Equity Funding
Equity investors provide capital in return for a shareholding in the business. Investment is made with a view to a time when the business will be a net generator of cash. Although for some private investors this may be anticipated as a flow of annual dividends, for most institutional investors it means a time when the business can be floated (typically on the AIM market in the UK) or sold to a corporate - otherwise known as an 'exit'. A central part of an investor's decision will be their assessment of the time to exit. This is a combination of the time required for technology development, and that required for market penetration.
All investments carry risk - the risk that the money invested may never return. Compared with 'everyday' investments such as bonds and shares, investment in early stage technology businesses is seen as high risk. Investors usually undertake a robust process of due diligence in order to assess the degree of this risk.
Equity finance can be provided by:
These are described in more detail below. For examples of suitable sources of finance and useful links see 'Where to Access the Different Sources of Finance'.
Angel Investors or Business Angels
Angel investors or business angels (also known as 'High Net Worth Individuals' or 'Sophisticated Investors') are private individuals, often successful entrepreneurs, who make financial investments in start-up ventures and young businesses. Many are interested in taking an active role in the business as well as generating a return on their investment.
Angels may invest alone or as part of a syndicate or angel network or alongside other sources of finance, such as a seed fund, and may invest from a few thousand to a few hundred thousand pounds. Angels are often well placed to back a proposition that does not fit standard institutional templates, and may often have a particular sector or market that they favour.
| Advantages | Disadvantages |
|---|---|
| As individuals, Angels can often act more quickly than institutional investors, and may bring other Angels into a deal. | Angels may invest for reasons which go beyond the strictly financial (though not always declared as such) and companies seeking Angel investment should understand as far as possible the expectations of the Angel. |
| They often bring a level of personal engagement to a business that institutional investors do not provide. | Angels vary as individuals in the level of direction and involvement they wish to contribute to the business. The nature of involvement required and sought must be in harmony for the arrangement to work. |
| Their experience may be a valuable aid to the company. | Accepting investment from multiple Angels inevitably results in the need to communicate with, and manage, multiple shareholders. |
Seed Funds
Seed funds are sources of equity finance that are targeted at relatively early stage businesses that are pre revenue and/or not yet ready or appropriate for private equity finance. As these investments are usually perceived as high risk, seed funds are often financed or underwritten by the public sector, and may be directed at economic development in strategically important regions or sectors.
Seed funds typically invest alongside other early stage investors that could include Business Angels and 'friends and family'. Deal sizes are generally in the region of 50k to £250k depending on the specific fund and their eligibility criteria, but some may be considerably higher.
The often quoted 'valley of death' is commonly experienced by young businesses in the stages after proof of concept and demonstration, but before revenue is secured and when they are still considered to be too high risk by venture capital funds. It is in this gap that seed funds and Business Angels tend to operate, often coming in as one of several investors (on occasions known as a 'syndicate') to provide the investment typically required to complete the pre-commercial development phase.
| Advantages | Disadvantages |
|---|---|
| Seed funds are particularly helpful at the stage when technology demonstration has been completed, and a significant injection of cash is required into the business to execute pre-commercial activities. | Most seed funds invest on the basis of taking an equity stake in return for a pre-determined level of control in the business (although some, such as the Scottish Seed Fund, may also consider providing loans). Some management teams may not be comfortable giving up equity at very early stages of business development. |
| They typically help companies to overcome the so called 'valley of death', and may also provide confidence in securing subsequent investment from venture capitalists. | |
| Typically seed funds provide business advice and support, and may take a position on the board to help guide the business. |
Venture Capital
Venture capital is medium to long term finance provided in return for an equity stake in potentially high growth unquoted companies. In the UK and Europe, the term venture capital is more or less used interchangeably with 'private equity' and may cover all businesses from the pre-commercial stage through to management buy-outs and buy-ins. Elsewhere, the term private equity tends to be restricted to later stage businesses.
Venture capital funds or venture capital trusts raise funds from other sources which they then invest in high-growth businesses. They are often 'closed funds', which means that they raise a fixed sum at a given point in time, and then accept no further investments during the term of the fund. At the end of the term of the fund (often 10 years) the proceeds must be returned to the original investors. For this reason, funds will only invest in businesses where they have a clear exit route achievable within the timeframe of their fund.
Venture capital funds operate at the high-risk, high-reward end of the institutional investment spectrum. They typically invest £500k - £5m and seek at least a 10x return on their investment. Many funds will have a specialised focus - by industrial sector, growth stage or geographic region, for example. They tend to invest in businesses which have clear potential for revenue, such as those supported by a strategic relationship with a key industrial player.
'Round A' is commonly used to denote the first round of financing when a venture capital fund or corporate investor comes on board, and significant finance is raised - typically in the region of £1m+. Subsequent rounds of equity funding are termed Round B, C etc and are undertaken as and when appropriate to the growth plans of the individual business.
| Advantages | Disadvantages |
|---|---|
| Venture funds will carry out rigorous due diligence before investing in a business, and will impose a strict corporate governance regime. This can serve as an endorsement and reassure acquirers that the company is as it appears, and may enhance the value of the business at exit. | Venture funds are almost always purely financial investors. They may take a more coldly objective view of a business than others and may decline any follow on investment if progress has fallen short of expectations. |
| Venture Funds will often contribute significant strategic and board-level guidance to an investee company, and may provide useful contacts. | Venture fund investment is a detailed, sometimes exhausting, process in which reading the small print is both necessary and difficult. The transaction cost of deals is high. |
Corporate or Strategic Investors
Corporate or Strategic investors are those who invest, not solely for the profit realised by the investment itself, but because the investment improves their position in some wider competitive context. For example, it may secure them insight or rights over an emerging technology, or deny a desirable acquisition target to a competitor. Large companies often make strategic investments in start-ups relevant to their field. In the automotive sector these may include vehicle manufacturers/integrators, oil companies, industrial gas companies and Tier 1 suppliers.
Corporate venturing tends to represent only a small fraction of overall equity financing when compared to venture capital.
| Advantages | Disadvantages |
|---|---|
| A Corporate investor can be a key first customer, technology developer or market access partner and, eventually, business acquirer. | Corporate investors can be a Faustian bargain, restricting the business’s strategic choices and curtailing its exit routes to the detriment of final exit valuation. |
| Strategic investors are likely to take a longer-term view of their investment than a financial investor might. | If the priorities of the strategic investor change, it may allow a business to fail where other investors would persist. |
| Strategic investors, of necessity, cannot be as candid about their ultimate aims as a financial investor. |
Exit
Equity investment on the part of most players is undertaken with a view to the point at which they can exit from the investment with a healthy return, and ideally the sooner the better. There is no simple rule of thumb as to when an investment is appropriate for exit; it will depend on the progress of the company, the markets within which they operate, and the aspirations and strategies of the individual investors. However, typically an investor will look for an exit within a 3 - 5 year time frame, by which stage the company will have reached the 'early markets' or growth markets' phase of development (see Sources of Finance are Linked to Stage of Business Development). The entrepreneur and the investors should discuss possible exit routes as early as possible to ensure that expectations are aligned, and that the investor's requirements for return on investment are clear.
There are a number of potential exit options:
- Flotation, or initial public offering (IPO) of the company, often considered as the 'holy grail' of exits. The result of an IPO is the replacement of a few dominant investors by a multitude of individual investors
- Sale of shares to another investor
- Management Buy Out (MBO) if the entrepreneur or management team can secure the finance to buy out the original investors
- Trade sale to a corporate or strategic investor. This could take the form of an entire takeover by a major player, a merger with another SME, or sale of the technology through license agreements.