Whether you're starting a new business or are a small business owner, you need capital to run your business. You have two options: raise money through debt/loans or equity. With equity financing, the promoter raises the money by selling shares.
Are you planning to raise capital through equity? Here's everything you need to know about equity financing, its types, why promoters should opt for equity financing, the key steps to raising funds by selling an equity stake in the company, and the disadvantages of equity financing.
Before we proceed, let’s first understand what equity financing is.
What is Equity Financing?
When company owners decide to sell shares to raise the necessary capital, this is known as equity financing. Raising funds through equity does not represent a financial obligation for the company, as the investors do not receive a fixed dividend on the capital provided, but rather a stake in the company in return.
Regardless of whether you are a listed or unlisted company, you can be funded through equity capital.
Again, there are various forms of equity financing, such as raising capital from friends and family members, private investors, wealthy individuals or angel investors, venture capitalists, or the public offering of shares as part of an IPO.
Other Options to raise capital
Let’s now discuss the types of equity financing available to companies.
Types of Equity Financing
As the name suggests, a company can sell its shares to raise capital. As a company founder, you can opt for a private placement of shares or a public offering of shares.
- Private placement of shares: In a private placement, SME promoters offer the company’s shares to a few investors, who can either be angel investors, venture capitalists, private equity firms or institutional investors. Investors who are convinced of the long-term growth of the company are interested in investing at an early stage. Such investors not only provide good access to capital, but also to their business networks.
- Initial public offering (IPO): Company founders and promoters can also choose to raise capital through a public offering of shares in an SME IPO. The IPO is a historic event for any company as it is listed on the stock exchange. However, the process takes time as the regulations issued by SEBI and the stock exchange have to be followed. If a company is already listed, it can make an additional share offer called a Further Public Offering (FPO) and raise the required funds.
10 Key Things to be Considered While Planning for SME IPO
Later in the article, we discussed the key steps involved in raising capital through the sale of shares.
Why Should You Raise Funds through Equity Financing?
Start-ups or small companies that want to expand often raise capital through equity. Let us briefly point out some important reasons why promoters should consider selling an equity stake;
- Equity funding is the best option for companies that do not want a fixed financial burden such as regular interest payments. The issuing company is not obliged to pay a fixed dividend rate to investors. SME promoters are not even obliged to pay back the money invested to shareholders.
- If your company is doing well, the owners may decide to sell a small percentage of the equity at a good valuation. This way, you can keep the majority of the shares yourself and also attract new investors without diluting control of the company. Also, when you raise funds from private investors, venture capitalists, etc. will give you access to funds and their business expertise, knowledge, and networks.
- Unlike debt financing, where companies must prove a good credit rating to obtain the required loan amount, equity financing does not require a credit check.
10 Key Steps to Raise Funds by Selling Equity Shares
No wonder, it is very difficult for small businesses to raise money. In the past, borrowing from banks was the only option available to them, but the terms were prohibitive, so small business owners had no choice but to sell shares in their companies.
Let’s now discuss how SME promoters can raise the required funds by selling shares in their company. Here are the key steps;
1. How much capital do you need and why?
Fundraising is the top priority of selling shares in an SME. However, promoters need to develop a clear agenda for the company’s capital requirements and also justify why it is needed
As the owner, determine your capital requirements and answer the question of how much capital you need, e.g. Rs 20 crore. You should also ask yourself what the purpose of raising capital is, i.e. how you intend to use the funds raised through the sale of shares.
There may be several reasons for this, such as the need for working capital for day-to-day operations or the need for capital to expand the business, develop new products, purchase new machinery or other strategic initiatives such as acquisitions. Some SMEs also go public just to be listed on the stock exchange and build a compelling brand value. (Brand building through SME IPO Link)
2. Determine your business value
Once you have determined the need for funding, you need to determine the value of your business, but how? This is a tricky question, as many factors play a role in company valuation.
Technically speaking, discounted cash flow (DCF), profit-earning multiples and asset valuation are the most common methods of company valuation.
Below are some important steps that promoters should consider when valuing their company.
First, determine the net worth of your company, i.e. the sum of your company's assets minus its liabilities.
Now check how well your company is performing, because companies that perform well are valued higher than those that perform poorly. So check the operating performance, such as the company's revenue and profitability, and assess how impressively they are growing.
In addition to current revenue and profitability, you should also analyze future growth prospects to estimate the growth rate of revenue and profitability.
SMEs with solid current performance and robust growth potential are in a position to rate their business highly. On the other hand, if the demand for the company’s products declines, this will have a negative impact on the company's valuation. Once the company valuation is complete, you should decide what percentage of stake you are ready to sell.
A correct valuation of your company is the key to successfully raising capital. Investment bankers or merchant bankers act as valuation experts, providing their expertise to help promoters value their business correctly.
3. Choose the type of equity sell offering
Now you have to decide how you want to sell the company’s shares.
As mentioned above, there are two options available to owners when selling shares: a private placement and a public offering.
In a public offering, a company raises funds from a larger number of investors, while in a private placement, the promoters sell their shares to a small group of individuals or institutional investors.
Detailed guide on the difference between private placement and IPO (Link)
4. Ensure regulatory compliance
When selling shares in a company, the owners must comply with various laws and regulations. However, the regulatory requirements for a private placement are comparatively less stringent than for an IPO.
The promoters must be aware of and comply with the applicable regulations for raising capital through equity. In this context, the company owners must ensure that the legal structure of the company, the composition of the board of directors, etc. comply with the legal requirements.
And the regulations of the securities market allow companies to sell shares.
5. Lay the Groundwork through documentation
Listing on the SME exchange requires a lot of paperwork and documentation formalities.
SME promoters planning an IPO must have all the necessary documentation ready to submit to the SME Exchange on time.
A preliminary list of documents that need to be prepared by the owners in advance includes
- Copy of Memorandum of Association
- Copy of Articles of Association
- An audited restated financial statements for the last 3 full finance years
- Copy of all materialistic business contracts and agreements
- Copy of Board resolution and Shareholders resolution for the IPO issue
- PAN and TAN number of the company
- PAN and DIN details of company directors and promoters
- Strategic business plan for future growth
6. Tips to find out Potential Investors
Selling equity shares means transferring ownership and control to shareholders. So before you get started, here are some tips to help you find the right investors.
Angel investors are early-stage investors who can provide your company with the required funds. Use your network or attend networking events to find angel investors.
Venture capitalists are different from angel investors, who provide sufficient access to funding primarily for high-growth promising SMEs. Use your professional network and attend industry events to find venture capitalists. You can also approach them directly and present your company to obtain funding. These investors will not only provide your company with funding but also build good industry connections and an investor network.
SMEs that are doing exceptionally well and have rapidly growing customer demand may need a larger sum of money to expand. These companies can sell shares to the public in the primary market and get listed on the BSE SME or NSE Emerge stock exchange.
7. Create a strong foundation for marketing the offering
Regardless of whether you as an SME owner opt for funding from private investors, VCs or a public offering, a major marketing effort is required. The reason for this is that marketing strengthens the company's image with potential investors.
If you sell equity through a private placement or an IPO, you need to meet with potential investors, and an IPO even requires roadshows to attract institutional investors. So you need to create a compelling presentation to encourage investors to invest in the company.
Here is a to do checklist for creating a convincing business pitch;
The pitch deck is of great importance and promoters need to include all the key business facts and figures in the presentation.
What should your business pitch include?
- Company’s strengths
- Competitive positioning: What is the USP of your business or how will you compete with industry peers?
- Business performance: Revenue and growth rate, profitability (gross profit, operating profit, net profit) and growth rate, EPS, etc.
- Financial performance: Use of debt and equity in the capital structure, net worth, turnover ratios, etc.
- What are your future business strategies for growth
- Future growth estimation of revenues, profitability, etc. with rationale
8. Negotiate with investors and prepare a term sheet
Promoters are not always able to get the funding they need on their terms, so negotiation plays a role here. Let us understand what are the key areas where promoters and investors are involved in negotiations;
Valuation is the most important aspect of negotiations with private investors. Venture capitalists consider the current growth rate and future growth prospectus of the company and analyse the industry dynamics to determine the correct market value of the company’s assets and liabilities and negotiate with the owners accordingly.
Venture capitalists, angel investors, private companies or other institutional investors provide their capital to take a stake in the company. In return for the capital they contribute to the company, they usually demand a certain percentage of ownership.
Other points of negotiation may include the rights of the investors, the timetable for the investment, the exit strategy, etc.
Based on the agreed negotiations, a term sheet is drawn up in which the terms of the investment are clearly defined.
9. Finalize the deal
Once the promoters and investors have agreed on the terms, the deal is finalized.
This is where all the necessary documents such as the subscription agreement, shareholders' agreement, etc. are prepared and signed to fulfill the legal formalities.
10. Utilize funds raised
Once all the legal formalities have been completed, the investors provide the capital. The promoters can use the funds for the agreed purposes, e.g. to cover operating costs or for the company's growth and expansion plans.
You should also keep investors regularly informed of financial and operational developments to build trust.
What are the cons of selling equity stake in the company?
Attention! Even if there is no fixed financial burden with equity financing, you must be prepared to share your ownership with external shareholders. Here are the key points to consider before you decide to sell an equity stake in your company.
- Dilution of ownership and control: When a company issues or sells shares to investors, they receive ownership rights in the company in return. Therefore, they can exercise their voting rights and influence important company decisions. So be prepared for this.
- Valuation: SMEs that need immediate funding to continue operations often compromise on valuation, which is not a good thing. This is because raising equity at a lower value will hurt the long-term valuation of the company.
- Maintaining relationships with investors: companies need to invite shareholders to meetings and communicate with them regularly to maintain transparency and build trust.
