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The Cost of Money: Equity Investment – What’s That All About? Part 2

By Wyn Jones, Regional Cluster Manager.


In our last newsletter I looked in more detail at the equity options for a business that is typically in the early stages of its life cycle; three Fs (family, friends and founder), crowdfunding and business angels. This time I’ll be examining venture capital, private equity, and initial public offerings. These types of options are typical for a well established business further along in its life cycle.


To re-cap, when a business receives equity investment, the following transactions take place:


  1. The business owners sell a portion of shares in the business to a third party (the investor)

  2. In return for the shares, the business receives a sum of cash

  3. The cash investment is not repayable, and interest is generally not charged on it, which is the major advantage ‘investment’ has vis a vis debt.

  4. The investor retains the shares with the plan of selling them in the future when they hope they will have increased in value, and could possibly receive dividends on their shareholding, if available through profits.


Types of Investors:


In this edition I’ll be looking at venture capital, private equity and Initial Public Offering (IPOs). These are typically best suited for well-established businesses.

Venture Capital


Venture capitalists are professional, institutional investors, investing money on behalf of funds, such as pension funds, foundations etc. Minimum amounts invested are normally between £500,000 to multi-millions. Venture capital is provided as minority shareholding, but always comes with terms and conditions which can be demanding on the business such as one or more seats on the board of directors, performance targets to meet and agreed exit strategy and timing. They look for businesses with strong growth potential as they are looking for high returns on their investment, which they hope will come from the sale of their shareholding at enhanced value. Planned exits can be as short as 3 years but generally at least 5, and up to 12 years.


Often, venture capital funds provide follow-on investment from their initial investment. Therefore, by finding and working with the right venture capitalist, you may be able to secure many years’ worth of funding.


Private Equity


Private equity comes in various formats and guises. Private equity firms use money raised from institutional investors to acquire a majority stake in private businesses. This form of investment often presents original business owners with an exit opportunity. Private equity firms aim to own and grow them for 3 – 5 years, and sell them for a profit, generating return for their investors. Private equity firms that invest in SMEs are usually small organisations of less than 30 people, often with a similar strong, entrepreneurial culture to the SMEs they invest in. Management within the private equity firm will have experience and expertise within the industry sector they are investing in. There are currently approx. 1,200 private equity firms in the UK, but firms from Europe and Asia are also targeting SMEs within the UK as potential investments.


Initial Public Offering


This form of investment is unlikely to be relevant to SMEs as it involves ‘floating’ a business on a stock market i.e. making the shares available for the general public to buy and sell. Private companies work with investment banks to bring their shares to the public. This requires tremendous amounts of due diligence, marketing, and meeting of regulatory requirements.


Summary


This article is a high-level overview of the types of investment potentially available to SMEs looking for finance at a more established stage of their business’ life cycle. One of the most under-estimated challenges of equity investment in your business can be the demands on management time. Maintaining ‘investor relations’ tends to be more time consuming and complex the further down the list of investment types. More sophisticated investors will demand a continuous flow of business performance data, up-dates on progress with projects, market information etc.


It cannot be stressed enough that whatever level of investment a business is considering, a critical factor is the chemistry or relationship between business leadership and investors. If this is not right, the investment is unlikely to be successful for either the business of the investor.

Each of the types of investment listed above has its place and is appropriate and beneficial for a specific set of circumstances in a business’ life cycle, but they all have challenges and disadvantages.


Use the links in our Equity Venn Diagram to understand the pros and cons of each type, or contact one of our Regional Cluster Managers if you would like to discuss further, contact details can be found here.


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