How can my small business partner with an equity investor?

Equity financing is a way of raising business finance by selling shares either to existing or new shareholders. It is one of several ways to fund a business, and equity investors can include venture capitalists, private equity firms, family offices and holding companies that own a number of businesses.

What equity investors seek

Most investors have unique preferences for the sector, size and type of business in which they invest. High-growth equity investors invest in high-growth companies with high returns. These are often established businesses that will be making a significant breakthrough in their field.

Other investors diversify their portfolio by investing in businesses that will provide consistent profits. They invest in small businesses that are sustainable but have limited growth potential, as well as those that expand slowly but steadily.

Some may specialise in particular sectors, such as the leisure industry.

How equity investors make money

This happens in one of two ways:

Through the payment of dividends

By selling the shares for a profit when they exit

The specifics are outlined in the shareholder agreement, which is finalised up-front.

Operational involvement

To safeguard their investment, an equity investor may be active in your business operations or even serve on your board. The extent of involvement is determined by the type of equity investor, so work with funders that match your needs and requirements.

You won’t necessarily lose control of your business, as a funder may invest in a minority stake. Some funding arrangements will include mentorship as a condition for funding.

Pros and cons of equity financing

TAKING ON AN EQUITY PARTNER IN YOUR BUSINESS
PROS	CONS
There’s no monthly repayment requirement.	Equity investors own a portion of your business.
Investors contribute skills, expertise and contacts, which benefit your business.	You may lose some control of management decisions which could lead to conflict.
Investors are interested in the success of your business and may even provide follow-up funding.	You will have to share profits with investors, which may become significant as the business grows.
	Raising funds from investors can be very time-consuming, distracting you from the crucial aspect of running your business.
	There may be strict performance terms attached to an equity investment which may see the founder redeployed in another role as opposed to chief executive officer.
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Exit strategy

Equity funders aim to maximize the return on their investment, and an exit strategy outlines how this will be accomplished.  It is a plan to sell an investment or exit a strategic position in a defined period, and it is included in the shareholder agreement. The exit plan must include the exit date, exit method, how the investor will be paid and estimated return on investment.

There are several ways for an equity investor to exit:

An Initial Public Offering (IPO) allows private investors to buy shares, allowing the equity investor to sell their shares

Strategically selling the business to a competitor or another business within the same sector

Selling their equity investment to another equity investor

A management buy-out where the management buys back the equity investor’s shares

If the business is no longer viable, it can be liquidated as a last resort, with proceeds shared amongst shareholders, once all the liabilities have been settled

There may be legal and regulatory issues to consider, such as compliance and intellectual property rights. Before deciding on an exit strategy, the business must be thoroughly valued. To conduct a due diligence and ensure that the shareholder agreement is legally sound, you will require the services of professionals, such as an accountant and an attorney.

What does equity financing cost?

There will be legal fees for drafting the shareholder agreement, as well as accounting costs for the valuing of your business and conducting due diligence.

Longer-term costs include the profits you have to share with the investors, which can be substantial if your business performs well. However, you may not have been able to attain this level of growth without their investment and expertise.

Where to find an equity investor

There is no clear-cut method to locate an equity investor who meets your needs. You may find them through business networks, online platforms like LinkedIn or by attending events that bring together business owners and investors. There are also several online investor directories which you can consult.

Equity financing vs debt

Alternatively, you could use a loan to finance your business expansion. There are some clear differences to consider when weighing up the two options:

• Borrowing money allows you to keep control of your business, but it’s riskier, as you need to repay the debt each month.
  
  
• Repaying debt may hinder business growth as it affects your cash flow.
  
  
• The interest you pay on debt financing is tax deductible, but dividends paid to investors are not.
  
  
• Once the loan is repaid, you have no more involvement with the lender; with equity financing, you are tied up for a specified length of time, and it may be more expensive for profitable businesses.

You could also use a combination of debt and equity, financing operational expenses with debt and large-scale growth with equity financing.

This article was written by Sylvia Walker and reviewed by Pat Mokgatle, a chartered accountant who is head of entrepreneurial business at audit, tax and advisory firm BDO.