Building on the post on debt from last week’s Finance Friday series, today we will consider another common means for financing a start-up – equity. At the end of this post there is a table showing the pros and cons of debt and equity. Next Friday, we will discuss some of the less common, more creative avenues for financing a business.
Equity
For equity financing, a business cedes partial ownership in exchange for capital. The benefits of this type of capital are several. First, you don’t necessarily need collateral or cash flow to obtain this kind of financing. The risks are also much lower for the entrepreneur – if the company fails, the investor is out of the money, not you personally. Equity financing often comes from venture capitalists or angel investors, and these types of investors usually bring relevant expertise and advice to your company as well. In fact, this expertise and partnership is one of the biggest advantages of equity financing. Since investors are betting on a bigger payoff from your company down the road, they have a significant interest in investing in you as an individual, making sure you have the knowledge needed to make your business work. The investors often will be able to leverage their skills and networks and funnel them toward your business, strengthening areas where you are weak and providing very valuable insights you may not have considered.
The main disadvantage of equity funding is that you are relinquishing some control in your company. You are no longer just accountable to yourself, and equity investors often want more reporting and monitoring to ensure you are staying on track. While this is a downside, it can also have the benefit of keeping you focused, forcing you to make sure you are taking prudent steps forward. Some entrepreneurs may find the idea of giving up a share of their company very unpalatable, but if you find a strong investor you can work well with, the payoff for your company can be huge, especially at an early stage.
Equity Exits
Investors want to know how their money will be returned; that is, they want to eventually “exit” the investment, hopefully with a sizable return. For debt, the investor’s exit is built into the instrument – there are defined terms for repayment with interest, which, if broken, lead to specific mechanisms for recovering as much of the investment as possible. The equity exit is not as clearly defined, and many entrepreneurs neglect to consider it at first. Entrepreneurs are often understandably attached to their businesses, and may want to continue managing them indefinitely. But it is important to realize that equity investors do want their capital returned at some point.
Thus, it is important to consider possible exit strategies for your equity investors, and there are two main routes to follow. The Initial Public Offering (IPO) is easily the most glamorous, and in the West an IPO is the dream of many start-ups. In an IPO, a company offers a portion of its shares to the public, to be traded on a recognized exchange. But IPOs are relatively rare, even in the West, as companies must be quite large before an IPO is possible. In Africa, they are even less common.
The more common exit is through either a merger or an acquisition. Perhaps your company builds mobile applications to help businesses manage their affairs. After developing your products and proving demand and profitability, a larger firm, such as Google or Safaricom might find your business attractive as an easy way to expand its services. Global companies who want to enter African markets may also be interested in acquiring a local company that is already established in Africa.
A new African exit strategy?
Exit strategies are largely defined by what has already been done in the US and Europe. But might there be more appropriate strategies for the African context? For instance, in the US, an investor providing a second round of funding is often unwilling to buy out the seed-stage investor’s share of equity, instead plowing all of its capital into the company in hopes of a large return down the road in an IPO or acquisition. But waiting for an IPO or acquisition in Africa might take many years, discouraging initial seed-stage investment.
At GrowthAfrica, we have been thinking about alternatives. What if we were able to set up an ecosystem of investors at different levels who were willing to return the initial capital of the previous investors?
For instance, a seed-stage investor puts $50,000 into a company, and a year later, the company is ready for larger financing. Then a venture capital firm puts $250,000 into the company, paying back the $50,000 to the seed-stage investor (though the first investor will still retain equity in the company, as the investment will have grown in value). That way, the seed-stage investor is more willing to invest in the first place, knowing that if the company is growing, the investor will not have to wait 8 or 10 years before seeing any returning capital. The same process could be repeated at each level of financing all the way to an acquisition or the rare IPO, improving financing for enterprises at all levels and reducing risk for investors.
What other solutions have you thought of to deal with the limited number of exit opportunities?
In summary, depending on the financial status of your business and your needs, equity may be more appropriate than debt. The table below summarizes the key differences between debt and equity. Having a firm understanding of their pros and cons will help you make better decisions as you seek funding. Check in next week for more creative (or less common) ideas for financing!
|
Debt |
Equity |
|
|
Description |
Loans paid back with interest over a specific time frame | Money given in exchange for ownership in the company |
|
Pros |
– No authority relinquished- Clearly defined expectations- Easy to renew once early loans are paid off; good long-term source of incremental funding | – No financial risk to entrepreneur- No need for collateral- More flexibility on cash generation
– Gain access to investor’s expertise and network |
|
Cons |
– Often requires physical assets for collateral- Need cash flow to ensure lender you will pay back on time | – Must give up a share of the company and with it, some control- More burdensome monitoring and reporting |
|
At what stage in development? |
Generally most appropriate once your company has begun to generate regular revenue and has some physical assets. Very appropriate for continuing operations as your company grows. | Often most appropriate at very early stages when the company is still getting to market and has not generated much revenue or acquired many assets. Becomes a good source of revenue much later at the IPO stage as well. |
Filed under: Business Tagged: entrepreneurship, equity, exit strategies, financing, IPO, mergers and acquisitions 
