosure: An IPO requires detailed public disclosure of company affairs, but new firms may prefer to
      keep this information private. Furthermore, the paperwork involved in meeting regulation requirements
      and providing regular information about performance may drain large amounts of management time,
      energy, and money that could be better invested in opportunities for company growth.
 •    Stockholder pressure: Stockholders are interested in a strong performance record on earnings and
      dividends, and so may put pressure on managers to focus on short-term performance. If managers do
      this, it can be at the expense of long-term growth and improvement.
The advantages and disadvantages of IPO funding are summarized in Table 3.
Table 3. Advantages and disadvantages of IPO funding. (Source: Terjesen and Frederick, 2007)

Advantages                                                       Disadvantages
Stronger capital base                                            Pressure for short-term growth
Improves other financing prospects                               Disclosure and confidentiality
Better placed to make acquisitions                               Costs—initial and ongoing
Diversification of ownership                                     Restrictions on management
Increased executive compensation                                 Loss of personal benefits
Increased company and personal prestige                          Trading restrictions

Should a firm decide to pursue an IPO, it is important that it be aware of laws with respect to securities and
investments, which vary across countries but include the following common elements.
Investor information: Firms must provide investors with key information.
Investment banker or underwriter: Most firms select a lead investment banker to sell the new shares, usually
at fees of about 7% of the issue value.
Ownership structure: The shares sold in the IPO are designated as primary shares, which are new shares,
and secondary shares, which were previously owned by existing stockholders, usually the founders and
managers of the firm. The size of the new issue relative to the existing shares and their distribution change
the ownership structure. The IPO often results in moving from management by firm founders toward
professional management of the firm. The IPO generally occurs when the founder’s entrepreneurial activities
are coming to an end, but often he or she will play a role in the future of the company.
Lockup provisions: When going public, IPOs almost always commit to a lockup period, whereby insiders
(major stockholders, directors, and senior officers) are prohibited from selling shares without the written
permission of the lead underwriter until a certain amount of time has passed. On average, the waiting time
is 180 days. These lockup provisions control the supply of shares sold during the period after the IPO by
insiders or existing stockholders who might have inside knowledge and, thus, unfair advantage.

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Presence of venture capitalists: Many firms may be financed by VCs, who take an ownership position and
have partial control over the entrepreneurs. The IPO may change this control as the VC distributes the
shares to their limited partners. The use of an IPO may be a cheaper form of financing than that provided by
VCs, and will certainly provide liquidity to the existing pre-IPO stockholders.
Issue size: With the fixed costs of an IPO to create a liquid market, the number of new shares in the IPO
should be large enough to provide sufficient liquidity, but small enough so that the issuing firm does not raise
more cash than it can profitably use.
Mechanisms for pricing IPOs: IPOs may be priced through auctions, fixed-price offers, or book-building. In
auctions, the market-clearing price is determined after bids are submitted. In a fixed-price offer, the price is
set prior to the allocation. If there is excess demand, shares are rationed on a pro rata or lottery basis. In
book-building, the investment bankers canvas potential buyers and then set an offer price. Book-building is
now the predominant mechanism by which IPO shares are sold around the world.
Prospectus: If a company is raising capital by offering its shares to the public for the first time, it will issue
a disclosure document called a prospectus. The prospectus is a formal written offer to sell shares and
provides an investor with the information necessary to make an informed decision. All negative information
must be clearly highlighted and explained. Some of the specific detailed information that must be presented
includes: the history and nature of the company, its capital structure, a description of any material contracts,
a description of the securities that are being registered, the salaries of major officers and directors and the
price paid for any security holdings they may have, underwriting arrangements, an estimate of and planned
use for the net proceeds to be raised, audited financial statements, and information about the competition
with an estimate of the probability that the firm will survive.


Case Study

An Angel in England
Anita Roddick started her own business, The Body Shop, creating and selling beauty products. Roddick was
keen to open a second shop in Chichester, but the bank turned down her request for a loan. In desperation,
Roddick asked her friend Aidre, who was helping to manage the first store, for help. Aidre had a boyfriend
named Ian Bentham McGlinn, who had some spare cash from operating a local garage. Scottish born
McGlinn offered Roddick £4,000 in 1976 in return for 50% equity in the business. Anita accepted the offer
but wrote to her husband Gordon (who was on a two-year hike in South America) to inform him of the offer.
Gordon wrote back suggesting that she “not do it, not give away half the company,” but it was too late.
With his equity investment, McGlinn became a business angel and sat on the board of The Body Shop,
resigning just before it was floated on the stock market in 1984. At the time of the flotation McGlinn was
worth £4 million, but he avoided the press by taking a holiday in Portugal. By 1991, McGlinn’s 52 million
shares were worth £150 million, though his dividends were worth only £638,000 annually. The Roddicks and
McGlinn together owned 56% of The Body Shop, preventing a takeover. In 1996, McGlinn sold 3.5% of the
business for £12 million. When L’Oréal took over The Body Shop in 2006, McGlinn’s 22% stake was worth
£137 million. As of 2007, Ian McGlinn was ranked no. 28 on the Sunday Times Rich List, with an estimated
worth of £146 million.


Making It Happen
When approaching venture capitalists, entrepreneurs must remember that VCs are inundated with potential
business opportunities. It is therefore advisable to keep the following in mind.

Do
 •    Prepare all your materials before soliciting firms.
 •    Send a business plan and a covering letter first.
 •    Contact several firms with this material.
 •    Keep phone conversations brief—prepare a one-minute and a three-minute pitch.

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 •    Remain positive and enthusiastic about your company and its product or service.
 •    Know your minimum deal and walk away if necessary.
 •    Negotiate a deal you can live with.
 •    Investigate the venture capitalist’s previous deals and current portfolio structure.

Don’t
 •    Don’t expect a response.
 •    Don’t dodge questions.
 •    Don’t give vague answers. Know what you can and cannot disclose before you start talking, so that you
      do not stumble over awkward questions.
 •    Don’t switch off—be an active listener as you will always learn something.
 •    Don’t hide significant problems.
 •    Don’t expect immediate decisions.
 •    Don’t become fixated on pricing.
 •    Don’t embellish facts or projections.
When considering an IPO, managers should ask the following questions:
 •    Can the company run without you while you are managing the IPO process? The work leading up to a
      public offering is time-intensive and can deflect your focus away from everyday operations, ultimately
      hurting the business. If the company lacks a strong management team, it can be helpful to appoint an
      interim CFO with experience of taking companies, preferably small, through the rigors of going public.
 •    Can you get to a market capitalization of $100 million within three years of going public? The value of
      a public company is a multiple of what it earns. If the result isn’t near $100 million, staying private may
      be best. This number is a good indicator because it is the level of earnings at which the company can
      attract brokers and investors.
 •    Are you building a company with high gross and operating margins? High margins are important
      because they keep companies out of the volume game. For a company to reach critical mass in
      earnings with low margins, it must generate enormous sales growth.
 •    Can your business deliver double-digit sales and earnings growth? The competition among public
      companies, mutual funds, and other investment networks is fierce. Investors won’t look twice at a
      company that doesn’t grow fast enough to warrant the use of their time and money.
 •    Are you building a family business? If the succession plan for the business is set in stone to be
      passed on to the kids, public may not be the right route. Families measure the success of a business
      generation by generation. Money movers are interested in the quarter-to-quarter progress.
 •    Can the business be built inexpensively? The main reason companies go public is to raise initial funds
      for major growth. As a result, sales and growth need to reflect the use of the first round of financing. If
      another round of financing is needed to achieve the original plan, investors may look elsewhere.


More Info
Books:
 •    Cendrowski, Harry, James P. Martin, Louis W. Petro, and Adam A. Wadecki. Private Equity: History,
      Governance, and Operations. Hoboken, NJ: Wiley, 2008.
 •    Gadiesh, Orit, and Hugh MacArthur. Lessons from Private Equity Any Company Can Use. Cambridge,
      MA: Harvard Business School Press, 2008.
 •    Terjesen, Siri, and Howard Frederick. Sources of Funding for Australia’s Entrepreneurs. Raleigh, NC:
      Lulu, 2007.

Report:
 •    Bygrave, William D., with Stephen A. Hunt. “Global entrepreneurship monitor 2004 financing report.”
      Babson College and London Business School, 2005.

Websites:
 •    Global Entrepreneurship Monitor (GEM) data: www.gemconsortium.org

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 •     US Small Business Administration on equity financing: www.sba.gov/services/financialassistance/
       basics/financing


See Also
Best Practice
 •  Capital Structure: A Strategy that Makes Sense
 •  Optimizing the Capital Structure: Finding the Right Balance between Debt and Equity
 •  Sources of Venture Capital
Checklists
 •   Dealing with Venture Capital Companies
 •   Investors and the Capital Structure
 •   Options for Raising Finance
 •   Raising Capital by Issuing Shares
 •   Raising Capital through Private and Public Equity
Finance Library
 •     Damodaran on Valuation: Security Analysis for Investment and Corporate Finance

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http://www.qfinance.com/financing-best-practice/understanding-equity-capital-in-small-and-medium-sized-enterprises?full




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