How to Finance a Small Business via Equity Investments
Funding a business is very much like gardening. Plant some money, and if the growing conditions are right and you tend your garden carefully, you will reap more money and yield more fruit. However, unlike gardening, locating the seeds (dollars) needed to begin your business is often the most difficult step in beginning your small business venture.
Choosing the funding method that is most suitable for your unique situation is a critical step in laying a strong foundation for your organization. No matter the current circumstances, there are a wide range of solutions a business owner can utilize to fund the launch of his or her venture.
Let’s begin by looking at traditional business funding methods. There are two types of traditional options for businesses to raise capital—equity (investor funded) and debt (loans). In this blog, we will focus on funding through equity. Next week, this blog will emphasize debt funding.
Equity Financingis the act of raising money for company activities by selling common or preferred stock to an individual or an institution. This type of funding can be very hard to obtain, especially when your business has not yet generated any revenue. Any informed investor would be aware of the risky nature of such an investment, as there is no contractual schedule for repayment of the investment like there are for loans and other forms of debt.
Self-Funding or Bootstrap Financingis the use of personal funds to launch a new business. Bootstrapping a new business means making all available resources, both financial and otherwise, go as far as possible. This often means the founder does not draw any salary or take any distributions until the enterprise becomes profitable. This type of startup can be hard on the family, but this option is a great way to maintain a business’ positive direction by starting off in the green. It forces the business to have discipline in spending, which is a very necessary trait to carry forward as the business grows.
Any means of personal finance can be used to start a business such as a signature loan from a bank, a loan with collateral (real estate, vehicles, or any valuable physical asset), credit cards, loans from retirement accounts, retirement account withdrawals, home equity loans, or a combination of any of these funding sources. All of these methods can be used by a business owner to make an equity investment in their business. When looking outside of self-funding and bootstrapping, there are different options available.
When a business is pre-revenue, the owner/founder self-funds the business to get it off the ground and develop a product, the first step required in order to raise capital. This is the most common method that is used in the early stages of a business.
Friends & Familyare the most common source of debt financing for start-ups rather than a commercial lending institution. Family members and good friends, the people who know you best and have the most confidence in you, are the ones who are often most willing to back your venture. These types of investments are often given in the form a loan or a direct equity investment.
Angel Investor is anindividual who invests his or her own money in an entrepreneurial company. Originally a term used to describe investors in Broadway shows, "angel" now refers to anyone who invests his or her money in an entrepreneurial company (unlike institutional venture capitalists, who invest other people’s money). Typically, angel investors invest in companies that are pre-revenue, an early phase when they are developing their service(s) or product(s) for their potential customers. Business owners may want to work with another party’s money, but they should understand that it can be very difficult to raise funds from an angel investor. There is also a very high cost, as this type of investor often takes a very significant portion of the company equity for a very modest investment.
Venture Capital (VC) is a person or enterprise that invests in a business venture, thereby providing capital for start-up or expansion. However, individual venture capitalists are a rarity; the majority of venture capital (VC) comes from professionally-managed public or private firms. VCs can be a great help as they often provide a lot of guidance to the business founder, but their help comes with requirements that a new or existing company proprietor may not be familiar with, i.e., regimented financial reporting.
Private Equity (PE)is person or firm who invests in businesses that are established and profitable, or can be made profitable with some managerial changes. From time to time, for established company founders, private equity firms will invest in start-ups, but typically, these firms do not back unproved companies. It is important to understand the PE market place, as a PE firm can be an exit strategy for a business owner. In the Dallas/Fort Worth area, businesses become marketable to PE firms when EBIT (profit before interest and taxes) reaches 2.5MM and have a minimum enterprise value of 10MM.
It is important that small business owners research and consider the entire spectrum of their funding options and how it will impact them both in the short and long term, and the potential risks they are willing to accept. Most investors who invest in small private businesses often look to a combination of debt equity funding. Utilizing debt is a means to lever one’s capital to increase an investment. When an investor invests via debt, they reap the benefits of being the creditor. Investing in business can be complex and next week we will discuss debt financing.
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