Equity funding is the most popular form of financing for high performance startups, and established businesses looking to take their company to the next level. This is a preferable method than seeking out a loan, as equity investors don’t require you to stick to a rigid repayment schedule.
Equity investors will also typically give your business a fair market valuation based on your current performance and future projections– whereas loan officers will base their decision only on tangibles such as your current sales, property, equipment and payables/receivables.
Equity investors are willing to take the risks banks aren’t. As you’ll learn, big risks come with big potential rewards.
How equity funding Works
Every company grows their business differently. However, there is a fairly common pattern that takes place with regards to when equity funding and investing becomes an option. After founders have tapped their own financial reserves, including any bank loans they may have secured, it’s common to start giving out equity in increasing doses.
Here’s an example of how equity funding works:
- A company may start with a small $10 – $20,000 equity investment from friends and family for a relatively small stake in the company’s future profits.
- Afterward, a business may seek out an angel investor to grow their business further. However, angels are rarely good for investments above $250,000.
- Next, the company will seek out venture capital funding when their available capital needs gravitate to the hundreds of thousands or even millions.
Once you’ve determined you need more capital to grow your business, the first step before approaching investors, is to calculate a reasonable valuation investors can get on board with. The valuation needs to be in line with accepted parameters such as industry, revenue (current and projected) and liabilities.
Note: Proof-of-Concept (PoC) is rarely a viable quantifier to approach equity investors with. However, times are changing in some industries, as you’ll learn as you read on.
Rising financial stake
At each investment stage, the financial stake you’ll be expected to part with will increase significantly:
- Friends and family seeking equity for their investment will only expect a small return such as 1 – 5 percent of your future profits.
- Angels have been known to seek out as little as 5 percent and as much as 20 percent, depending on how much they’ve invested.
- Venture capitalists will want at least 25 percent of the company, with many looking for as much as 50 percent, if their investment is high in relation to your valuation. Most VC deals are in the 30 percent range.
Friends and family are likely to be happy with their investment as long as it’s making them some residual money. Angels and VCs, all other factors considered, make their final decision about whether to invest or not based on how liquid your business is. Can it be sold for a massive profit tomorrow? Six months from now? A year from now?
Angels may not always look toward liquidity as a factor if they believe in the business, but VCs always will. The exit strategy must always be either selling the business, or an IPO where they can sell their shares, bank their profits, and move onto the next deal. An exit strategy, even if it’s just an IPO, must be part of your vision to secure large amounts of equity funding.
What’s Trending in Equity Funding Right Now
The biggest trend taking place in equity investing is in how many startup deals are being made these days. Discounted convertible notes are quickly becoming a standard in an age where in particular; many early-stage tech startups are receiving early rounds of equity funding based just on proof-of-concept alone.
This is not only a savvy move on the investor’s part, but also great for startups that have no chance at securing traditional funding from a bank – or friends and family for that matter.
Discounted Convertible Note Defined
You’ll hear a lot of confusing chatter on the Internet about how convertible notes work. The definition is much less complicated than most people make it:
- The equity investor makes a large investment in your company today (eg., $5,000,000); even though your company is only worth $1,000,000 currently on paper.
- Rather than agreeing on a set equity amount now, the investor “loans” you the money, at an agreed upon interest rate for repayment (ie., 15 percent).
- However, that loan is going to convert at some agreed-upon future date into equity shares of your company (this will usually take place when the next equity investor comes along and the valuation is considerably higher and/or prior to your IPO).
- The loan won’t just convert dollars-to-dollars on the valuation at the time though. Instead, you’ll agree to give the early equity investor a considerable discount on the shares they choose to buy, typically in the 10 – 30 percent range, or whatever the investor’s comfort level is with the investment they’re making.
The benefits to this kind of deal for an early-stage startup are obvious.
For the startup:
In the example of the investor making a $5,000,000 investment into a company that’s only worth $1,000,000; your startup just increased its value 5 times with a handshake and a few strokes of a pen.
For the investor:
They’re taking a chance on the uncertain future of your company by giving you the cash it needs to grow. Their risk is almost entirely eliminated, in the sense that you’re now on the hook for the money loaned + interest owed, regardless. Even though they could end up making more money by putting their cash into a more secure investment vehicle, they are making a deal based on their belief that your company is going to be worth MUCH more money in the near future.
Discounted Convertible Note with a Cap
While convertible notes have been used for years, the modern tech-investment landscape has created a demand for amendments to traditional thinking on this form of equity investing.
With valuations blowing up overnight, with so many apps and other new technology being release based largely on proof-of-concept and little market testing; equity investors engaging in these types of deals need to insulate themselves from an over-zealous investor coming into the picture in the future and grossly over-valuing the company.
The “cap” can be hard to understand, but again, its quite simple when broken down into simple terms:
- In the earlier example, our investor offered $5,000,000 in cash for a company that’s only currently valued at $1,000,000.
- This investor doesn’t want to get stuck buying $5,000,000 in future shares if the next investor agrees on a valuation of $10,000,000 (likely once again based on future earnings) when the company is only worth half that much; thus, severely diluting the share pool.
- Therefore, the investor sets what’s called a “cap” on the convertible note to prevent getting in over their head.
- The cap in this scenario is likely to be set at the original valuation of $1,000,000 – perhaps higher depending on negotiations – even though their investment was 5 times that much.
Pros and Cons of Equity Funding
- Instantly change your market advantage: Money talks. When it comes down to you with your new larger bank account, and your nearest competitor who’s still bootstrapping their business; you’re likely going to win the battle for more customers.
- No repayment necessary: The investor is taking all the risk when they cut you a check, which is why equity funding is so hard to secure. If your company goes belly up, you’re not on the line for the balance, nor any interest payments.
- Access to investor’s contact list: Because this isn’t a simple loan with a fixed interest rate, your investor has an obvious interest in the success of the company. Once they sign on with you, you instantly get their entire professional network at your disposal.
- Less debt equals access to future funding options: Including more investors willing to step on board. But also since your company is going to grow more quickly while accruing less debt, you’ll also have access to low-interest bank loans and lines of credit as needed.
- Competition for investments is high: There’s more people looking for money than there are checks in the world to fund all of them. Consider most investors will listen to at least 100 pitches before they ink even one deal.
- You have to cater to investor’s demands: Since they’re mutually invested in your business now and have bought a significant stake in the company, you’ll have to give up some say in how things are done moving forward.
- Equity capital takes time to secure: If you’re in immediate need of cash, consider that the vetting process takes much longer and that you’re dealing with investors who’re stretched in a hundred, perhaps a thousand different directions. Then, once an investor has performed their DD process, it will take time for their legal team to draw up the necessary documents to finalize the deal. Plan for 3 months minimum; 6 months as more than likely.
- Like time, you can never get equity back: Pure and simple. Once that equity’s gone, the only way you’re likely to get it back is if it becomes worthless to the investor and they need someone to offload it onto. Otherwise, you’ll need to become super wealthy and make the seasoned investor a deal he/she can’t refuse.
When’s the Right Time for an Equity Investor?
There are only certain scenarios that make sense when it comes to bringing in the equity funding from an investor:
If profits aren’t in your immediate future
You’ll need cash to sustain you over the lean times. For instance, many Internet startups have to run for some time to build their brand before monetizing their website or app. Few VC firms or private VCs will listen to a pitch for a company that isn’t already making a profit, let alone one that isn’t set to make one for some time. Angels and/or friends and family are a great option in this case.
When you have no tangible collateral
Not a loan officer in the country will even give you a car loan unless you can sign that car over to them as collateral. All banks and private lenders want assurances they can recoup at least some of their money if you can’t pay. Since equity investors are looking for a stake in your future profits, they’re interested in opportunity over collateral.
When bootstrapping isn’t a viable option
There are too many scenarios where bootstrapping isn’t possible – even legal – to do with a startup or established company moving into new growth opportunities. Say you’re building self-guiding missiles and need safe laboratories to do so, or if you’re launching a new airline – neither example begets any smart way to bootstrap. You need facilities, expensive equipment, marketing dollars, etc. And you need them ASAP to get your business traveling in the direction it needs to go.
When massive growth is imminent
Whether you’re an established business with all the boxes checked to evolve into a franchise, or on the verge of your first IPO; growth at this stage requires massive amounts of capital, with investors waiting in the wings to accommodate any hiccups that come up along the way.
7 Tips for Pitching Equity Investors for Success
Equity funding only matters when it comes from trusted sources. To find reputable equity investors here are some tips:
- Ensure you know what problem you’re solving and exactly how your business is solving that problem. If you’re not enriching people’s lives by making them easier, no equity investor is going to waste their money on you.
- Once the problem’s been identified, make sure you’re telling the investors about the opportunity lying in front of them. The size of the market, how much are people spending to solve the issue you address, etc.
- After the set up, come in with your product and how it can solve said problem in the marketplace. The biggest challenge is differentiating your product from others. Make sure your niche in the market is clearly defined – you’re better, but how?
- How do you plan to capture the maximum amount of marketshare? Don’t discount this information, as your audience is likely to have a lot of experience in this department. If you’re talking to an investor who has the keys to your marketing strategy (ie., you own a clothing line and you’re pitching Daymond John) make that known. Make sure you understand what they can do for you ahead of time though, as this can score big points.
- Lay out your team for the investor. All smart investor realize that Christopher Columbus didn’t find his way to the Americas alone. Try your best to describe a fully-stocked lineup of professionals with strengths that complement each other perfectly to ensure the company’s success.
- Where’s the money now, where’s it coming from tomorrow? Be as honest as you can. If you have none, how’s their money going to help you with revenue? Outline exactly how you plan to deploy the capital they’ll be giving you and when they can expect certain milestones to be achieved. How educated you are/appear to be in financial savvy can go a long way here.
- Tone. Tone is very important for capturing your audiences attention. Look at any great salesman and you’ll find someone full of knowledge, energy, and creativity. Avoid the lure of trying to appear too consummate a professional, instead favoring showing them who you really are (or at least the slightly cleaned up version).
Want to Learn More?
Funding Note is here to help with all your funding questions and concerns. Send us a message through our contact page and we’ll get right back to you.
If you’d like to keep abreast of everything going on in the world of equity funding and other funding platforms, sign up to our newsletter here.