Investment guide:

Equity
Introduction

Equity financing is a form of investment where capital is deployed into a business in exchange for
shares in the business. Equity investors become partial owners of the business, sharing in its profits
and losses. This type of financing is commonly used by early-stage businesses (pre-revenue and pre-
profit), which have minimal cashflows and need capital for growth and expansion.

This guide explores the dynamics of equity financing, highlighting the roles and characteristics of
different equity investor types. It also delves into the benefits and risks of equity financing, to help
entrepreneurs understand this form of capital.

Key terms in equity financing

Key terms
Term Description Business consideration

Equity Ownership in a company, typically in the form Businesses should carefully evaluate the
of shares or stock. It represents the residual percentage of equity they are willing to offer in
interest in the assets of the business after exchange for capital. Dilution of ownership and
deducting liabilities. Equity investors are decision-making control are important
entitled to a portion of the company's profits. considerations to weigh against the financial
benefits of equity investment.

Equity investor Individual or entity that invests capital in a Businesses need to assess the specific expertise,
business in exchange for equity ownership. networks, and resources that equity providers
This can include angel investors, venture bring to the table. Aligning the goals, values, and
capital firms, private equity firms, long-term vision between the business and the
institutional investors, and even equity provider is crucial for a successful
crowdfunding platforms. partnership.

Valuation The process of determining the worth or fair Companies seeking equity financing must
market value of a business. It involves understand their valuation and be prepared to
assessing several factors such as financial justify it to potential investors. A realistic
performance, assets, growth prospects, valuation is necessary to attract investment and
market conditions, and comparable increase the chance of a successful equity
transactions. fundraising.

Dilution Occurs when additional equity is issued, Existing shareholders need to carefully consider
resulting in a reduction of existing dilution to ensure their interests are protected.
shareholders' ownership percentage in the Dilution can affect control, voting rights, and
company. Dilution happens when new equity future financing options. It is important to strike
investors come on board or when equity- a balance between raising capital and preserving
based employee compensation plans are ownership.
implemented.

Investor rights Privileges and protections afforded to equity Entrepreneurs should carefully evaluate the
investors. These rights can include investor rights requested and their potential
information rights (access to financial and impact on decision-making and operational
operational information), approval rights autonomy. Balancing investor rights with the
(such as major business decisions), and rights entrepreneur's vision and operational flexibility
to participate in future financing rounds. is crucial for long-term success.

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Key terms
Board representation Refers to the right of an investor to have a seat Entrepreneurs should assess the balance of
on the company's board of directors. It allows power, expertise, and alignment of interests
investors to participate in strategic decision- between the investor-appointed board member
making processes within the business. and the entrepreneur.

Types and sources of equity financing

There are various types of equity investment for founders to choose from depending on their business
stage and long-term objectives as set out in Error! Reference source not found.. Each investment
instrument carries a different risk and reward profile, which in turn impacts which investor type will
be most appropriate at each business stage as demonstrated in Figure 2.

Figure 1: Types of equity

Figure 2: Sources of equity

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Source of Equity Description

Pre-revenue

Family and friends Family and friends are usually the first source of external finance for a business. They have flexible
repayment periods and low interest which is useful to pre-product and pre-revenue businesses.

Equity-based Equity crowdfunding is raising equity by offering shares or ownership stakes to many individual
crowdfunding investors through online platforms. This method can help startups access funding from a broad
investor base and gain initial traction.

Angel investors These are typically high-net-worth individuals who invest in pre-revenue businesses through equity
or quasi-equity instruments. They may be mission-driven industry experts, looking to share
knowledge, expertise, and networks through closer mentorship of entrepreneurs, or simply motivated
by the opportunity of outsized returns associated with investment in higher -risk earlier stage
businesses.

Venture capital firms Venture capital firms invest in high-potential pre-revenue companies in exchange for an equity stake.
Venture capital investors provide essential seed capital and signal confidence in the market potential,
technology, or business model of the start-up. This allows businesses to develop their products, build
their teams, and lay a foundation for future growth, while also attracting additional investors,
customers, or partners who may be more reluctant to work with an early-stage company.

Post-revenue

Equity-based Equity crowdfunding at the post-revenue stage involves offering ownership shares to a diverse group
crowdfunding of individual investors through online platforms. This approach enables established startups to secure
capital from a wide range of backers and further accelerate their growth and expansion, leveraging
their existing revenue streams.

Venture capital firms At the post-revenue stage, venture capital fuels scaling efforts by offering significant capital for rapid

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Source of Equity Description

expansion and leveraging extensive networks to form strategic partnerships that drive growth and
create synergies. This enables post-revenue businesses to accelerate their growth trajectory, achieve
significant market share, gain access to new markets, secure valuable distribution agreements, and
enhance their competitive position in the market.

Impact investors Calls for cooperation and cross-sector collaboration to solve global challenges such as poverty, climate
change, and hunger, have led to the emergence of impact investors. These are investors who focus on
initiatives that have an impact-first criteria before financial return. Examples of impact investors
include Development Finance Institutions (DFIs), private foundations, and impact funds. Impact
investing is explained further in the special instruments guide.

Profitable

Private equity firms Private equity funding at the profitable stage of business may take two forms: growth financing or
buyouts. Private equity firms channel investments into highly profitable, mature businesses that need
additional capital to fund growth of products or markets in exchange for equity stake in the company.
In the buyout scenario, private equity investment is used to purchase the entire stake of an existing
mature business.

Public markets (initial Mature, profitable companies can raise capital for growth from public markets by offering their shares
public offer) in a new stock issuance. IPOs are also used as an exit option for private investors since they provide a
premium on shares, thus allowing them to realize the gains from their early investment.

Impact investors Calls for cooperation and cross-sector collaboration to solve global challenges such as poverty, climate
change, and hunger, have led to the emergence of impact investors. These are investors who prioritise
initiatives that have an impact-first criteria before financial return, even as they aim for profitable
returns. Examples of impact investors include Development Finance Institutions (DFIs), private
foundations, and impact funds. Impact investing is explained further in the special instruments guide.

An investor could sometimes invest in businesses at distinct stages of maturity taking a portfolio
approach to de-risk investments. However, the table above gives an indication of the typical investors a
company can approach based on its stage of maturity.

Other early-stage investment support

Companies seeking early-stage capital may also find non-financial resources available at business
incubators, accelerators, and as set out below.

Type of support Support offered

Business incubators Development of pre-revenue businesses or concepts through the provision of wide-
ranging support such as business coaching, access to business networks, etc,
provided in return for equity.

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Business accelerators Development of early-stage businesses through wide-ranging support including
investment readiness to speed up the path to profitability and external fundraising
rounds, provided in return for equity.

Company valuation methods

Company valuation is a key component of the equity financing process that involves assessing the total
economic value of the business. The value established lays the foundation for term sheet negotiations.

The methods used in company valuation vary depending on the life cycle stage of the business as each
stage presents unique characteristics and challenges.

1. Early-stage businesses – During this stage, the business may not have operating history or
be generating revenue. As a result, investors focus on the market opportunity that the firm
can capture and revenue potential to determine its value. Some of the methods used include:
a. Discounted cash flow (DCF) - This method estimates the present value of the
company's expected future cash flows, adjusting for factors such as revenue growth,
profitability, and risk.
b. Comparable company approach – This approach estimates a company’s value by
comparing it to similar companies in the industry that have raised equity. It considers
factors such as revenue, user base, and market potential as reference points for
determining comparable value.
c. Venture capital method - This method involves estimating the company's value
based on the expected return on investment and the level of risk associated with the
investment.
2. Growth-stage businesses – During this stage, the business has developed a functional
product with proof of concept and is generating revenue. The valuation methods used are
therefore a mix of quantitative and qualitative concepts to capture the company’s growth
potential.

Quantitative concepts include:

a. Multiples approach (precedent transaction analysis) – This method uses
multiples based on financial metrics as a yardstick to assign value. Some of the
commonly used multiples include price/earnings (P/E) ratio, enterprise value/
EBITDA, and dividend yield. These metrics are compared against similar companies
whose valuations are public to establish comparable values.

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Qualitative concepts include:
a. Premiums – Premiums assign additional values to a company's shares based on
qualitative factors such as leadership quality, brand reputation, growth prospects,
competitive advantages, unique technology, or significant market share. This
approach helps stakeholders and investors recognize and account for a company's
competitive strengths, leading to a higher valuation than solely derived from financial
metrics.
b. Discounts – Valuation discounts are applied to companies in volatile industries or
facing regulatory uncertainties. Appraisers evaluate potential risks and weaknesses,
considering factors like market exposure, reliance on a single customer, regulatory
challenges, financial stability, and management risks. Applying discounts during
growth stages ensures potential investors and stakeholders consider the risks and
limitations of the business, resulting in a lower valuation than derived solely from
positive financial metrics.

Benefits of equity financing

Key Benefit Description

Access to Equity provides an opportunity for businesses to raise funds for growth initiatives, expand
capital operations, develop new products, or enter new markets.

Long term Unlike debt financing, equity financing does not have a fixed repayment schedule. Investors
funding become shareholders and provide funding with the expectation of sharing in the company's future
success. This long-term nature of equity financing provides businesses with stability and flexibility
in managing their financial obligations.

Shared With equity financing, the burden of risk is shared between the investors and the business owners.
risk Investors are willing to take on the risk associated with the company's performance because they
have a stake in its success. This shared risk can provide a sense of security for business owners and
reduce the pressure of repaying debts during challenging periods.

Expertise Equity investors often bring more than just capital to the table. They can offer valuable expertise,
and industry knowledge, strategic guidance, and mentorship based on their experience. This can help
guidance businesses make informed decisions, refine their strategies, and overcome challenges.

Network Partnering with equity investors can expand a business's network and access to resources.
expansion Investors may have a vast network of contacts, including industry professionals, potential
customers, suppliers, and other investors. Leveraging these networks can open new opportunities
for collaboration, partnerships, and growth.

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Key Benefit Description

Enhanced Securing equity financing from reputable investors can enhance a business's credibility and
credibility reputation. It serves as a vote of confidence in the company's potential and can attract further
interest from customers, suppliers, and other stakeholders. This increased credibility can help in
attracting top talent, negotiating favourable partnerships, and differentiating the business from
competitors.

Challenges and risks of equity financing

Key Challenge/ Description

risk

Loss of control Equity financing can lead to a loss of control and decision-making power for the original
and decision- founders and shareholders as new investors with different perspectives and strategies come on
making power board.

Dilution of Issuing new shares of stock as part of equity financing can dilute the ownership stake of existing
ownership shareholders, reducing their proportional ownership.

Investor Equity investors often have specific expectations and demands regarding the company's growth
expectations and profitability, which can create pressure on the management team to meet aggressive targets
and demands and shift focus away from long-term sustainability.

Impact on Introducing external investors through equity financing can impact the existing company
company culture, potentially creating tension and challenges in maintaining a cohesive and aligned
culture culture due to differing risk appetites, management styles, or strategic priorities.

Market Equity financing carries inherent risks related to market volatility and investor sentiment, as the
volatility and value of a company's shares can fluctuate significantly based on a range of factors, potentially
investor affecting the overall valuation and future funding prospects of the company.
sentiment

Further reading

Equity Financing - https://www.investopedia.com/terms/e/equityfinancing.asp

Equity valuation - https://corporatefinanceinstitute.com/resources/valuation/equity-valuation/

Equity valuation methods - How to Value a Company: 6 Methods and Examples | HBS Online

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Types of Equity financing - https://www.thebalancemoney.com/types-of-equity-financing-for-small-
business-393181

The Equity financing process – https://fastercapital.com/content/The-Equity-Financing-Process-a-

Startup-Investor-s-Guide.html

Investment guide: Equity 9