Equity finance - what, how, and from where?

Last week, new European rules came into force allowing businesses to secure equity finance more easily.

The rules should help many more firms access this kind of funding, by cutting some of the red tape through which they previously had to battle.

Equity finance can be a very effective way for innovative firms to secure the cash they need. But what exactly is equity finance – and could it be right for your business?

What is equity finance?

Equity finance involves selling part of your business to an investor, in exchange for capital. The investor buys a share in the business, on the basis that they believe they will make a return on their money in the future.

Generally, equity finance arrangements see the investor taking on ownership of part of the business. But different deals can have very different terms. For example, some equity investors take on a share of the control of the business, while others simply receive a portion of the profits.

Equity finance is distinct from a loan in a number of important ways. Primarily, you will not normally have to make interest payments on share capital. Instead, the investor makes money through dividends or by selling on their share at a later date. You should also understand that an equity finance deal may well require you to give up some of your control of your business, while a loan agreement generally will not.

Is it right for me?

There are a number of factors that you should consider when determining whether or not to seek equity finance.

To begin with, you should seriously think about whether or not you are willing to sacrifice a share in your business. Remember that this could have significant financial implications in the medium-term. You should also think carefully about the practical implications. Are you happy to give up some of the operational control that you currently enjoy? Many entrepreneurs find this difficult.

Meanwhile, consider whether or not equity finance is the best way for you to secure the cash you need. Have you considered a loan arrangement instead? Despite the fact that business loans are currently quite difficult to come by, they can allow you to maintain full ownership and control of your business while providing you with the cash you need. You must ensure, however, that your cashflow situation is sufficiently strong that you will be able to make the repayments.

Finally, you should also remember that your business will need to represent a pretty attractive proposition in order to secure equity finance. In practice, this means that you will need to be able to demonstrate that its prospects for medium-term growth are high, particularly in relation to its competitors. Potential equity investors will generally want to know what your firm offers that others in its field do not. They will also want to be sure that you and your management team have sufficient knowledge and expertise to guide the business through its expansion.

Where can I get equity finance?

Equity finance is available in a number of different forms, and from a number of different sources. The sources you investigate will depend in great part on the nature of your business and the amount of money you are seeking.

So-called ‘business angels’ are an increasingly popular source of finance. These individuals or syndicates tend to invest relatively small sums (normally up to around £750,000, but the investment may be much smaller than this), and they generally favour firms that present particularly high prospects for growth and which are in their early stages. Crucially, business angels often provide practical assistance and expertise, as well as cash.

Meanwhile venture capitalists (or VCs) may be an option for larger organisations. They tend to invest more than business angels, and they also tend to be rather more risk averse. Venture capitalists tend to deal with their investments on an ‘arms-length’ basis, in contrast with the more hands-on approach favoured by many business angels.

Depending on the sector in which you operate, you may also be able to leverage the government-sponsored Enterprise Investment Scheme (EIS). This scheme is intended to offer tax breaks to investors who inject cash into certain types of high-risk business.

More information on the EIS is available on the HMRC website.