In the early 1970s, a small business owner by the name of Frederick W. Smith was in dire straits. His fledgeling company showed promise, but revenue was barely enough to cover costs. With wages to pay and bills threatening to bring the company to a halt, Smith cashed out the last $5,000, flew to Las Vegas, and bet the lot on a game of blackjack. Smith’s gamble paid off. The $5,000 became $27,000. The bills went away. Smith’s company grew. You may have heard of it – its name is FedEx.
While Frederick Smith’s story may be unusual, many startup founders can probably easily relate to his cash flow situation. In the early stages of running your business, you will probably have used your own money and perhaps that of your family and friends to keep things moving. But what about growth? If it’s time to buy some new vehicles, fit out a second location, upgrade plant or hardware, or enter a new stage of testing or rollout, how do you fund such big costs?
Small scale injections of debt-driven funding, such as bank loans, allow you to maintain ownership of your startup while still getting the cash you need. However, there may come a time when the amounts you’re able to borrow, or the prospect of further demands on your monthly revenue cause you to search elsewhere for funds. Equity funding comes with its advantages and disadvantages and can take a wide variety of forms. This article is designed to provide you with a brief overview of some of the different types of equity funding.
Private Equity and Venture Capital
Venture capital and private equity are regularly classed together (although the terms are not interchangeable). Both are equity-based: in return for venture capital or private equity funding, you will typically part with shares in your startup.
Both are relatively high risk and high reward. Investors buy shares in a business that offers the most alluring returns at a price point that reflects uncertainty about its long-term profitability. This uncertainty is driven by immature commercialisation, existing financial distress, or some other variation on these themes.
A further similarity exists in the source of funds that private equity and venture capital funds draw on to finance their investments. High net worth individuals, private companies or organisations, and other managed funds are conventional sources. For many, including superannuation and pension funds, making a small high risk, high reward investment offers the potential for substantial upside at a relatively modest price in the scheme of the overall fund. Such investments can enhance the potential return of an overall low-risk strategy.
A key characteristic of this funding type is that it typically comes with a high level of involvement from your new business partner. While this does not (usually) extend to involvement in day-to-day operations, private equity and venture capital investors will typically exercise influence through a board or advisory role to help safeguard their investment.
Angel investors are wealthy individuals who are prepared to invest their own money in the hope of receiving a return. Importantly, Angel investors are accredited or sophisticated investors. A sophisticated investor requires a certificate from a certified accountant to affirm they have either:
- Net assets of at least $2.5 million; or
- A gross income for each of the last two financial years of at least $250,000 a year.
You can find these requirements and the regulations surrounding them in Chapter 6D of the Corporations Act 2001 (Cth).
Angel investors often want little to no involvement in the operation of the business. For some business owners, this is a positive. However, it can also be advantageous to have an angel investor that is switched on and wants to contribute, whether it be through broadening your network by introducing you to their connections or acting as a mentor.
Capital raising is often an important part of growing your startup, and it’s essential you find the right investor your stage of growth. Venture capitalists, private equity investors, and angel investors can sometimes offer more than just money to help your business grow, and you should consider this when looking for investors.
Finally, always seek legal advice before signing any term sheet or making promises to investors. While money is important, so too is protecting your interests in your business. If you have any questions, get in touch with our startup lawyers on 1300 544 755.