David Lerner Associates: Equity Financing Sources
Every business needs capital – either to get started or to fund operations and expansion. Here are some ideas for equity financing sources.
A. Personal savings. The money an owner contributes to a new business will likely represent his or her equity in the business (though it is possible to make this money a loan to the business).
B. Friends and family. Contributions from friends and family can take the form of either equity or debt investments. The advantage of obtaining equity investments from family and friends is that it can usually be done without having to give up too much control. Conversely, it is quite possible that a friend or relative may, because of the relationship, feel more comfortable by giving his or her opinions as to how the business should be run. Keep the relationship formal to avoid any misunderstandings, and choose carefully the relatives or friends who invest.
C. Angel Investors. An "angel" is usually an individual with lots of money who invests in startup businesses. Because angels typically engage in such investments regularly, they may be a good source of business expertise. However, the problem with equity investors is the extent to which they demand ownership and control. Assuming the angel has sufficient funds, he or she may require a large share of ownership, and the owner may have to surrender control and be content with a smaller voice in the company.
D. Venture capital. Venture capital firms are a good idea for two reasons. First, the money invested does not have to be repaid. Second, because the invested funds are equity, banks may be more inclined to extend credit to the business. However, there is a down side too – primarily that a venture capital firm could demand control of the business. In addition, because venture capital is a risky business, firms try to reduce risk by limiting the types of businesses in which they invest to those with the most potential for profitability. Consequently, many venture capitalists may not be interested in new businesses and the risks they present, unless, of course, the potential for significant profit can be identified and measured.
E. Investment clubs. In many areas, business people get together to form investment clubs. By pooling their funds, they can make larger equity investments (though, of course, as with other equity investors, they will want some control over your business). For more information, contact the National Association of Investors Corporation at (877) 275-6242, or visit the web site at www.betterinvesting.org.
F. Going public. You can also issue stock-ownership interests in the business that are sold by the share. The money or assets contributed in exchange for shares of stock represent shareholder equity in the business. Going public can be complex and very expensive, and it is subject to securities regulations at the federal and state levels. As a result, public offerings are not usually conducted by small businesses or start-ups.
G. Employee stock ownership plan (ESOP). If you have employees, it might be possible to sell stock directly to them. Employees participating in an ESOP are equity investors. In return for a reduction in salary or in fringe benefits, the employees may be given an ownership interest in the business, which motivates them to make the business a success. An ESOP will not be an option for many startups that do not have employees. For more information, consult an attorney or accountant, or contact the ESOP Association at 866-366-3832. Visit the organization's web site at www.esopassociation.org.
H. Private placement. A private placement is less complex than going public and involves selling shares of stock to a select group of equity investors. The investors typically exercise control over the company in direct proportion to the number of shares they own. There may be state "blue-sky" or securities restrictions on the number of investors. Check with an attorney familiar with local state laws.
I. Other sources. Customers. An early collection policy or an advanced payment arrangement can be instituted. With an early collection policy, customers would be given an incentive to pay before a specified date, typically prior to the date by which bills are due. A customer may, for example, be given a 1 percent discount if payment is received 10 days early. An advanced payment arrangement, on the other hand, would involve payment for a product or service prior to the customer's receipt of that product or service. For example, a new magazine publisher might contact potential subscribers and offer them a discount if they subscribe early. The funds collected may then be used for the publishing costs of the initial issue. Keep in mind, however, that any money received would have to be returned should the product or service is not be rendered, or there could be charges of fraud.
J. Suppliers. It is sometime possible to negotiate a deal with suppliers whereby they agree to wait several weeks for payment. This gives the business time to sell the merchandise or provide the service and use the income to pay suppliers rather than having to borrow to do so. Keep in mind, however, that this is surely an easier task for a large, established business than for a startup. Moreover, suppliers that do agree to wait for their money might not offer the best price in town.
K. Factors. You might also consider "factoring": the sale of accounts receivable (money owed to the business. The person or firm who “buys” the accounts receivable is called a "factor." Factoring is typically a luxury available to large established firms rather than startups. In addition, a factor will buy only at a discount, the amount of which may depend upon, among other things, the size and success of the business.
L. State and local government. Both are likely offer some type of technical or financial assistance to new businesses that operate within their borders. For more information, contact the local chamber of commerce.
M. Leasing companies. Rather than purchase the equipment or supplies needed which might require large outlays of cash, consider leasing. The company that does the leasing, called the lessor, allows the business to use the equipment for a specified period of time. For this use, there is typically a monthly payment, as specified in the lease contract. The upside is that no purchase is necessary. One of the downsides of leasing, however, is that there is no equity in the equipment. When the lease terminates, the equipment goes back to the lessor–unless, of course, the lease contract permits purchase of the equipment at termination. For more information, inquire about leasing at the same companies that sell the equipment you desire; they most likely offer leases as well.
N. Federal agencies. If the business is high-tech, consider Small Business Innovation Research Grants. These grants are provided to qualifying businesses with proposals for new technologies designed to satisfy agency needs. Competition for these grants, however, is quite heavy.. Moreover, the initial qualification for the research grant does not automatically qualify a business for a developmental grant. For more information, visit the organization's web site at www.sbir.gov.
Once all the possible financing options have been carefully weighed up – loans, equity and other sources – decide on the path best suited to the business need and circumstances.
IMPORTANT DISCLOSURES
Material contained in this article is provided for information purposes only and is not intended to be used in connection with the evaluation of any investments offered by David Lerner Associates, Inc. This material does not constitute an offer or recommendation to buy or sell securities and should not be considered in connection with the purchase or sale of securities.
To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable– we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
Some of this material has been provided by Broadridge Investor Communications Solutions, Inc.
David Lerner Associates does not provide tax or legal advice. The information presented here is not specific to any individual's personal circumstances. Member FINRA & SIPC.