Provided by the International Finance Corporation
Equity financing involves giving away a portion of the ownership of your business in return for funding. This is commonly used by very large corporations to raise funds for the purchase of large assets or for the acquisition of another company. At that level, highly specialized and expensive professional advice is required. However, it is also possible for smaller businesses, including start-ups, to gain access to this type of funding. There are a number of investors who look out for new or growing businesses around the world that offer the potential for big returns in the long-term. These individuals or firms are sometimes referred to as angel investors or venture capitalists.
You might be unaware of this type if funding, or believe that it is only available to firms in more developed countries. However, there are local sources of equity financing in most countries as well as the global opportunities made available by the internet.
The agreements can be quite complicated with different types of shares offered to allow for different levels of risk, but, essentially, an agreement is made to match the level of funding with a fair proportion of the ownership of the business, and the cash is handed over. The deal might include business advice or access to other business support functions provided by the investor. These can be just as valuable as the cash especially where international expansion is planned.
Before entering into such an arrangement, it is very important that a business owner obtains specific professional advice that will help determine the value of the company. This is necessary to establish the value of the share offered to the investor. The investor will conduct its own valuation, which is likely to be considerably less than yours. An alternative valuation will provide a strong negotiating position, helping you negotiate a fairer deal.
Valuing your business
A key element in any equity financing arrangement will be the value placed on your business. The problem is that there is no single method that will provide a definitive value. Like any item, your business it is only worth what someone else is willing to pay for it. The key to a successful negotiation is understanding the methods potential investors will use to value the business. Two main approaches are used. The first, simply adds up the current market value of all the assets of the business (ie what each item could be sold for individually). The second is to consider how much profit the business is likely to make in the future (say 5 to 10 years) and work out a value after allowing for the time value of money.
These methods often provide very different values. The situation is made more complicated when you try to assess what the intangible assets of the business are worth. These include things like brands, customer loyalty, local reputation etc which can often account for a significant portion of the value of any business.
In the end, the amount that an investor pays for a share in your business will come down to how strongly you negotiate. As a minimum, knowing the value of your physical assets and a reasonable assessment of your intangible assets should provide a minimum value you might accept. When it comes to future profit projections, they depend on so many variables that it can be difficult to agree on a common basis for the calculations. However, for most businesses that do not have significant physical assets, this will be the best method to use.
Types of equity
In return for financing, the investor will receive shares in the business. Those shares can have voting rights, rights to dividends, or even rights to change the rights of the shares in the future. Each of these will have a different value to the investor who may be happy to receive regular dividends or capital gains (as the business grows in value, so the value of the shares owned in it grow in value). However, many investors will also want a say in how the business is run, and that means voting rights.
For more resources
- Equity financing do’s and don’ts
- How to Finance Your Business
- How to Finance your Business (video)
- Alternatives for Capital Allocation (retained earnings)
- Business valuation methods
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