So what is equity funding? It is the process of raising money for your company where you are selling-off ownership portions of your company. To understand this better, let’s look at some basics of Corporate Finance, look at Capital Structure, then specifically at equity financing. Then we’ll take a look at how a startup can raise equity financing.
Financial Statements and the Importance of the Balance Sheet
The Balance Sheet is one of three financial statements of a company, along with the Income Statement and Statement of Cash Flow. The Income Statement is also called the Statement of Profit & Loss, or P&L. You can derive the Statement of Cash Flow from the company’s Balance Sheet and its Income Statement.
The Balance Sheet shows the financial status of a company as a “snapshot”, on a particular day. On one side of the balance sheet, it shows all of a company’s Assets that can be quantified in monetary terms. On the other side of the balance sheet it shows the combination of a company’s Liabilities plus Equity.
Book Value versus Market Value
In a balance sheet, the Equity value is derived. In other words, Equity = Assets – Liabilities. This is sometimes known as the Book Value of a company. That number may have very little bearing on the actual Market Value of a company. The Market Value is the price for a share of stock in a company times the number of shares issued and outstanding. I recently wrote a blog post about company valuation where I talk primarily about private company valuation. As I said in that post, your company is worth the exact amount someone is willing to pay for it, as quantified by the price per share of stock times the number of shares.
A portion of the liabilities, the company’s debt, plus the equity, make-up a company’s Capital Structure, or the combination of Liabilities and Equity that were used to finance the company.
There are two ways to raise money for a company: debt, which is part of liabilities, and equity. Most people think of debt as a loan, and that is exactly what debt it. A loan a company takes is similar to a loan you would take as an individual. You borrow money, promise to pay it back, and pay an interest rate plus principle for the term of the loan. In the case of corporations, they can borrow from individuals, from banks, or from other institutions. Corporate debt may have other features besides interest rate and term, but those are the two most important terms, unless it is convertible debt. Convertible debt has another provision that allows the debt to be converted into equity at some pre-set price. That price can be set as a monetary amount or derived from a future price of equity that is sold, usually at some percentage discount to the price of the equity being sold.
In the event that all the company’s assets are sold for an amount less than the value of all the liability, the liabilities get paid first before any equity holders get paid. This is called the Preference Stack. There is a great example of a Generic Capital Structure in an article in Axiel Forum, Capital Structure: What is it and Why it Matters.
What are the Types of Equity?
So what about equity? Equity, according to Investopia, is “A stock or any other security representing an ownership interest. This may be in a private company (not publicly traded), in which case it is called private equity, or in a publicly traded company.” Just like there are multiple types of debt, there are different types of equity. The two basic types of equity in a company are preferred stock and common stock. I took the definitions from Investopia and added a few clarifications:
Preferred Equity is a class of financing representing ownership interest in a company. As opposed to fixed income assets like debt, equity is a so-called variable return asset. However, preferred equity has both debt and equity characteristics in the form of fixed dividends, like debt, and future earnings potential, like equity. Correspondingly, it gives the holder upside and downside exposure. Its claims on the company’s assets and profits come behind those of debt holders and ahead those of common stock holders in the preference stack. This is actually the most important feature of preferred stock in a privately held company, along with the conversion provisions. In a private company financing, outside equity financing is almost always raised as preferred stock. Generally, preferred equity obligates management to pay its holders a predetermined dividend before paying dividends to common shareholders. On the flip-side, preferred equity typically comes without voting rights. However, this is typically not the case in a private company financing. In doing a private company financing, it is critically important to understand valuation, conversion terms, and ALL other deal terms. In fact, the deal terms are sometime just as important or even more important than valuation.
Common Equity is also a class of financing representing ownership interest. Common equity is the junior-most block of the capital structure in the preference stack, and therefore represents ownership in a business after all other obligations have been paid off. For this reason, it comes with the highest risk and the highest potential returns of any tier in the capital structure.
If you are raising private capital, it is called a Private Placement, and if you are raising money in the public markets, it is called a Public Offering. The first time you sell company stock in the public markets, it is called the Initial Public Offering, or IPO.
Raising Money for Your Startup
That is pretty much the basics of capital structure, so how do you go about raising capital for your startup? Well, you can raise capital using the various forms of debt or you can raise equity capital, typically in the form of a private placement of preferred stock in the company.
So, what are the sources of equity financing for a company? Typically, before raise any outside money, there is a “Bootstrapping” phase, where a founder will use her or her own money and take personal loans. They may also raise money from friends and family, usually in the form of convertible debt.
At the stage of seed funding, companies usually look to individual Angel Investors, and sometimes, wealthy family home offices. These same sources, along with so-called Super Angels, can also be involved heavily in Series A financing rounds. Venture Capitalists typically don’t get involved in company financing until Series A, and sometimes even later. A relatively new way to raise private equity financing is called Crowdfunding, and is available in the US via the JOBS Act.
The best way to raise outside capital for your startup is to build a target list of prospective investors that have technical and domain expertise in your target market and then work the list. You want to get so-called “Smart Money” investors into your deal at a fair valuation with the right deal terms. The process of defining your list is something I discuss in my blog posts.
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This is Patrick Henry, CEO of QuestFusion, with The Real Deal…What Matters.