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 cannot 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.
Many companies are still reluctant to seek equity financing as they see it as relinquishing control. There is a misconception about ‘giving away’ equity. In fact, companies sell the equity for valuable consideration. And many companies are giving up effective control if they rely on an overdraft as a major source of finance.
There are many different options available for small businesses. Each business should investigate the options outlined here and choose the right finance for the right purpose.