Equity financing means investing money in a business organization in exchange for an ownership interest in the business. Selling equity to private investors in a business is commonly called a “private placement”. Early equity financing may come from the founder(s), friends, and family. That is, these individuals capitalize the business very early on and receive a share of the ownership. It is not until later in the development of the business ventures that third-party investors would seek to invest money in the business venture in hopes of making a return on that investment.
What is Equity?
Equity is considered any ownership interest in a business. It may include a partnership interest, membership interest in an LLC, or shares of a corporation. It may even include any contractual obligation to shares proceeds of the venture with third parties (“known as an investment contract”). Any of these types of equities are known as “securities”, the sale of which must comply with state and federal law. In any event, equity investment is the sale of securities to third parties as a method of financing the firm’s formation, growth, or operations.
Who are the Equity Investors?
Outside of founders and friends and family, equity investors in startup ventures are generally broken down into four groups.
- Angel Investors – Angel investors are high-net-worth individuals who invest in startup ventures in hopes of earning a profits. Angel investors sometimes join together in small groups to collectively invest in an early-stage ventures. Angel investment runs anywhere from a few thousand dollars to a group investment of $1 million. In any event, these are the earliest third-party, equity investors.
- Venture Capitalists – Venture capitalists are professional funds managed by an individual or small group of investment managers. These individuals assemble funds from third-party investors. They then manage these funds by investing in promising startup ventures. Venture capitalists may invest a few hundred thousand dollars, up to hundreds of millions in a single firm.
- Private Equity Firms – These are large professional funds. They are organized similarly to a venture capital firm, but generally are far bigger. Their primary purpose is to purchase controlling or total interests in companies. They generally make changes to the company (such as operational streamlining, mergers, acquisitions, etc.) and then resell the company either to companies, other private equity firms, or to the public via an Initial Public Officering.
- Going Public– Going public is the process of registering and selling a companies equity own a public market. In some cases the equity is sold on a large public exchange. Anyone can purchase the companies equity at this point without any restriction. At this point, the company no longer belongs solely to a closely-held group; rather, it is owned by the public at large.
How are Equity Investors Compensated?
Early stage investors seek a return on investment via an exit event. That is, they invest money with hopes that the value of the business will rise. At some point in the future the investor will sell her interest in the company for a profit. This is known as an exit event. Common exit events for early investors are the sale of the company equity to other investors or sale to the general public through an initial public offering.
Notably, early investors generally do not seek a dividend from the startup venture. Rather, the company should use any earnings or profits to continue growing the business venture. A startup that turns a profit early in the life of the business is generally not using the money to meet its growth projections. This can be a very bad sign. As such, startups typically survive and grow by burning all available capital to achieve growth. Often the primary form of growth capital is from outside investors.
Given the objectives of the firm, investors understand that investing in an early-stage venture is risky. As such, investors generally want a generous return on their investment at the time of exit. Early stage investors may seek between 10 and 50 times their original investment. This means that investors require a large stage in the company compared to their investment. Entrepreneurs are often hesitant to sell such large stakes early in the life of their business, as this reduces the ownership and potential gains for the entrepreneurs. The entrepreneurs often take very small or no salaries from the business venture as it grows.
Rights of Investors
It is important to remember that equity investors are owners of the business. As such, they have certain rights that inhere to them as owners. Further, the investor may want to exercise additional controls over the business as a method of protecting their investments. Common ownership rights and control measures for an investor are as follows:
- The right to vote to elect a board of directors (or specific members of the board);
- The right to vote on all major business decisions (or specific approval rights for certain decisions);
- The right to be informed about all significant business decisions (this may include significant record review rights);
- The right to exit the company by forcing redemption of their shares by the company;