What is equity finance?

Would you give someone a stake in your business in return for funds?

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There are two main types of capital; debt and equity. They are very different and will therefore have a very different effect on your business as it grows and develops.

What is equity finance?

Many small businesses actually use equity finance without even realising it. As Bank of England figures show, some 61% of businesses are launched with either personal capital or that of friends and relatives. That can be equity arrangement where friends and family take a stake in the business.

The big advantage of equity finance is that it never has to be repaid and there is no interest rate paid on the money. Equity investments are true risk capital as there is no guarantee of the investor getting their money back. The investment is not tied to any particular assets that can be redeemed from the business and, should the business fail, an equity investor is less likely to get their original investment back than other investors.

The return from an equity investment can be generated either through a sale of the shares once the company has grown or through dividends, a discretionary payout to shareholders if the business does well.

However, the reason that firms will give you cash in this form is that they will take a share of the business in return.

Formal equity finance is available through a number of different sources, such as business angels, venture capitalists or the stock markets.

Each varies in the amount of money available and the process to completing the deal. For example, business angels are typically looking to write a cheque for a minimum of £25,000 – any smaller amounts are not usually appropriate because the fixed costs are too large.

However, they all have one factor in common. Equity investors are prepared to put up risk capital in return for a share in a growth business. If your business can not support growth rates of at least 20% you may not be able to attract equity funding.

It is this control and the prospect of a higher return if your business is successful that attracts investors to put up this type of capital. It is also these factors that many small businesses are wary of – they are reluctant to give up control of their business. Particularly firms that are likely to grow fast, such as IT or internet companies, that are likely to need further cash injections as they grow, there is some reluctance to give away a share of the business at an early stage.

“There is a real ignorance about the possibilities of selling shares and because of that ignorance there are fears. Companies here usually reinvest the profits or go to a bank for money because they always think they will lose the business,” said John Hughes, an advisor with the Gordon Enterprise Trust. “There is this sacred cow that I don’t want to part with my business. But why do you want 100% control? There is a suspicion about selling equity and the common thing is to simply get a bank loan.”

However, the very rapid growth and capital consumption that these businesses experience makes them unpopular with the banks. Banks, the major providers of debt finance, like to see steady growth projections based upon a surefire business plan. But many companies are still reluctant to seek equity financing as they see it as relinquishing control.

There is a misconception about ‘giving away’ equity, explained Ray Hurcombe of Xenos, the Welsh business angel network. In fact, companies sell the equity for valuable consideration.

In fact, many companies are giving up effective control if they rely on an overdraft as a major source of finance.

Nick Reed, a founder of software startup RVC before it was sold, noted that they steered clear of bank debt when setting up two years ago. “We didn’t want to owe money to the bank because they can shut down your business overnight if they suddenly call in the overdraft,” he said.

There are many different options available for small businesses. As Martin explained, “It is horses for courses.” Each business should investigate the options outlined here and choose the right finance for the right purpose.

If your business can not support growth rates of at least 20% you may not be able to attract equity funding

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