7 Things to Know About Equity Financing | Tory Burch Foundation

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7 Things to Know About Equity Financing

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What to know before you approach venture capital firms for equity financing

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Thanks to Shark Tank’s popularity and buzzy news coverage on companies when they first start trading on the New York Stock Exchange, many founders are laser-focused on getting investors. Raising capital through equity financing, where individual investors or venture capital firms receive partial control of a company in exchange for their checks, is a great funding option for some companies, but not all. The Jump Fund’s Kim Seals returned to our small business webinar series to give our community a crash course on equity financing for small businesses. Here are seven things you must know before seeking startup equity financing.

Start from the end.

You should have a very clear picture of what kind of business you want to have in the long run to figure out if equity financing is the right step for you. If your goal is to have a company that makes a comfortable living for you and future generations, then you have what’s called a lifestyle business. Investors rarely put their money into lifestyle businesses because they won’t see a big return. Also, most people with lifestyle businesses don’t want to give up decision-making power.

Equity financing is for founders who ultimately are okay with ceding control of their companies. If that sounds like you, you then need to assess three important things before looking for investors:

How will you use the funding? Investors want to know how the money will be used and if that use of funds will generate a large return.
How will you pay it back? Investors want to know your exit strategy, which tells them how they will get a return on their investment. Do you plan to sell or merge your small company with a larger one? Begin trading shares of your stock via an initial public offering (IPO)? Investors expect one of these things to happen within four to six years of their putting money into the business.
What’s the cost of attaining the investment? In addition to giving up ownership, founders may have to honor other agreements, like giving investors advisory board seats. Is that the best move for your company?

You can get investment at different stages.

Fundraising isn’t a one and done situation. Startups will need cash infusions at different points in their lifecycle, raising investment in what are called rounds. The first round is typically a seed round, which helps a company that has some early traction continue to grow, followed by Series A, Series B, Series C and so on. There is no real limit to the number of rounds a business can raise, however, each round significantly reduces the founders’ ownership.

Know what you’re giving up…

Dilution refers to the decrease in how much of the business a founder actually owns as they take on investment. On average, founders see 25% dilution in a seed round, meaning they give a quarter of the equity to the investors. When new investors join in a Series A round, they usually get 25% equity, leaving the seed-round investor with about 19% or 20% and the founder with around 56%. Dilution continues with each round and the median founder ownership at IPO is 11%. But keep in mind, those companies are usually quite big when they IPO.

…and know that you have a say about what you’re giving up.

Entrepreneurs have tools available to them that help them manage the authority they give to investors. This is called structuring a funding round using particular instruments. Equity instruments require legal documents that founders should not try to create themselves.

Preferred Equity

This instrument gives investors ownership at an agreed-upon price per share. Investors receive voting rights, meaning they have some say in the company’s operations.

Convertible Note

When you structure your round with a convertible note, you are taking on debt. This agreement indicates that the company will borrow money now and repay that debt plus accrued interest later on using equity in the company. Most convertible notes reach maturity (meaning, they must be repaid) within 18 to 24 months of a company receiving the funds.

Assessing a company’s value is often difficult when companies are very young. That’s why businesses in their early stages often opt for a convertible note; it lets them put off having to calculate their company’s valuation until they’ve grown it some more. Convertible notes also benefit investors in that they account for the fact that investing in a business at this early stage is usually quite risky. They may get benefits in addition to the interest on the debt as the company grows. These agreements are usually very detailed and outline other benefits early investors will receive as the company continues to grow.

Simple Agreement for Future Equity (SAFE)

Sometimes, newer companies don’t want to give investors equity right away. In that case, the founder will make a document called a simple agreement for future equity, or SAFE, which states that the investor will be granted equity at a later date. Usually used in place of convertible notes, SAFEs aren’t debt instruments. SAFEs are generally a lot shorter and less complex legal documents than convertible notes. They are often used when businesses are raising small amounts, like $100,000.

You can get lots of investors with equity crowdfunding.

Typically, we think of crowdfunding as a tool to get lots of small amounts of money from many people in exchange for a reward, and without having to pay it back. However, equity crowdfunding means getting lots of (usually) small investments and rewarding those investors with a stake of your company. Platforms like Indiegogo and SeedInvest are great options for startups interested in equity-based crowdfunding. Many founders like crowdfunding because they raise funds and generate buzz. “When you look at these crowdfunding sites, some of the most popular and active [campaigns] get featured in their newsletters, they get talked about on social media, they’re shared with other users,” explained Seals. “So, you can really create a nice network effect if you do this well.”

Your campaign’s investors will be combined into what’s called a special purpose vehicle, which lists them all under a single entity on your capitalization table, the document that outlines your company’s ownership. They will choose one lead investor to make decisions on their behalf.

Just remember, crowdfunding sites will take a fee. There are also costs associated with the legal and compliance aspects of adding these new investors to your business.

Most investors want you to grow big and grow fast.

Companies that are considered good investments are almost always ones that are scalable, meaning they can increase their revenue rapidly without a significant increase in resources spent. “Sometimes it’s scaling through people, a lot of times it’s scaling through technology,” explained Seals. “It’s a lot easier to scale with technology than it is to build a very intensive people business.”

Even if your business generates high revenues because of its high-end handmade products, for example, it likely isn’t going to attract individual high net worth investors or venture capital firms. Seals used the example of a high-touch doggy daycare as a business that is interesting, but not scalable as-is. “They need 100 workers for every million dollars of revenue. And these are part-time workers and different things just to kind of keep this thing going–that’s way too people-intensive for me.” People, even part-time workers, cost a business a lot of money, which is why tech-powered businesses are so often attractive to investors.

Some investors just want to solve a problem.

There are some high net worth individuals who prioritize solving a problem over maximizing the return on their investment. They use their money to support companies with missions close to their heart. “In some respects, maybe we’re not looking for you to make a big exit, but we’re looking for you to help us solve a problem that we know either we have or other people have,” said Seals. This values-based investing is another reason to clearly understand where you want your business to go and what an investor wants before signing an agreement.

Equity investing is an attractive financing strategy because it usually means a big cash infusion that can lead to major growth. Before entering any partnership, Seals advised, do your homework on both the investor you’re working with and the terms of your agreement.