Equity finance

Equity finance is a way of raising capital from external investors in return for handing over a share of your business. This may take many forms, including a share of future profits, but is most frequently associated with sharing the ownership of the business to some degree.

The two main providers of equity finance for smaller private businesses are venture capitalists – a type of private equity firm – and business angels – who are typically high net worth individuals often with experience of being entrepreneurs themselves. Business angels could also be members of the public who are joining together to invest smaller amounts of money though crowdfunding.

This guide explains what equity finance is, examines the benefits and drawbacks, and gives advice on when it might be the best option for your business. It also explains how to obtain equity finance and where to get more information.

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What is equity finance and is it right for your business?

Equity finance is capital invested in a business for the medium to long-term in return for a share of the ownership in – and sometimes an element of control of – the business.

Unlike lenders, equity finance investors don’t normally have the legal right to charge interest or to be repaid by a particular date. Instead they expect to make a gain on capital dependent on the growth and profitability of the business, and may also receive dividend payments.

Because equity investors share the risks your business faces, equity finance is often referred to as risk capital.

Is equity finance right for your business?

Different forms of equity finance suit different business situations.

It is likely to be most suitable where:

• the nature of a project does not suit bank loans or other forms of debt finance
• the business will not have enough cash to pay loan interest because it is needed for core activities or funding growth

Questions to ask yourself include:

• Are you prepared to give up a share in your business and some control? Investors expect to monitor progress and many seek involvement in significant decisions.
• Are you and your key people confident in the business’ product/service? Does it have a unique selling point that singles it out?
• Do you have the drive to grow the business?
• What industry experience and knowledge does your management team have? Is there a variety of skills?

Remember that, because of the risk to their funds, investors expect a higher potential return than for safer, more secure investments.

After considering the above, seek advice from a professional, eg your accountant or business adviser.

Understanding Finance for Business can also help you understand your options for getting the money you need to start or grow, and can also introduce you to potential sources of finance – see the page in this guide on sources of equity finance.

This initiative is part of a wide range of support offered to businesses in England through the government’s Solutions for Business portfolio of publicly funded support for businesses. (Government support for business is different in Scotland, Wales and Northern Ireland.)

Your business may also be eligible for the Enterprise Finance Guarantee (EFG), a loan guarantee scheme aimed at facilitating additional bank lending to viable SMEs with no or insufficient security to secure a normal commercial loan.

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Sources of equity finance

There are various sources of equity finance.

Business angels

Business angels (BAs) are wealthy individuals who invest in high growth businesses in return for equity in – ie a share in the ownership of – those businesses. Some BAs invest on their own, others as part of a network, syndicate or investment club. BAs are often experienced entrepreneurs themselves and therefore, in addition to money, they bring their own skills, knowledge and contacts to the company.

BAs can offer investment, particularly in the early or growth stages of development, in return for equity. For more information on BAs, see our guide on business angels. 

Venture capital

Venture capital is also known as private equity finance. Venture capitalists (VCs) look to invest larger sums of money than BAs in return for equity in – ie a share in the ownership of – your business.

Venture capital is most often used for high-growth businesses destined for sale or flotation on the stock market. For more information on VCs and the types of business they invest in, see our guide on venture capital.

Crowdfunding

Crowdfunding – also known as crowd financing or crowd sourced capital – is an alternative form of business angel investment. Usually conducted online, it allows a number of investors to individually invest smaller amounts of money – usually between £100 and £10,000 – into a business. The individual investments are then pooled collectively to help a business reach its funding target.

Investors using crowdfunding will usually look for:

• an investment requirement of between £10,000 and £200,000
• evidence of good seed or early stage development or expansion
• a business that shows the potential for high return 
• a business operating in a specific, perhaps high growth sector, or that the investor has a personal interest in

You can find information on crowdfunding on the Crowdcube website- Opens in a new window.

Finance for Business offers flexible finance solutions such as loans and equity finance for businesses with viable business plans that are unable to get support from commercial banks and investors.

This initiative is part of a wide range of support offered to businesses in England through the government’s Solutions for Business portfolio of publicly funded support for businesses.

Enterprise Investment Scheme (EIS)

Some limited companies can raise funds under the EIS. The scheme applies to small companies carrying on a qualifying trade.

There are potential tax advantages for individuals who invest in such companies, such as:

• the buyer of the shares gets income tax relief at 30 per cent on the cost of the shares
• Capital Gains Tax (CGT) on the sale of other assets can be deferred if the gain is reinvested into EIS shares
• when EIS shares are sold after the qualifying period, there is no CGT charge (although previously deferred gains may come back into charge)

If the borrower also qualifies for EIS income tax relief, interest on loans taken for the purpose of investing in qualifying companies is not tax deductible.

Certain conditions must be met for a company to be a qualifying company and for an investor to be eligible for tax relief. You can find guidance to the EIS on the HM Revenue & Customs (HMRC) website- Opens in a new window.

The stock market

Joining a public market or stock market is another route through which equity finance can be raised. A stock market listing can help companies access capital for growth and enable companies to raise finance for further development. It can also raise their public profile and enhance their status with customers and suppliers.

However, flotation on the stock market is not suitable for all businesses, and there are a number of points to consider.

You can find more information on UK stock markets in our guides on London Stock Exchange Main Market and the Alternative Investment Market.

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The equity gap

The equity gap is a term used to explain the gap a company experiences in funding as it moves up the ladder of different finance sources.

For example, some businesses require much greater funding than that which can be provided by business angels, but do not need the levels of funding venture capitalists would consider. The gap between these two finance situations is known as the equity gap.

Businesses in this situation may wish to approach private equity firms for help. These are organisations that invest and manage investments and they tend to focus on management buy-outs and buy-ins.

The government provides a multi-million pound equity finance scheme to close the equity gap by providing Enterprise Capital Funds (ECFs).

ECFs are commercial funds that invest a mix of private and public money in small, high growth businesses seeking up to £2 million in risk capital. You can find out about ECFs on the Department for Business, Innovation & Skills (BIS) website- Opens in a new window.

In Scotland, Scottish Enterprise runs a number of equity finance initiatives. The Scottish Venture Fund, Scottish Co-investment Fund and Scottish Seed Fund provide equity investment between £20,000 and £2 million to companies with good growth prospects.

Find out about Scottish Enterprise investment funds on the Scottish Enterprise website.

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Advantages and disadvantages of equity finance

Equity finance can sometimes be more appropriate than other sources of finance, eg bank loans, but it can place different demands on you and your business.

The main advantages of equity finance are:

• The funding is committed to your business and your intended projects. Investors only realise their investment if the business is doing well, eg through stock market flotation or a sale to new investors.
• You will not have to keep up with costs of servicing bank loans or debt finance, allowing you to use the capital for business activities.
• Outside investors expect the business to deliver value, helping you explore and execute growth ideas.
• The right business angels and venture capitalists can bring valuable skills, contacts and experience to your business. They can also assist with strategy and key decision making.
• In common with you, investors have a vested interest in the business’ success, ie its growth, profitability and increase in value.
• Investors are often prepared to provide follow-up funding as the business grows.

The principal disadvantages of equity finance are:

• Raising equity finance is demanding, costly and time consuming, and may take management focus away from the core business activities.
• Potential investors will seek comprehensive background information on you and your business. They will look carefully at past results and forecasts and will probe the management team. Many businesses find this process useful, regardless of whether or not any fundraising is successful.
• Depending on the investor, you will lose a certain amount of your power to make management decisions.
• You will have to invest management time to provide regular information for the investor to monitor.
• At first you will have a smaller share in the business – both as a percentage and in absolute monetary terms. However, your reduced share may become worth a lot more in absolute monetary terms if the investment leads to your business becoming more successful.
• There can be legal and regulatory issues to comply with when raising finance, eg when promoting investments.

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Alternatives to equity finance

Equity finance may not suit your business. For example, you may not feel happy about losing a degree of control, or the intended project may be too small to be an attractive investment opportunity.

Consider the following alternatives:

• Loans – there are many options available, from commercial mortgages secured against your business assets to short-term borrowing for periods of between three and five years. See our guide on commercial mortgages and lenders. It’s probably best to approach your own bank first, but do not overlook other lenders. See our guide on bank finance. 
• Overdrafts – overdrafts can be expensive but are a flexible form of borrowing. They’re not especially suitable for long-term finance as they are repayable on demand. See our guide on bank finance. 
• Loans from family and friends – these can be a sound method of raising finance, but beware of potential damage to relationships if the money isn’t repaid on time. See our guide on financing from friends and family.
• Additional funds – from you or your fellow partners/directors.
• Government support – there are government support schemes that may help your business as well as private sector initiatives. Search our business support finder for grants, loans, expertise and advice for which your business may be eligible- Opens in a new window.
• Joint ventures – these can take many different forms. The term normally applies to the co-operation of two or more individuals or businesses in a specific enterprise rather than in a continuing relationship. See our guide on joint ventures and partnering.
• Credit cards – these are a quick way of raising finance and a flexible form of borrowing. However, unless you can manage your cards very carefully to avoid paying interest and other fees, they are not suitable for long-term finance. See our guide on debit and credit cards for your business.

Mezzanine finance

Mezzanine funding combines elements of debt and equity finance and can provide access to bank funding that the business may not have otherwise been able to obtain. Under mezzanine funding a provider charges interest on the debt and also takes a share of profits when a company grows.

Mezzanine arrangements do not involve issuing shares to the lender and do not affect the value of the company’s shares. Debts are usually repaid in a single payment, rather than monthly repayments over an extended period, and are often payable over a longer period of time than normal credit terms. However, mezzanine loans can be expensive and the one-off repayment will involve a large sum of money which would affect businesses that have failed to fulfil their growth strategies.

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CASE STUDY

Here’s how I found a business angel to invest in my business

By the start of 2003, London-based design consultancy d3o lab had patented d3o, an innovative shock-absorption material, and wanted to start manufacturing and selling the product. But founder Richard Palmer needed finance so he could fully exploit the opportunity. Here’s how he did it.

What I did

Examine the business’ needs

“We developed our product, d3o, to a stage where it had great potential as a highly lucrative technology. However, we needed to get additional finance into the business to manufacture, sell and promote the product. In identifying our preferred funding route we thought carefully about our priorities, such as the amount of funding we required, any security we may need to provide and the amount of day-to-day involvement investors would require. Business angels tend not to require security and, having decided that we needed a substantial investment without having to cede too much day-to-day control, we decided that business angel funding was ideal for our business.”

Refine our business plan’s presentation 

“We had already prepared a business plan, but we refined it by including sections detailing how the business angel finance would develop the business and what involvement potential investors might have. We also spent time on the plan’s presentation – ensuring it was focused and professional – to demonstrate our commitment. This stage was vital. A tailored business plan clarifies what the benefits of the investment are for both parties and specifically what the funds will be used for – and what they will achieve.”

Secure the funds

“Armed with our business plan, we contacted the British Business Angels Association who introduced us to several business angels. As a small but growing business our choice of angel was based largely on the sort of practical assistance they were offering. We then pitched our proposal to a shortlist of investors and tried to show them the benefits of their involvement – both for them and for us.

“One investor – David Richards – decided to invest after our first meeting with him. To secure the funds, we negotiated issues such as our respective responsibilities and growth targets. Finally, our legal adviser helped to negotiate the investment terms, such as our financial forecasts, which helped our investor complete his due diligence checks and agree the deal.”

What I’d do differently

View investment as an ongoing process

“When I was initially pitching for investment, I was trying too hard to make the business cash-positive in one single stage. Had I appreciated that the business would develop and grow in value so quickly, I would have outlined my longer-term investment requirements more strategically.”

Allocate more time to the project

“It takes a long time to secure any form of finance and it’s no different in the case of business angel finance. If we had known at the start just how much time and effort it takes, I would have spent more time preparing an investment strategy at the outset.”

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