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Equity Financing

Equity Financing Explained
Sources of Equity Financing
Approaching Equity Investors

Equity Financing Explained
Equity funds come from personal moneys of the partners (such as savings, inheritance or personal borrowings from financial institutions, friends, relatives and business associates) and from stockholders of the shares in a corporation. These funds are normally unsecured and have no registered claim on any of the assets of the business, freeing those up to be used as collateral for the loans (debt financing). Higher equity creates " increased leverage." Leverage reflects the business' ability to attract other loans and investment. An equity position of $30,000 may enable the business to obtain debt financing of up to three times that amount, $90,000. A fully-leveraged business has no further ability to borrow money.

 

Twenty-five to fifty percent of your own money in the business shows a lender or investor that you are prepared to share the risk alongside his/her money (your commitment to the project). As the business grows, you should always try to keep your own equity (ownership) at approximately 25% of the total project (as per the current balance sheet). Earnings retained in the business will increase both your equity position and your leverage.

Shareholder Loans represent equity (and, on occasion, debt) paid into a private company by relatively few "partners in profit and risk" in exchange for share ownership. The shareholder loan may be secured by the share certificate(s) alone or by a debenture. If it is secured by a debenture or something other than the participation in the profits, then technically it is not equity. Most financiers of commercial debt will insist on a priority claim against assets and force this shareholder to a secondary or subordinated security position.

A stockholder's liability in a limited corporation is limited to the value of the shares he/she has purchased. Normally there is no claim by these stockholders on the business' assets; rather they have accepted the risks and rewards that go with that business. The rewards are direct participation in the profits of that business as well as any appreciation in the perceived value of the shares. The risks represent the possible reality that the share-value could drop to zero. True equity money is unsecured and directly reflects the faith of the investor in the business, its management and the commitment of its principals to it.

Venture Capitalists could be companies with more retained earnings than they require for reinvestment into their own operations, holding companies who wish to diversify their bases; "venture capital corporations" formed for tax advantage reasons; or individuals seeking to shelter excessive earnings from high taxes or hedge their fixed incomes against inflation. Venture capitalists are usually shareholders, secured by share value and legal agreements.

Sources of Equity Financing

Family, Friends, Inheritances & Personal Mortgages
The most accessible sources of personal money are inheritances, mortgage extensions (on a personal residence) and family and friends. But venture cautiously, many cherished friendships and family relationships have been destroyed through inadequate protection and provision for personal creditor repayment related to the possibility of a business failure.

If you borrow money from family members and/or friends, consider setting the loan up on a straight business basis. You may also want to provide some personal security or personal guarantee outside of the business itself. The offer of a deferred repayment scheme of some kind may be welcome.

Most often these persons are assuming a high risk with little real basis for the investment as a favour to you. Your concern about protection for their money will go a long way to ensuring their future cooperation and avoiding dissension. They will be most favourably impressed if you can show them a well thought-out and orderly presented business plan, even though they may not have specifically requested one.

Partners
In seeking out a general equity partner, it will be wise to identify persons who have not only the money to complement your contributions (equity), but who are knowledgeable in the industry itself, connected in the industry and who have expertise in the areas of the business in which you do not. Limited partnerships have special provisions to limit the direct involvement of the partner in decision-making as well as their liability in the debts of the company.

Investors
In seeking active investors (venture capital) for a project, look first within the industry. Logically, an investor will prefer to invest in a business he/she understands. You will also have far less explaining or selling of the concept to do. There is a possibility that once they have made that investment, they will also be looking pro-actively to involve your company in the other things they may be doing, and their influence in the industry may well provide access to additional contract opportunities in the industry.

In seeking passive investors who will have little or no involvement in the project, try to find those groups of professionals who have steady income (to tax shelter) and a prime responsibility of their own that allows them no time to interfere in yours (e.g. a doctor or group of medical practitioners, a dentist with a busy practise, or a lawyer or professional financier preoccupied with their own activities).

Approaching Equity Investors
In seeking partners who will be putting their own money into the venture, you must be prepared to accept the fact that a partner will most often expect to be involved in the decision-making process of the venture. At the very least, they will expect to be kept updated regularly on your activities.

These persons are being asked by you to take a relatively unsecured position in the company and should be presented with a sophisticated, detailed business plan that reveals everything related to the financial basis for carrying on this business. The prospective investor will rigorously evaluate the abilities of the management team, the financial strength of the company structure and principals, and the commercial viability of the enterprise as to the risk factors portrayed in the projected financial submissions.

This evaluation will normally require a detailed business plan (in a bound presentation format) which provides extensive information on the management of the company or project; a detailed history of the business concept, its products, its production methods, operations and costs, its target markets and position in the marketplace; the purpose to which this additional equity (cash infusion) will be applied (in intimate detail); any assets the company owns as well as a detailed summary of all liabilities (debt) and shareholdings etc.; and extensive financial information and projections.

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