It’s useful to understand different types of equity because at some point you might want to grow your business by getting others to invest in it.
Equity-holders partake in the ownership of a company.
Equity includes any money that the founders of a company put into the business themselves and any money that they might have received from venture capitalists or other private equity investors. If someone gives you money in return for a share of your company they become an equity-holder or a shareholder.
The money shareholders put into a company does not have to be repaid.
In return for their investment, shareholders receive a share of any profits made. The payments made to shareholders are called dividends.
If a company is liquidated shareholders are the last to be repaid. If after the debtholders have been paid there are no assets left to liquidate, then the shareholders get nothing back. Equity is therefore said to be subordinated, or rank junior relative to debt.
Even within debt and within equity there are different subcategories which determine who needs to get paid first if a business goes bust.
Types of Equity
Start-up companies don’t have enough of a track record to get a significant bank loan or to raise equity in the capital markets (on a stock exchange). To fund growth they can obtain equity capital from one of the below. The list is not exhaustive.
Angel investors are businesspeople that invest in high risk start-ups; they typically look to get their money back several times over, five times or more within four to eight years. The decision behind an ‘angel’ investment usually comes from an individual or family. Some angels group their funds together to enable bigger investments and economies of scale on admin, e.g. project due diligence.
Venture capitalists (VCs) are a special category of private equity investors that invest in early-stage start-ups, typically in technology or some other unproven field. The investment will normally be smaller in size. As VC funds look at higher risk investments than mainstream private equity, they similarly look for higher returns: 10-50 times the initial investment within five years.
Private equity investors (also known as ‘Financial Sponsors’) pool together the funds of various private investors and manage them in a fund. Investors can include high net-worth individuals, companies or even institutions like pension funds and insurance companies. The fund makes investment decisions in a formalized manner as dictated in the private placement memorandum (PPM) that is used to set the fund up and attract money from investors. Private equity investors typically look for a return of 20-30%. To buy an asset, mainstream private equity funds will combine private equity with bank debt
How do these equity investors get their money back?
Firstly, by selling the asset. Secondly, by listing the asset on a public stock exchange through an Initial Public Offering, IPO. Thirdly, dividends may also be paid by the assets of private equity firms but are not likely in angel or venture capital investments as all funds are typically ploughed back into the business to generate growth.
Crowd funding is money sourced from ordinary people normally through some internet-based method. Frequently, funds sourced from the crowd don’t have to be paid back. A business that raises capital from the crowd receives small amounts of money from many people, most of whom are not professional investors. The contributors will all be people that appreciate the business idea under consideration and possibly see themselves or their friends and family using it.
With the growth of the internet and the ease of making e-payments, crowd funding has grown rapidly in recent years. Check out milliondollarhomepage.com for the kid who raised over USD1 million in just 128 days to fund his university education through crowd sourcing and he doesn’t have to pay it back!
“In investing, what is comfortable is rarely profitable.” Robert Arnott
For 2 years until early 2014 I wrote a weekly personal finance and business column for Malawi's leading media house, The Times Group. The target is middle-class, working African women.
This is a reproduction of the articles that appeared in the weekend edition of Malawi News.