Accessing equity financing
Some entrepreneurs borrow money to finance their businesses; doing so means they go into debt right from the start, and, in most cases, have to pay back their loans with interest. Equity financing, on the other hand, allows you to stay out of debt, but give up a percentage of your business and/or profits to an investor.
Some investors may want more control than others in exchange for their investment, depending on what expertise and connections they bring to the table, and how much time they have to help you run the business. You can negotiate the extent of creative and strategic control your partner(s) will have prior to signing any contracts.
The key to getting equity investors is preparation. You must prepare a strong plan in order to convince an investor that you know what you are doing and that your business is worth their time and money. Take the time to study the elements you'll need to consider before moving forward.
Table of Contents
Financial needs and performance
Begin with a thorough, strategic business plan that projects your financial needs and performance into the future and answers these key investor questions:
- Where will you be in 5 years?
- How will you get there?
Preparing your plan and accompanying financial data can be time consuming. It also requires some special skills, as the economic environment is always changing. Management and external advisors may be able to help in putting it together.
Investors will look very closely at your business plan and projected financial statements to see if your business will generate an adequate return in a reasonable amount of time.
Your plan and financial projections must show, in detail, how you'll use the funds you get and how your business will perform over the next 2 to 5 years (long range).
Determining financial needs
To finance your growth initiative, you'll need to know how much of each of these types of funds you'll need:
- Working capital (for day-to-day and month-to-month operating costs)
- Fixed costs (for equipment, buildings, etc.)
- Special marketing costs (for advertising, promotions, etc.)
- A financing cushion
Investors will want evidence that you can actually achieve the gains that you forecast. They'll be looking closely to see if:
- Your analysis of expected future market conditions is convincing and realistic
- The working capital needs, production capacity and human resource requirements you predict are consistent with the level of growth you forecast
- The growth rate you forecast is reasonable for the market you're in and in line with current economic conditions
- Your projections will hold up under different economic and market conditions
Your investment proposal should include:
- Annual projections for a period of 1 to 5 years
- A detailed monthly cash flow budget for the first year
- Sensitivity analyses of your projections under different scenarios
Your business expansion will likely tap into all three major sources of financing:
- Conventional external lending (e.g. mortgages, operating lines of credit)
- Internal sources of working capital (e.g. improved cash flow, reduced inventory, better terms from suppliers)
- External risk capital investors
External risk capital investors, who will invest by purchasing equity shares, include:
- Angel investors
- Venture capital firms
- Institutional investors
- Labour-sponsored venture funds
- Some government corporations
Cost, control and risk
Risk capital sources will finance businesses that conventional sources may avoid. Risk capitalists will assume some of the risk of growth, but it will come at a price; you may have to pay more, or give up more control.
When you consider different types of financing, the key questions are:
- How much will it cost?
- How much control will I have to give up?
- How much risk will I be exposed to?
Risk capital equity investment:
- Is more expensive than debt financing because the investor expects a high rate of return
- Generally has a low cash cost for the business because the investor usually holds the equity for a number of years and then sells the shares in the marketplace
Equity financing involves a loss of control since equity investors will:
- Be buying a portion of your business when they purchase shares
- Likely demand a presence on the board of directors
- Probably want to be involved in management and decision making
Not all entrepreneurs are ready to dilute their ownership — are you? Before you answer, consider that in many cases the investor's active involvement can be worth a lot, as they are providing management experience, industry contacts and other resources.
When you take on debt, you're adding risk because you're committed to scheduled interest and principal payments. On the other hand, if you accept equity investment, the investor assumes some of your financial risk. At the same time, you assume another type of risk, but also benefits from the reward that equity affords.
Investors are looking for three things. You've got to show them how your venture will deliver all three:
- Excellent growth potential
- Exceptional return on investment
- A way to get their money out
When capital is in short supply, you will also need to demonstrate why your business is a safer and more profitable investment than other potential ventures an investor could support.
Proving growth potential
Investors will look for evidence that you can actually produce the growth you project. One effective way to show them what you can do is to provide a situation analysis of your business. Analyze your company's:
- External business environment: Show the threats and opportunities
- Internal business operations: Cover the strengths and weaknesses of all key business functions
Measuring return on investment (ROI)
To show investors what return they'll earn on their investment, you need to show them what your business is worth today and what it will be worth in the future. The reason is, equity investors make their money based on the change in the value of the company. If the business' value increases, their investment value increases.
Measuring your business' value — valuation — is a complex but critical process. You'll probably need the professional assistance of a financial advisor or business valuation expert to determine the company value.
Because the investor likely won't see any money until some years in the future, the best valuation method is one that assigns a present value to future earnings.
The specifics of your deal all hinge on the valuation of your business. The amount the business is worth will determine:
- How much investors will invest
- How large a share they will get in exchange
- How much they are expected to make from the investment
Getting the investor's money out
Investors will be looking for assurance that they'll be able to get their money out of your company. You've got to include such an exit strategy in your proposal to show them how they can realize their investment. The exit strategy also affects how the valuation is calculated. Exit strategies for equity investment include:
- Initial public offerings
- Sale of all the shares of the company
- Purchase of the investor's shares by a third party
- Buyback of the investor's shares by the company
Investors will look to see if your management team can implement your business plan and realize the investment potential.
They are not looking for an operation dominated by one person. Instead, they want to see a talented team with:
- A range of appropriate skills and experience
- A solid track record in all key business functions
- An effective structure
- Good communication, decision-making and consensus-building skills
- The ability to grow
Assess your team
One of the key criteria for investors is that your team is able to take on the new challenges of growth. Assess your team's abilities and readiness for growth by comparing available skills to needed skills. You can do this using tools such as:
- Management audits
- Report cards of key management functions
Prepare for investors
You'll have to provide investors with evidence of your team's readiness and competitive advantage. Be ready for tough, specific questions about each management function:
- Marketing and distribution
- Production and operations
- Accounting and finance
- Human resources
- Research and development
Strengthen your team
If your team is weak in some areas, start planning to improve it now. You can strengthen your team by:
- Upgrading your managers' skills
- Hiring new people
- Modifying team structures and roles
- Bringing in outside directors and advisors
You need a concise and compelling proposal to grab the investor's attention.
The proposal may not be the same as your business plan. The business plan is often designed for an internal audience (namely your managers), to guide their work. The proposal is designed for an external audience, to sell your idea and raise the funds you need.
Investors want the proposal to give them an immediate understanding of:
- The terms of the deal
- What makes the deal or opportunity unique
- The balance sheet
- The calibre of the people involved
- The characteristics of the business and the industry
The executive summary
The executive summary should be brief and complete. If it's successful it will encourage investors to read more. It needs to show them:
- How much they can expect to earn from the deal
- Evidence that your team has the skills to execute the plan
- How they can protect their interest
- How they can realize their investment
Getting the investors' attention
The proposal needs to capture the investors' interest by providing them with the information they need in an attractive and easy-to-understand style. Pay close attention to the writing and visual presentation.
- Keep the writing clear and concise
- Avoid jargon and explain technical information
- Use graphics and formatting to help convey your message
- Package the proposal so it's easy to read
Table of contents
A typical proposal contains the following sections:
- Executive summary
- Business and ownership
- External environment
- Products and services
- Management team
- Financial plan
- Financial structure and valuation
- Operational plans
Finding potential investors
Who are potential investors?
There are many different types of risk capital investors. Each one has different characteristics.
- Love money: Family and friends are important sources of capital in the early stages of business development.
- Angel investors: These individual investors may want to be silent partners, or they may want to be actively involved in the business by contributing their experience and know-how.
- Venture capital firms: These companies are managed by professional venture capitalists and typically have particular investment strategies or preferences.
- Institutional investors: Pension funds, life insurance companies, banks and other institutions also provide risk financing.
- Government-backed corporations: The Business Development Bank of Canada and others provide equity financing as well as counselling, training and mentoring to small businesses.
- Corporate strategic investors: Major corporations sometimes invest in smaller companies when they're looking for strategic partnerships.
How do you find them?
Let people know what you're looking for. Look for introductions or referrals from:
- Business and personal acquaintances
- Professionals who serve your business
- Financial advisors with expertise in venture capital
Valuable contacts can be made through:
- Trade shows, conferences and investor forums
- Local Chambers of Commerce
- Industry associations
- Local and regional business development organizations
- Investor associations
Other possible sources include the Internet, news articles on investment deals, professional and industry directories and listings, and local entrepreneurship centres or economic development units.
Who should you target?
Find investors whose criteria match your situation. These are the key areas to look for common ground:
- Stage of development: Does your business's stage of development match the investor's criteria?
- Capital required: Does the amount you need fall within the investor's limits?
- Industry: Does the investor have a preference for specific industries?
- Geography: Is the investor located close to you?
- Leadership: If you're looking to syndicate your deal, will the investor consider taking a leadership position?
The first meeting with your targeted investor is an opportunity for you to make your investment proposal come alive. During the meeting, the investor will be looking for your belief in yourself and in your product or service. He or she will be trying to judge your credibility and integrity. It's also an opportunity for you to learn about your potential investor.
Usually only a small group of people — you and your advisors, your potential investor and the investor's advisors — attends this first meeting. The meeting might include:
- Your formal presentation
- A question-and-answer period
- Preliminary decisions as to the next steps, if applicable
- A tour of the facilities, if the meeting is held at your location
Preparing for the meeting
The first meeting is not a casual affair. You've got to plan the meeting and your strategy very carefully. To help prepare:
- Send the investor your proposal before the meeting
- Ask in advance what the investor's needs are
- Consider the details: meeting room, equipment, dress
- Rehearse your presentation
The investor's questions
Be prepared for tough questions. In fact, intense questioning can be a sign of stronger interest. The investor will be looking for answers to questions like these:
- Who are you?
- What is your track record?
- What is your commitment?
- Do you have a solid management team and, if so, who is in charge of what, and why?
- Are the assumptions used to project revenue growth reasonable?
- Does your company have a competitive advantage?
- Is there a viable exit strategy for this investment?
- How will the financing strategy influence the business strategy?
You should be looking for answers to questions like these:
- Does the investor believe that your financial projections are reasonable?
- Does the investor understand your specific requirements?
- Does the investor need additional information?
- Does the investor have access to the type and amount of capital you believe is needed to fund your project?
- Does the investor plan to take an active or passive role in the management of your business?
- Does the investor have the experience and the ability to work with your management team to improve your firm's operating and financial performance?
- Is the investor someone you could talk to about the challenges, opportunities and threats that your business faces?
The term sheet
Negotiations will officially begin when you receive a term sheet from the investor. This is his or her response to your proposal, covering the main elements of the deal:
- How much the investor will invest
- How much of that investment will be in the form of equity (shares) and how much will be in the form of a loan
- Details about the shares and/or loan, such as type of share, when dividends will be paid, or terms of loan repayment
- What features the investor wants to see in a new or revised shareholder agreement
What's on the table
Price: The value of the business and the amount the investor will pay, and the share of the business they acquire are central to the negotiation.
Control: Investors will be looking for ways to control their investment, such as representation on the board of directors or some type of involvement in decision-making. As the entrepreneur, you have to decide how much control you can give up.
Performance measures: You need to decide what measures and targets for success that both you and the investors accept, and then you need to hammer these out (e.g. sales volumes, cash flow levels, debt repayment).
Exit strategy: You'll need to determine how and when the investor will be able to take his or her investment out of the business (e.g. sale of the company, initial public offering, share buyback).
Employment contracts: Contracts to ensure that key players keep their positions may be part of the financing agreement.
A negotiating session
A good approach to a negotiation meeting is to proceed along these lines:
Open the discussion: Briefly state the differences you see between the investment proposal and the term sheet.
Focus on interest and goals: Discuss your interests and listen to the investor's.
Find common ways to calculate financial elements: Some differences may be due to different assumptions or approaches in financial calculations. Try to get some clarity and consensus on these. Seek expert advice, if necessary.
Create alternatives that benefit both parties: Stay flexible and look for alternatives. Reserve time to explore possibilities and be creative about solutions.
Keep the future in mind: Be sure any deal you make leaves you with options for raising more funds in the future if required.
Hold multiple negotiating sessions: Use the breaks between meetings to develop alternatives, analyze the investor's position and get additional information to support your goals.
Closing and due diligence
Assess the deal
Take a good look at the deal from these standpoints:
- Your company's future: Is this the best thing for you and the company, now and in the future?
- Financial needs and goals: A good deal will be good for the financial health of the company, and it won't limit your ability to raise capital in the future or to embark on other ventures.
- Trust and chemistry: This is going to be a long term relationship, so be sure you feel you can build a profitable and constructive partnership that will stay strong, even if the business hits a rough patch.
Scrutinize legal and other obligations
Things to consider:
- Legal issues: Be sure you understand the legal implications of the agreement, such as what representations and warranties the company is prepared to give, the composition of the board of directors, the dividend policy, compensation arrangements.
- Government regulations: Have your lawyer check that all applicable regulations, restrictions and registration requirements are considered.
- Existing contracts: See what effect the deal will have on existing contracts, such as licences, employment contracts, supplier contracts and bank loans.
Before closing the deal, the investor will conduct a due diligence review to verify your information and to obtain more data, if necessary. Every investor will perform the due diligence review differently. Some will have advisors (usually from large accounting firms) to perform the task, whereas others will handle it themselves.
A due diligence review will generally include a detailed look at these main elements of your business:
- Financial review: Your company's financial status
- Management review: Your management team's capabilities
- Market review: Your marketing plan and activities
- Operations and technical review: Your equipment, plant and processes
Build and maintain good relations with investors
It's important to remember that the closing of a deal is the beginning of a relationship. For that relationship to flourish, you need good communication and trust. You can strengthen that relationship by making sure the investor gets all relevant information in a timely manner and is included in decision making.