Essentially, equity capital is money that is invested into a company in
exchange for an ownership interest in that company. Traditionally, equity
capital—unlike debt—is not intended to be repaid according to a specific
schedule and is not secured (or guaranteed) by the company's assets. Instead, an
equity investor (i.e., the individual or entity that supplies the company with
the money) expects that, within a certain time frame, the ownership percentage
she holds will be worth more than the original amount she invested.
You may be more familiar than you think with the concept of equity capital.
Millions of people are public equity investors because they own shares in large
corporations such as Microsoft and Wal-Mart, companies whose ownership interests
are priced and traded publicly. In Equity Capital Market Landscape, however,
when we say equity capital, we are referring to private equity capital, which
represents money that is invested in private companies, or those that are not
listed on the NYSE or NASDQ exchanges.
How do you know if equity capital is for your company?
Public equity capital is only for large proven companies, often with hundreds of millions of dollars in revenues and profits. The opportunities for companies to secure public equity capital for the first time, or to go public in an IPO, are extremely limited.
Private equity capital, on the other hand, can be appropriate for fast-growing, young companies. Check out Springboard's Equity Assessment Tool to see if equity capital is appropriate for your company. Also, please note that for those fast-growing, young companies that have (1) limited capital needs and (2) stable cash flow or a substantial tangible asset base, debt financing may be a better financing alternative.
Why might debt financing be more appropriate?
At first glance, it may seem like equity is a better deal for a company than debt, but private equity investors are no fools. In fact, experienced private equity investors usually make a 25% return on investment (ROI), far more expensive for a company than the typical debt interest rate of less than 15%. Additionally, private equity investors know that an equity investment in a company is much a more risky vehicle for their money than a loan (i.e., debt) to a company, so there are a number of checks and balances inherent in the structuring of a private equity investment and the corresponding ownership interest. (See more about debt financing in Sources of Capital: Debt Financing.)
So why does any company seek private equity capital?
Private equity capital can often the only option for a start-up company with high growth potential. For example, TechForCash, a start-up software company, anticipates product development expenditures of $1 million during the two years of its life. In its third year, fourth, and fifth years, it expects to make $1 million, $2 million, and $4 million, respectively. Despite this remarkable growth potential, TechForCash would probably not be able to get a loan to finance its launch. However, if TechForCash has a strong business plan, an impressive management team, a pilot product, and a couple of clients, a private equity investor may be willing give the company $1 million in development capital, in exchange for, say, 25% ownership in the company.
What are the sources of private equity capital?
These corporate venturing programs may be loosely organized programs affiliated with existing business development programs or may be self-contained entities with a strategic charter and mission to make investments congruent with the parent’s strategic mission. There are some venture firms that specialize in advising, consulting and managing a corporation’s venturing program.
Angels In the early days of venture capital investment, in the 1950s and 1960s, individual investors were the archetypal venture investor. While this type of individual investment did not totally disappear, the modern venture firm emerged as the dominant venture investment vehicle. However, in the last few years, individuals have again become a potent and increasingly larger part of the early stage start-up venture life cycle. These "angel investors" will mentor a company and provide needed capital and expertise to help develop companies. Angel investors may either be wealthy people with management expertise or retired business men and women who seek the opportunity for first-hand business development. (Springboard thanks the NVCA for this informative description.)
Venture Capital Firms Venture capital firms are pools of capital, typically organized as a limited partnership, that invest in companies that represent the opportunity for a high rate of return within five to seven years. The venture capitalist may look at several hundred investment opportunities before investing in only a few selected companies with favorable investment opportunities. Far from being simply passive financiers, venture capitalists foster growth in companies through their involvement in the management, strategic marketing and planning of their investee companies. They are entrepreneurs first and financiers second. (Springboard thanks the NVCA for this informative description.)
Leveraged Buyout Firms Leveraged buyout firms specialize in helping entrepreneurs to finance the purchase of established companies. The approach of such firms is to provide a management team with enough equity to make a small down payment on the purchase of a business, and then to pay the rest of the purchase price with borrowed money. The assets of the company are used as collateral for the loans, and the cash flow of the company is used to pay off the debt. Because the acquired company itself is paying the freight for its own acquisition, these investments were originally known as "boot-strap" deals. Eventually they became known as leveraged buyouts, or management buyouts. (Springboard thanks Private Equity Interactive for this helpful description.)
Large Corporations One form of investing that was popular in the 1980s and is again very popular is corporate venturing. This is usually called "direct investing" in portfolio companies by venture capital programs or subsidiaries of nonfinancial corporations. These investment vehicles seek to find qualified investment opportunities that are congruent with the parent company’s strategic technology or that provide synergy or cost savings.
What is the private equity market like right now?
The typical distinction between corporate venturing and other types of venture investment vehicles is that corporate venturing is usually performed with corporate strategic objectives in mind while other venture investment vehicles typically have investment return or financial objectives as their primary goal. This may be a generalization as corporate venture programs are not immune to financial considerations, but the distinction can be made. The other distinction of corporate venture programs is that they usually invest their parent’s capital while other venture investment vehicles invest outside investors’ capital. (Springboard thanks the NVCA for this informative description.)
Meeting with VCs
(1:24)
Before an entrepreneur meets with a VC, see if they are meeting or have term sheet with any competitors. Do not be paranoid about telling people your idea; it is just "the seed to the company."
What Are Investors Looking For?
(1:44)
Venture capitalists are looking for presentations that include: what the market drivers are, what the competition is like, who the management team is, and how the company is going to use the funds. The entrepreneur must be committed and excited about the idea that they are presenting.
Being Scaleable (0:36)
Springboard Director and accountant Cal Hackeman explains what it means for a business to be scaleable, which is a necessary attribute of a business that seeks to attract venture capital.
