Equity Finance for your Startup

What is equity financing and what are the pros and cons of equity financing?

Siert BruinsSiert Bruins
Equity Finance for your Startup

Equity is not the same as personal funds. Equity refers to the financial resources of a company (the private limited company), while personal funds refer to money that comes from one of the founders. When it comes to business financing of a startup, it is rarely possible with just personal funds. Although the starting entrepreneur often invests personal money into their startup, this is usually not enough. Additional financing must be found. It should be noted that this is not applicable to most advisors who start as sole proprietorships from their attics. Financing is especially necessary when hiring personnel, purchasing a business property and machines, or stocking inventory. While this can be done with equity, it is not the same as the entrepreneur's personal funds.

Difference between Equity and Debt

To meet financing needs, equity, debt, or a combination of both can be used. Here we will discuss financing through equity. You can find more information about borrowing money to fund your new business venture on another page of this website. The term equity can be misunderstood by new entrepreneurs, as it is often confused with personal funds. However, financing with equity does not only refer to one's own money. The term equity refers to the capital invested in the company by oneself and/or others in exchange for shares (i.e., a portion of the company). In addition, equity is the money that has been set aside from the company's profits as a reserve. Someone who provides financing and receives a portion of the company's shares in exchange is taking on a certain risk. After all, profits are not always made, and sometimes companies go bankrupt, causing the investor to lose their money. The shares can be owned by individuals or other companies, such as an investment company or a regional development company.

Equity for financing

Financing in the form of equity has several advantages. It is money that does not require interest to be paid, so there are no interest costs and no concerns about interest rate fluctuations. One disadvantage is that a portion of the company, in the form of shares, is owned by others than the business owner. This means that others also have a say in the company. If profits are made, it is customary to pay a portion of the profits to the shareholders. However, if no profits are made, no portion of the profits needs to be paid out. This is much more difficult with a bank loan. If no profits are made, the bank will still expect to receive the agreed-upon interest on their loan.

Additional financing

When a portion of the profits is accumulated in the company in the form of equity over time, this can help attract additional financing in the form of debt (such as a bank loan). This is especially important if the company needs to make significant investments, such as during a (rapid) growth phase. On another page, we will discuss debt financing for your startup. Here, we will delve deeper into financing your startup with equity. Below, we will discuss the most important forms of equity.

What is venture capital?

What is venture capital? We refer to venture capital when capital is invested by a venture capital company in a young, rapidly growing company. Venture capital is also called "VC" in English. In addition, we also have the typical Seed Capital, which is also called "seed money." This primarily involves funding to actually start a startup in the very early stages. With seed capital, research and development are financed to further develop an invention and prove that the concept is viable. There are venture capital companies...

There are venture capital firms that also provide seed capital. The forms of corporate financing mentioned here for your startup are also referred to as risk capital. Below we will discuss the differences between the types of money and the types of money lenders.

Venture capital and rapid growth

Typical venture capitalists prefer to invest in young, rapidly growing companies that have already passed the startup phase. They hope to enter just before the big growth (the hockey stick) takes off, although it is always a gamble when this moment will occur. If they are unlucky, there will be a long period of moderate growth or slight loss after the entry point. To help realize growth, they usually demand a portion of the management positions of the company to "keep an eye on things" and steer the company in the right direction. This can mean that they require the CEO position to be taken by someone from their network. Before a venture capitalist actually invests in your company, there is usually a months-long period of negotiation where they try to get as many shares and therefore control as possible, but also to make agreements about management and the direction of the company. The providers of venture capital, for example, have no interest in the company getting involved in all sorts of peripheral activities but want to maintain the focus as much as possible. Of course, all of this is intended to ensure that the realized return is as high as possible. There is nothing wrong with this, but it is important to be aware of this before negotiating with a venture capitalist. If you are not careful, your hands may be tied during the negotiations, and you may have to watch from the sidelines for the next few years as your company develops with your business idea. This can also have advantages. If you are better at creativity than at management, you have the freedom to develop new plans...

Venture capital and debt

A prejudice that exists among the general public is that venture capitalists and private equity firms overload healthy companies with debt, causing them to collapse. Of course, too much debt is never good, but a certain amount of debt is part of a healthy financial structure of the company. It is important to carefully adjust the amount of debt to the market in which the company operates, how healthy the company is, what the investment plans are, and of course, the state of interest rates. If all goes well, the potential investor will closely coordinate the financing structure with the management and supervisors of the company. If they do not agree, the acquisition will not go through.

What is private equity?

What is private equity? This is the general term used for risk capital in the form of shares or active capital in unlisted companies. Private equity literally means private money, and we roughly know of two types of it. Private equity can come from a so-called venture capital firm (also known as an investment company). This is a company that invests money from third parties in exchange for shares in companies. When the private equity comes from a wealthy (former) entrepreneur, we usually speak of business angels. In addition to the parties that provide the capital, there are also different terms for the invested capital. The goal of private equity investments is to achieve a high return on investment within a certain period. Since this type of investment is associated with high risk, it is of the utmost importance that the investing party closely collaborates with the management of the company. These investments usually involve a large minority or even a majority stake in a company, with the rest of the shares being owned by management. The investors work closely with management over a period...

Investors work closely with management over a period of several years, often bringing in a manager from the investing party. The focus is primarily on creating value in the medium or long term. Most private equity firms specialize in certain areas, so it is important not to approach a firm that is not interested in your story. Research is crucial in this regard. Private equity firms can be distinguished by the amount of capital they invest and the type of companies in which they invest. It is also common for them to invest only in a specific region where their professional network is strong and they are familiar with many companies. Private equity and venture capital firms are often confused with hedge funds in the press. Hedge funds buy parts of a company, sell unprofitable parts, restructure the rest, and resell it for a profit. This kind of activity has given private equity a negative reputation in the eyes of the public. However, venture capital firms invest in young, rapidly growing, non-publicly traded companies with a focus on the medium or long term. Of course, they also scrutinize costs and sometimes divest activities that are not part of the company's focus, but it is clear that simply stripping down a company cannot create value in the long run. Hedge funds focus on publicly traded companies that have become vulnerable due to a wavering strategy and a low share price. Participation companies invest third-party funds in companies in exchange for shares. Participating in private equity can involve dealing with professional investors who attract capital from large investors such as pension funds and insurance companies. The capital acquired is then placed in a fund from which it is reinvested in usually young, fast-growing non-publicly traded companies. It is important to realize that participating companies are not initially looking for inventions or ideas to invest in, but rather for companies. Per deal, amounts can range from approximately half a million euros to several hundred million euros. Larger deals involve a more complex and longer negotiation process.

Large private equity firms sometimes manage billions of euros and are not interested in small deals. They only find it worthwhile when the investment is for more than 50 million euros. This is because they have to do as much work for a 3 million euro investment as they would for a 30 million euro investment. The fund managers' work consists largely of evaluating dozens of investment proposals from companies that need money. The interesting proposals are invited to give a presentation (the famous elevator pitch). This process is called deal flow management, and it keeps the fund manager very busy. So, realize that you are one of many when you approach a private equity firm for venture capital. There are private equity firms that are essentially subsidiaries of large banks or insurance companies. The money they earn is constantly reinvested. However, there are also private equity firms that fill a fund with capital from various parties (known as limited partners) up to a certain amount. Then, the fund is closed and the capital is invested in various companies. The fund managers (the general partners) then focus on managing and monitoring the invested capital and report back to the limited partners on progress, successes, and failures. There is often a period of 10 years in which the intended return on investment (the multiplier) must be achieved, and the fund is closed. Some investments by the fund will be successful, and others will not, but the goal is to make a nice profit overall. The fund managers often receive an annual fee of 2% of the managed capital, which they use to run their business. When an investment is successful, they also receive a percentage of the profit. This is called carried interest, and it is not uncommon for this to be 20%.