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Home > Financing Best Practice > Understanding Equity Capital in Small and Medium-Sized Enterprises

Financing Best Practice

Understanding Equity Capital in Small and Medium-Sized Enterprises

by Siri Terjesen

Table of contents

Executive Summary

  • Equity capital or financing is funding raised by a business in exchange for a share of the ownership.

  • Equity financing enables firms to obtain money without incurring debt, or without needing to repay a specific amount of money at a particular time.

  • There are four stages of equity investment: seed, early-stage, expansion, and late-stage financing.

  • Equity capital sources differ in terms of timing, amount provided, type of firm funded, extent of due diligence, contract type, expectations of timing and payback, and monitoring of business decisions.

Introduction

Entrepreneurs may require both debt and equity financing, and often start their firms by financing growth through equity. Equity capital is money invested in the venture with no legal obligation on the entrepreneur to repay the principal amount or to pay interest on it; however, it requires sharing the ownership and profits with the funding source, and possibly also paying dividends to equity investors.

After value has been built, entrepreneurs may consider debt financing, which involves a payback of the funds (with interest) for use of the money. In short, debt places a burden of repayment and interest on the entrepreneur, whereas equity capital forces the entrepreneur to relinquish some degree of ownership and control.

The stages of equity financing are depicted in Figure 1. In the first stage, known as the seed stage, entrepreneurs tend to raise capital from their own savings, though they may also seek informal investment from family, friends, business angels, and public sources. Entrepreneurs may then choose to pursue formal equity capital through rounds of early-stage, expansion, and late-stage financing. This may be followed by an initial public offering (IPO) and, finally, raising of finance from public markets and banks. Summary details of the financing stages are as follows:

  • Seed financing is the initial funding to develop a business concept, for example by expenditure on research, product development, and initial marketing to reach early-adopter customers. Companies that receive seed funding may be in the process of incorporation, or may have been in operation for a while.

  • Early-stage financing is sought by companies that have completed the product/service development stage and test marketing but require additional financing to expand.

  • Expansion financing is provided when the company is poised to grow rapidly. The funds may be used to increase production capacity, marketing, or product development, and/or provide additional working capital.

  • Late-stage funding refers to pre-IPO investments to strengthen a company’s positioning and to gain endorsements from top venture capital (VC) firms as the company prepares to list.

At any stage, equity investment can come from informal or formal sources. However, it is more usual to access informal sources in the seed and early stages, and formal sources in the expansion and late stages.

Informal Equity Sources

Informal and Angel Investment

Informal investment refers to equity provided by individuals. In addition to accessing their own savings and those of family, friends, and even neighbors, entrepreneurs seek informal “angel” investors who provide financial capital as well as business expertise for running a company.

As shown in Figure 2, the rates of informal investment vary dramatically around the world, from a high of 13% in Uganda to a low of 0.5% in Japan. Business owners are approximately four times more likely to make informal investments than are non business-owners (Bygrave and Hunt, 2005). As can be seen in the figure, many informal investors have experience as owners/managers of their own businesses.

Although the profile of angel investors varies, in developed economies, angels tend to have entrepreneurship experience, be retired from their own firm or a corporation, and have net incomes in excess of US$100,000 a year. Most angels invest in companies within a two-hour traveling distance of their home, and therefore the informal investment market is geographically diverse. On average, the angel capital market is approximately ten times the size of the formal venture capital market. Indeed, small firms are eight times more likely to raise finance from business angels than from formal institutions.

Business angels tend not to have any previous relationship with the entrepreneur, and are often more objective. Angel investors can be passive (backing the judgment of others) or active (hands-on, with advice or direct management input to help the business to establish itself). Angels tend to invest as individuals or as part of a larger group, and generally as a part-time interest rather than as a full-time job (as is the case of venture capitalists). In addition to financial goals, informal investors often seek other, nonfinancial returns, among them the creation of jobs in areas of high unemployment, development of technology for social needs (for example, medical or energy), local revitalization, provision of assistance to indigenous peoples, and just personal satisfaction from the assistance they give to entrepreneurs.

Business angels prefer to fund high-risk entrepreneurial firms in their earliest stages. They fill the so-called equity gap by making their investments in precisely those areas where institutional venture capital providers are reluctant to invest. Angels may also prefer to fund the smaller amounts (within the equity gap) that are needed to launch new ventures, and they invest in almost all industry sectors. Angels tend to be more flexible in their financial decisions, and also tend to have different criteria, longer investment horizons (“patient” money), shorter investment processes, and lower targeted rates of return than venture capitalists. Business angel funding can make a firm more attractive for other sources of finance. However, business angels are less likely to make follow-on investments in the same firm.

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Further reading

Books:

  • Cendrowski, Harry, James P. Martin, Louis W. Petro, and Adam A. Wadecki. Private Equity: History, Governance, and Operations. Hoboken, NJ: Wiley, 2008.
  • Gadiesh, Orit, and Hugh MacArthur. Lessons from Private Equity Any Company Can Use. Cambridge, MA: Harvard Business School Press, 2008.
  • Terjesen, Siri, and Howard Frederick. Sources of Funding for Australia’s Entrepreneurs. Raleigh, NC: Lulu, 2007.

Report:

  • Bygrave, William D., with Stephen A. Hunt. “Global entrepreneurship monitor 2004 financing report.” Babson College and London Business School, 2005.

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