What Is Equity Raising and How Is It Done?
Finances are a primary concern when it comes to operating any business. However, while adequate financing is desirable before any business plans are made, the reality is not every business starts with sufficient capital.
Most companies utilise equity, debt financing, or a combination of these two financing verticals in the course of their business life. This article will delve into the features and characteristics of equity financing, and in particular, how to raise funds with equity.
What is Equity?
Equity is essentially a representation of ownership in a company, assigned to individuals or other companies in the form of ownership units/shares.
In practice, equity can be utilised as a financing instrument by for-profit businesses in exchange for ownership, control or an expected return to investors.
In contrast to debt financing instruments, equity financing usually does not necessitate collateral. However, it is typically based on the potential for the creation of value, or generation of profit through the growth of the business.
This means that equity investors usually do not require ongoing interest payments. In comparison to debt investors, equity investors have higher return expectations in the future, typically ranging from 8% to 25% per year, over the lifetime of the investment.
What is Equity Raising?
Put simply, equity raising (also referred to as equity financing) refers to the process of raising funds by trading shareholding interests in an enterprise. In practice, shares are issued to investors to support an enterprise’s business operations, especially during a company’s start-up stage.
With equity financing, investors make profits when there is an increment in the share price, and via the distribution of annual dividends by the company they have purchased a stake in.
Aside from proportionate cash dividend pay-outs that come from profits made during the year, equity shareholders can also receive additional incentives whenever the enterprise issues bonus shares out of accumulated profits, in proportion to the shareholding.
All things considered, it’s important to know that equity shareholders are also entitled to vote at the annual general meetings. The power of the voting rights is tied to the equity-type/class, as well as shareholding proportion.
Why do companies issue Equity?
Business entities tend to issue equity to start new ventures or to expand existing operations. Since shares purchased are not returnable in the ordinary course of the business, equity investors need to believe in the business’s potential.
With that being said, the funds collected during equity raising can be utilised to develop new products and technologies, engage in R&D, expand working capital, make acquisitions, or even strengthen a business’s balance sheet.
Advantages of Equity Raising
- The first benefit of equity raising is that it provides another source of funding that circumvents tedious loan applications from banks or other financial companies. In essence, equity financing can be advantageous for entrepreneurs looking for ways to cover the start-up costs.
For the most part, the company can later utilise the cash flow from its subsequent operations to directly grow the company or to diversify into other niches.
- Equity investors also tend to take a long-term view, and usually do not demand an immediate return on their investment. As such, equity raising is sometimes referred to as ‘patient capital’. Consequently, equity enables companies to keep more cash on hand to expand the business, instead of having to pay a portion of their profits to repay loans.
Overall, this makes equity financing less risky than debt financing because companies do not have to pay back their shareholders immediately, which is perfect for companies that cannot afford to take on (additional) debt.
- Equity financing enables companies to tap into unique and diverse investor networks, thereby enhancing their legitimacy and credibility.
- With equity financing, management teams can access prospective investors who can offer invaluable business assistance that an enterprise may not be able to access by itself. For example, management expertise, business contacts and access to bigger capital sources. This is highly beneficial, especially in the start-up phase of a new business.
Disadvantages of Equity Raising
- The most notable disadvantage is that investors require some ownership of the company and a significant percentage of the profits. In scenarios where the company’s business takes off, the entrepreneurs will have to share portions of their earnings with the equity investors. Over time, the distribution of profits to shareholders could exceed the sum that the business would have had to pay for loans, and hence the cost of equity financing can be deemed as “expensive”.
- Some investors take a 25–51% equity stake, especially when dealing with risky start-up companies without a solid financial background. Unfortunately, this creates issues and stalemates as company owners are sometimes unwilling to dilute their controlling power via equity raising.
What are the main sources of Equity Capital?
Family and friends
Family and friends are one of the more straightforward equity capital sources, especially for early-stage businesses development. However, it’s worth noting that business failure can impact ongoing relationships with family and friends who have invested in a company. This means that it’s essential to formalise such arrangements with family and friends.
Business angels (also called angel investors), are high net-worth individuals who invest in high growth businesses, with the potential to offer high returns. Generally, the level of risk and involvement varies from one investor to another.
Business angels often have an active involvement in the progression of the business, bringing experience, skills, contacts and networks, in addition to funding. Typically, they provide financing during all stages of the business lifecycle, over the long term. Angel investors also tend to consider the company’s geographic location to be actively involved in the business.
Generally, venture capitalists tend to be highly specialised financial intermediaries seeking high returns from investing in high-risk companies. Most venture capitalists take an active and influential role in the development of the business, and tend to seek an exit by selling their investment in a given timeframe.
In practice, venture capitalists offer significantly more funds than business angels and release funds according to the achievement of defined milestones. Furthermore, despite their high-risk profile, venture capitalists tend to favour businesses with a successful operating history.
On the downside, the equity raising process via a venture capital firm typically takes 3 to 9 months.
Most VCs also demand at least 25% per annum over the life of the investment. Additionally, the rate of return desired by a venture capitalist investor will depend on the level of risk. For example, venture capitalists demand higher equity stakes for start-up companies than for businesses in the expansion stage.
The Stock Market/ IPO
Entrepreneurs can also raise equity by joining their public market or the local stock market. A stock market listing can allow small companies to access capital for growth and further development.
Such an instrument is better suited for well-established companies that can leverage an Initial Public Offering (IPO). With an IPO, the business can raise equity funding by offering its shares to the public and institutional investors.
A company should utilise this mode of equity raising only when it has already exhausted other sources of equity finance since an IPO is not only costly and time-consuming but it is also subjected to a much higher level of scrutiny from the public which tends to complicate decision making.
Institutional investors are also an avenue of equity financing. These investors include insurance companies, hedge funds, mutual funds, pension funds, etc.
How is equity raising done? (The Equity Raising Process)
During equity raising, investors purchase shares of a business with the price per share determined by the total company value divided by the total number of shares outstanding.
This means that for new enterprises with little value, the share price will be very low and will be set at an arbitrary value around a penny.
Essentially, the idea is that as the business grows over time and new capital is brought in, the value will be generated, and the price per share shall therefore increase.
Also known as equity financing, during equity raising, common equity is sold. However, other quasi-equity instruments can also be sold like preferred stock, convertible preferred stock, and stock warrants.
The business owner will need to determine whether equity raising is appropriate for your company, based on your control tolerance and return potential. It is crucial to find the right investor with a passion for your domain, and at the right time in their investment cycle.
To increase the chances of success, entrepreneurs should have key business elements and documentation in a place like:
- A complete business plan (with an executive summary, milestones and financials)
- Historical and projected financials (5-year projections)
- Details of how you will deploy the invested capital.
- Capitalisation table that demonstrates equity holders, their percentage ownership and investment, if any.
The equity financing process can take anywhere from 4 weeks to a year. This depends on how prepared the business owner is, and the ability of the targeted investor to focus on the investment analysis and structuring. The equity financing process generally entails:
- Identification and qualification of prospective investors.
- Initial outreach (with executive summary)
- Provision of a detailed business plan with full financials
- Initial pitch meeting
- Investor due diligence (a deep dive into the business to substantiate assumptions, assess the management team and determine return potential)
- Investment negotiations and terms
- Closing (where funds are transferred to the entrepreneur’s account)
Considerations for enterprises dealing in equity raising
When choosing the route of equity raising, it’s important to consider two aspects:
1) the level of ownership and control you are willing to relinquish in their business
Additionally, the two main categories of equity are ‘common’ shares (for founders and employees) and ‘preferred’ shares (usually for investors). Preferred shares typically include special features like liquidation preference, anti-dilution protection, and redemption rights.
It’s also imperative to know that venture capitalists usually invest in less than 3% of projects presented to them, so it’s essential to present your business in a manner that maximises the potential for it to be chosen.
For the most part, equity utilised to finance an enterprise’s growth depends on several business factors, such as the availability of funding sources, the industry in which the company is operating, and banking requirements.
Companies that maintain good networks and collaborative relationships with banks, business angels and venture capitalists always have fair opportunities to access equity financing, should they choose to!
Co-Founder, Chief Executive Officer
Haruhito was the Executive Director of Marcuard Heritage Singapore Pte Ltd, a Swiss multi family office. He was instrumental in building up their European and Asian clientele base which comprised of a global network of asset managers, distribution partners, and legal & tax specialists. Prior to that, he held various positions for 10 years in Deutsche Bank where he gained extensive experience in various Asian markets.
Haruhito has been accredited as a Trust and Estate Practitioner (TEP) by STEP, and as a Financial Industry Certified Professional (FICP) by Singapore’s Institute of Banking and Finance. His vision for Salzworth is to steer it to establish multi-asset class portfolios and funds that seek to achieve steady returns for investors.