An introduction to equity finance

Equity finance is a way of funding a business or a business project. The funding is provided by an external investor who receives a share of the profits, usually a share in the ownership of the business and often a share in the running of the business.

Since the investor faces the same uncertainties as the owner of the business, equity finance is also known as risk capital.

Businesses turn to external investors as an alternative to other means of raising capital such as loans, grants and joint ventures.

Equity finance is not a suitable route for all businesses, and to consider it a business must have particular needs and circumstances. Typically, a business may be embarking on a project or an expansion plan which lenders such as banks would not be prepared to support. Or the business may be deterred from taking out a loan because it wishes to invest in the project or plan money that would otherwise go on interest payments.

There are also different types and levels of equity finance. Venture capitalists, for example, prefer larger companies aiming for a quick, high rate of growth. Business angels, or individual private investors, on the other hand are more favourable to smaller, start-up or early-stage enterprises.

Venture capital

Venture capital companies generally invest substantial amounts - £2 million or more - in projects or enterprises that offer a potentially high return within a defined period of time, say five years. For this reason, in order to attract venture capital, a business will usually need ambition, a track record, experienced people, and a product or service that is unique or has a distinct advantage in its market. While venture capitalists do not as a rule play a part in the day-to-day running of the business, they can provide guidance on overall growth strategies. More information on finding and approaching venture capital companies is available from the British Venture Capital Association.

Business angels

Business angels are individuals who are prepared to put their own money into suitable enterprises. As such they tend to occupy the funding gap, or at least part of it, that can exist between banks and venture capital companies, injecting sums of, say, between £50,000 and a £250,000. Sometimes they invest on their own, sometimes as part of a group of other private investors.

Like venture capitalists, business angels usually take an interest in enterprises that occupy a niche market, or have a new product or an obvious advantage over their competition. Unlike venture capitalists, business angels may be more inclined to invest in start-ups or early stage businesses, and can be adaptable in the way they finance a business.

Owners should be aware that, usually, private investors will want some direct involvement in the company. Depending on the experience of the investor, that hands-on involvement can, however, be a real business benefit if their expertise adds a new dimension to the running of the company. Business angels do not usually advertise themselves but operate through network organisations. These will often vet any investment proposals before forwarding them to possible investors. The British Business Angels Association will be able to direct any interested entrepreneurs towards the most relevant business angel network.

Why choose equity finance

There are a number of benefits to equity finance. The investment can be concentrated on business activities without the distraction of loan repayments. Private investors and venture capitalists can brings additional skills, expertise, contacts and knowledge to an enterprise. The investors will have a commitment to and interest in the success of the business, and will be more likely to provide follow-up funding.

Why not to choose equity finance

There are, however, a number of disadvantages to equity finance. The actual process of finding and then attracting investors can be expensive in time and effort. The owner(s) will have to surrender at least some control over decision-making and some of their share in the business. Time will have to be devoted to keeping any investors updated on the progress and development of the enterprise. In some cases, there will be legal and regulatory matters to address.

Attracting equity finance

A successful application for equity finance will need to include an exhaustive business plan, a persuasive account of the product, service or project, financial forecasts, an accurate appraisal of the level of funding required, the use to which the funding is to be put, details of the expertise and experience of those people involved in the business, the amount of control the owner is willing to concede, and the returns the investors may reasonably expect.

Before deciding to seek equity finance, a business should consult with their accountants who will be able to offer practical advice and guidance on the whether this type of funding is appropriate and, if it is, the best approach to adopt.