Equity finance

Equity is one of the hardest types of finance to acquire. Yes, there are a plethora of equity investors out there, but this is far outweighed by the gargantuan number of businesses all vying for attention at the same time.

Equity investment is, by its very nature, one of the most risky ways to invest money. Recouping an equity investment usually involves selling the business or listing on a stock exchange. Even when the business is sold, the equity investor is only be repaid after all debt holders are paid back first.

Prospective equity investors, therefore, expect to see a strong business case: outlining significant growth prospects, profitability with scope to pay out dividends and a visibility of an exit or listing on the stock exchange with a high return.

Choosing the right investor

Diluting your equity stake to raise money can feel scary but don’t forget the end goal. The additional funds should help move the dial on your business and, as the saying goes, ‘fifty percent of something is better than a hundred percent of nothing’.  

However £1 of investment from one investor does not always equal the same as taking £1 investment from an alternative investor. That’s because different investors bring different skills, knowledge, connections and requirements to the table. Some will want more involvement and some will be happy to be a silent investor. The decision of who to choose will always come down to aligning your goals and the investor’s as well as ensuring your personalities will gel. Knowing who and how to approach will determine how successful you are at raising equity finance.

In order to do that we should look at the main equity investor categories (excluding family and friends) out there and what they typically offer:

Private equity

• Invest from £5m upwards in profitable, growing or mature companies

• Sector specific investors with clearly defined investment criteria and screening process

• Clear investment horizons holding investments for a three to five year period in order to deliver returns to their limited partners

• Expect to hold a board position and additional reporting requirements, but usually bring helpful expertise and skills to the table

• Have significant legal control over company decision making whether a minority or majority shareholder and can put fairly onerous constraints over the operations of the business so this should be assessed thoroughly

• A good option for development or replacement capital or part of an equity debt package to support MBO acquisitions

Venture capital

• Invest from £2m to £20m+ in early stage companies, sector specific

• Most often invest in high growth businesses on a trajectory to a sale or listing on the stock exchange

• Seek similar level of control and board representation as private equity investors

Corporates

• Large corporates are often regarded as acquirers of businesses looking to exit, but they are quite often receptive to investing at an early stage of a company’s growth

• Invest either directly or through a formal corporate venture arm

• Normally invest in a sector they are currently operating in or a related horizontal or vertical segment

• Due to their operational clout, they can offer more than just cash investment, for example, assisting in premises for staff and operations, manpower, marketing and established distribution networks

• Investment structures can mimic a private equity model allowing management control over the setting and implementing of the business plan

Family offices

• Funds managed for single or multiple family offices

• They do not necessarily have a formal investment criteria and objectives are usually determined by the family and guided by management.

• Long term support is not always based on investment prospects but also internal family politics and emotional dynamics

• Investment support and response can be more agile than traditional private equity allowing quick decisions on investment, but can also have a more fluid exit timeline

• Typically will have longer investment horizons regarded as ‘patient capital’ meaning short term losses are absorbed and longer term objectives are more easily fulfilled

• More elusive to find such offices and get in the door than private equity

High net worth investors

• Wealthy individuals who often are/were entrepreneurs in their own right

• Often bring invaluable skills, knowledge and contacts to the table

• Like family offices, they do not necessarily have a formal investment criteria or horizon

• May want a role on the board if taking a substantial stake in the business but sometimes may invest via institutional vehicles with more of an arm’s length relationship

• Business angels are high net worth investors who typically invest £10k to £2m in early stage companies

• Not as easy to directly connect with as private equity and venture capital

Crowdfunding

• Small amounts of money invested by large number of individuals that often include a large number of high net worth investors as well as venture capital

• Popular equity crowdfunding platforms include Crowdcube and Seedrs

• Predominately used by start-up companies and often by those who have struggled to source funding from traditional funds.

• Fund raises are, on average, just under £1m but there are those who have successfully raised a lot more. Successful examples include BrewDog’s Equity Punk, Camden Town Brewery, JustPark and Chilango.

• Platform provides direct access to a diverse number of investors and public exposure

• Unlike bank funding, crowdfunding is not protected by the Financial Services Compensation Scheme and there is a risk of non-payment by investors or slow payment processing by platform

• Can be difficult to row back investor pitch campaign once live and if the campaign is not successful it can taint your business quite publicly

• Secondary market to sell such shares is still in its infancy so investors mainly rely on some form of exit to realise their investment  

Equity capital markets

• In the UK, the London Stock Exchange includes the Main Market, AIM market and PLUS markets where companies can raise new equity from financial institutions including pensions funds, insurance companies and private individuals

• Platform allows for equity capital raises from £5m to over £1bn

• Liquid market enables investors to quickly buy and sell their investments to realise gains unlike any other equity source

• Raises company profile significantly enhancing its status with customers and suppliers

• Public exposure means greater need for transparency, accountability and significant reporting requirements that may not suit many owner managers

Checklist of considerations before embarking on an equity raise

1.    Chemistry matters

• Choose investors who have the right contacts and bring genuine commercial and strategic expertise to take your business to the next stage of growth.

• Put together an ‘A-list’ of potential investors and prioritise your time with these before moving down to your ‘B’ list and so on. Research who are the main investors in your space and find out as much as you can about them and work out the rationale why they should invest in you before you make your approach.

• Ask them questions too and be honest with yourself if you can really work together, if that’s expected. Speak to the owners of businesses the investors have previously backed and do your own due diligence.

2.    Have a plan

• Take the time to prepare all the required financial information and formulate a business plan and pitch document. Don’t forget to really focus in on your business purpose and ambition. Be ready in advance for any due diligence by making sure you tidy up your systems, processes and compliance beforehand. You will be asked for a wide ranging amount of information as some investors, particularly private equity, will look at everything!

• Put together a timetable marking out the key milestones of the fund raise and make time in your diary to attend presentations, meetings and your day job, of course!

3.    Get an accurate valuation

• Unrealistic valuations of your business can stifle your chances at the first hurdle particularly if you intend to conduct a series of ongoing fundraises as each round will be at a higher valuation.

• The valuation will also determine the level of dilution for existing shareholders so it is important they have all bought into this before you embark the fundraise.

• Research similar companies’ valuations of listed companies and M&A transaction history as well as sourcing up to date market intelligence on current investor and buyer appetite

4.    Set up an Enterprise Investment Scheme (EIS)

• Certain companies can qualify for raising finance under the EIS. This can offer very attractive tax incentives for individuals to invest in such companies - for example, income tax relief at 30% on the cost of the shares and the deferment on capital gains tax on the sale of other assets if the gain is reinvested into EIS shares. Check out the EIS guidance provided by the HMRC for full conditions and requirements to qualify.

5.    When an offer comes in, look at the terms and conditions carefully

• Offers of finance can be complex, for example, equity ratchets, and they should be looked at in the context of completion, but also in terms of what happens on a subsequent sale after any loan stock is converted and debt repaid. Equity ratchets help flex the percentage stake of the investor and management based on the how the business performs so you need to look at various scenarios and ensure you are comfortable with this.

• Consider carefully the rights an investor is requesting to attach to the shares being issued. There can be subtle differences between different shares, but in general terms the two main categories are:

  • Ordinary shares: usually have the option to vote at shareholder meetings where decisions are made around dividend payments and salary packages of the board members; and

  • Preference shares:  can be treated preferentially to other classes of shares in terms of payment of dividends.

• Draw up a shareholder agreement which defines the relationship between all or some of the shareholders (e.g. a particular class of share). It protects the shareholders’ investment in the company, how the company is run and sets out the shareholders’ (minority and majority shareholders) rights and obligations. You will see provisions on what happens on the sale of the shares including compulsory transfer of shares, pre-emption rights and drag along and tag along rights.

• It is wise to get financial and legal advice to ensure you fully understand the implications of any investment. They should be brought in at an early stage to guide you and run the process for you allowing you more time to get back to focusing on growing your business.

The information contained on this page is intended to be a summary of some of the available options and does not amount to tax advice and therefore should not be relied upon alone. Independent tax advice should be sought before entering into any finance arrangement.