July 11th, 2022 | By: The Startups Team | Tags: Funding
Continuing in Phase One of a four-part Funding Series:
Phase One - Structuring a Fundraise
Part 1 - Startup Bootstrapping
Part 2 - Debt as Startup Capital
Part 3 - Equity Funding for Startups ( ←YOU ARE HERE 😀)
Part 4 - Convertible Debt
Phase Two - Investor Selection
Phase Three - The Pitch
Phase Four - Investor Outreach
Let's dive in!
Pursuing equity financing means that, in exchange for the money they invest now, angel investors or venture capitalists will receive a stake in your company and its performance moving forward.
Equity financing is one of the most sought-after forms of startup funding for entrepreneurs, although certainly the least available (compared to something like a business loan or friends and family financing). Simply put – there are very few equity investors who have a check to write and there are 1000x more Founders with a business plan to fund. It’s a supply problem for working capital.
Key Takeaway: Equity financing provides startup funding for a piece of your company in exchange for their startup capital but they are hard to find because private equity investor’s checks are in very limited supply.
Equity financing is valuable when a business owner requires startup funding that will involve a high degree of risk without an immediate payback or return of capital. That's why certain high growth companies that require a long runway before they will start generating cash flow look to business funding vs. traditional debt financing. They cannot be stuck making payments for small business loans when they don’t have the money raised!
Equity financing is the method of raising capital by selling company stock to investors. In return for the investment, angel investors or venture capitalists receive ownership interests in the startup company. Unlike debt financing, there is no personal collateral involved.
You negotiate the startup funding amount and a valuation of the company (more on this later). Based on that valuation and the equity financing angel investors or venture capitalists gives you, they will own a percentage of stock in your startup company, for which they will receive proportional compensation once your company sells or goes public.
The Founders of FacePalm agree to raise capital of $250,000 from an angel investor at a $750,000 pre-money valuation (the value before you add the $250k check). The angel investors get 25% of the company ($250k check + $750k pre-money = $1m). When it sells, or does an Initial Public Offering (IPO) they get 25% of the proceeds.
The challenge for most business owners isn’t simply understanding that you’re giving up a piece of your startup business to support an equity finance option. It’s understanding the entire startup business funding process. Next we’ll discuss when to use equity financing, what the challenges are, how they compare to debt financing and how to understand the key business funding terms used.
There are several situations in which an equity finance option makes the most sense, especially since most startups can’t secure debt financing to begin with.
Not many small businesses will start generating income as soon as they launch, but spending a few years in the red doesn’t mean your company can’t take on equity financing (most startups are in this boat). Internet companies, often getting their equity finance capital from venture capitalists, are notorious for going years in operation without even attempting to charge their customers.
If you’re going to need a sizeable infusion of operating cash to sustain your business before it starts turning a profit, equity financing is the only form of capital that makes sense.
In order to take out a traditional business loan, you need to have something to offer as collateral in case things with the young business don’t work out like thoe financial projections suggested. If you don’t have anything of value to give debt financing providers for security, your only real option is to secure equity financing from angel or venture capital investors who use the equity in your startup as collateral instead.
While using personal savings to fund your business plan bit by bit may not sound as glamorous as hitting the ground with equity financing already lined up, most seed funding investors will expect you to start there before they invest. But some businesses—a private jet service, for example— require a massive amount of equity finance capital just to get off the ground. In those cases, you have little choice but to go directly to equity financing.
Equity financing tends to follow a business model for startup companies that have potential for massive growth and exponential paydays, eventually seeking venture capital. Your local coffee shop concept may do really well, but it doesn’t have the potential to become Google, so you’re not likely to attract many equity investors like venture capitalists. They will rely on debt financing.
On the other hand, if you’re looking to build the next Starbucks chain, and you have a vision and a plan that supports that kind of growth, chances are investors will be very interested in jumping onto your bandwagon on the road to IPO by infusing some startup funding.
Bear in mind that just needing money doesn’t qualify you for startup funding – you also have to be the type of company equity investors tend to fund. But if you’re nodding your head to all of these conditions, chances are you’ll be pitching investors in the not-too-distant future.
Not surprisingly, for small businesses there are some real challenges around going the equity financing route when raising capital. These shouldn’t necessarily keep you from considering equity, but they are real challenges that every startup faces no matter where they are in the continuum of fundraising:
Equity investors are interested in one thing: liquidity. That means they won’t be satisfied with a cut of your profits each year. Unlike debt financing, which has modest returns, venture capitalists typically look for the opposite. If they’re going to provide seed funding, at high risk, potential investors want massive returns from their equity stake.
With most equity financing, especially with venture capital investors, they expect a startup to be either sold or IPO within 7-10 years. That means you only have one outcome that will get you there – serious growth.
A big outcome to you might be a $5 million business generating $1 million in profit each year. A big outcome to them will more likely be a $100 million or $1 billion business.
One caveat – the expectations tend to scale with the size of the check, which also tend to scale with each funding round. Individual investors putting $10k into your specialty greeting card business may be just fine with a small outcome, including distributions. But as you look for bigger checks, it’s a safe bet to expect investors to ask for big rewards.
There are far more people looking for equity investors than there are checks being written.
A single angel investor may look at hundreds of deals in a year and write just one check. Now imagine how hard it is to get funded if you’re even the least bit unprepared versus all of the other promising startups who did their homework.
Finding an investor is not about just having a great idea – everyone has a great idea. Finding an investor is about having the most traction, the best plan, and the biggest return on their investment. Every aspect of your startup is in competition with every aspect of someone else’s start, and the stakes are high.
Finding an investor can easily take 3-6 months, sometimes longer. This isn’t like applying for a mortgage and waiting for a yes/no response. Debt financing is much faster. Outside investment is more like trying to find a partner to marry.
There’s no way to guarantee when you’ll find the perfect love connection between your idea (which again is one of many) and an investor who just can’t say no.
Even once an investor shows interest, there are lots of follow-on meetings to do diligence to make sure they are ready to make a bona fide offer. Once they make an offer, you then spend more time negotiating all the finer details of the deal. Then the lawyers come in and the process gets even longer.
Founders budget many months where they expect to prepare their materials, identify investors, setup pitch meetings, and hopefully close a round of funding. It rarely happens quickly, so just be prepared.
Once you give up equity, there’s a 99% chance you’ll never get it back. Of course this applies not only to equity investors but to co-founders, employees and anyone else you incentivize with stock. But investors tend to take very large blocks of stock very early in the company’s infancy.
What may seem like a small amount of stock now — say 25% — becomes exponentially more when you consider the next round of capital that you raise will also want a meaningful chunk of stock – maybe another 25%.
This compounds over time until some Founders find themselves with a very small stake in a company that they felt like they owned outright just a few years ago.
Sometimes a smaller piece of a bigger pie is more valuable. Most of the time it's just a smaller piece.
Some entrepreneurs will say “Well so long as I control the majority percentage of my company, I’m still the boss so who cares if I take capital?” That’s the kind of advice we hear from people talking to someone like the Small Business Administration who tend to think in a different way or tend to coach businesses on a very different type of startup funding.
First, most investment documents in the seed round will have key provisions that prevent you from doing many things you’d assume you can do, such as setting your own salary or selling to an acquirer on a deal that makes you wealthy.
The “Term Sheet” of an investment is designed to outline terms that an investor will want to protect their investment and provide very real controls over the company despite what percentage they own.
Second, there’s something in the investment world known as the “Golden Rule – She with the gold, rules.” That’s a fancy way of saying whoever controls the purse strings of your company, be it a banker, private equity investor or an angel investor, truly has control over the fate of the company.
Last, startup investments usually establish a Board of Directors to make key decisions when they raise money. Most of the decisions may be made by you day to day, but the big ones, such as when you can sell the company, will most certainly require Board approval.
Despite all of these challenges, many of the most well-known startups raise money with these terms have done just fine. So while these are concerns with these types of startup funding options, they don’t need to be deterrents.
Most of us don’t sit around talking about the details of an equity investment deal (thankfully) but once you start talking to equity investors, you’re going to need to know a handful of important terms that relate to how equity deals are done.
Don’t worry about memorizing terms, just focus on the concepts. Some of these you will have heard before, and right now we’re just going to provide a basic understanding so you don’t get held up when talking about an investment.
There are a handful of terms that will almost certainly be thrown around when you raise capital. These are the most common and represent the least you need to know when talking to investors:
How much your company is worth when an investor puts money into your deal. This can often be a speculative (read: made up) number but it often aligns with how much money is being raised and the stage of the business.
You started with 100% of the business. You gave 30% of the company to an investor. The process of giving away equity is called dilution.
When investors put money in your deal, they get a different class of stock than you do (yours is called common stock). That means their stock can have special rights that yours does not, including different voting rights on key issues. But what it usually means is that their stock gets paid first in a sale.
This is the type of stock that you and the rest of the employees will likely have. It has no rights attached, and you get paid after the investors get paid first (in most cases).
Investors often ask for a provision in their investment that guarantees they will get the amount of startup capital invested 100% paid back first, and then whatever cash is left over is divided based on what percentage ownership everyone has. Yes, that means you could get zero.
For now you don’t need to become an expert in talking through the complicated investment terminology of equity finance. But if you understand the basic concepts you should be well on your way to starting the conversation amongst investors from pre-seed funding, private equity investors, investment banks, equity crowdfunding, for your new business venture funding needs.
Continue to Part 4 - Convertible Debt