Sources of Equity Financing

Business financing

Big advantage of equity financing is that it doesn’t have to be paid back. It is an investment, and the investors get a piece of your company and expect their payback to come when the company is sold or goes public.

How can owners of smaller companies obtain equity financing? First and foremost, they need to be able to make a convincing case (preferably via a business plan) that the company will grow significantly over the coming few years.

Three important sources of equity financing:

Family and friends

This can be the easiest sort of equity financing to obtain, but it can also be the riskiest in non-business ways. The relatives may expect you to be eternally grateful and to eternally demonstrate your gratitude. Ideally, you either treat the relationship as business-like as you would any other investment relationship, complete with written agreements, or you and your relatives or friends all understand up front that this is an informal arrangement between people.

Some business owners feel more comfortable obtaining money from family than from friends, apparently on the theory that you can risk losing valued friends, while close relatives will always be there.

Private investors

These are wealthy individuals (often successful entrepreneurs who have sold their businesses for lots of cash)who like to invest in startup or early-stage companies. It gives them an opportunity to again become involved in entrepreneurial situations.

Business owners often fail to understand the financial motivations of such private investors (thinking of them as angels too much in the giving sense). Private investors are seeking very high returns (30% to 60% annually) on their investments to justify the high level of their lifestyles. Some will invest individually, others like to invest in small groups, via private offerings or limited partnerships. These are essentially ways of pooling funds. For guidance on using these vehicles, consult with an accountant and/or lawyer. And be careful!

Venture capitalists

Probably the key fact for entrepreneurs to remember about venture capital firms is that their names are misleading. Though the term venture capital strongly suggest a willingness to take risks on young companies, the fact is that they don’t.

If you manage to attract their attention, you will quickly discover why they are often referred to derisively by many entrepreneurs as vulture capitalists. They drive a hard bargain, seeking as much as 70% of a company in exchange for making it possible. One encouraging development among venture capital firms, though, has been their growing willingness to look beyond their traditional turf of high technology, and to become involved with consumer products, retailing, manufacturing and service companies. Venture capital firms have also shown increasing flexibility in the kinds of arrangements they will negotiate. Whereas they traditionally took equity for their investment, some now make part of their funds available as loans, perhaps convertible into stock. Again, be careful!

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