Financing a small business initiative by offering investors a percentage of ownership equity in your business is called equity financing. When angel investors or an equity firm invest in a company, they don’t do it for a loan payment. They do it for a percentage of ownership, or equity. And, instead of periodic payments, the investor is anticipating what’s sometimes called a liquidity event — either a public offering or an acquisition — to earn profits from their investment.
This is how a lot of high-tech companies find capital to quickly grow their businesses. They rely on investors willing to invest in their young companies in anticipation of a big payoff down the road. The potential for fast growth is one reason why high tech companies are so appealing to equity investors; your business being scalable will perk up ears.
How can you tell if equity financing is a good fit for your business, and how does being scalable help you tell?
Investors aren’t typically looking for the same things a lender might look for when evaluating a business.
If the following description describes your business, you might consider an investor:
- You have a business model that could scale profits quickly with additional capital.
- You’re willing to offer equity (or ownership) to an investor in return for capital today.
- You’re willing to give an investor a seat at the decision-making table.
- You see a potential advantage to a more experienced voice to help you guide your company.
Whether or not your business is scalable is the first and most important question to ask because that’s what a potential investor will ask.
If your business can ramp up sales or ramp up production with the infusion of some extra capital, that’s what we’re talking about when we say “scale,” or being scalable, in this instance. The greater your business can scale, the more likely you are to look attractive to an investor.
The Sharks on “Shark Tank,” for example, are looking for businesses that have the potential to grow quickly with an infusion of cash, leveraging their contacts or incorporating their expertise into the product or service. If a Shark sees a lot of growth potential and the opportunity to seriously ramp up profits, he or she will be more likely to invest.
If this describes you, an angel investor or venture capital firm might be a good place to look for growth capital. Finding the right investor isn’t always easy, and many business owners spend what can quickly become a full-time job courting and pitching potential investors — so it’s important to recognize that finding the right equity investor can sometimes be more time-consuming than applying for a loan.
“Angels” are people who invest their personal wealth into specific businesses. Some angels work alone while others work within a network. The investors on “Shark Tank” are a popularized version of angel investors. Angels often get involved with businesses before other investors, like a venture firm might, but they are still looking for the same thing — a company that can scale and grow quickly with the infusion of additional capital.
Venture capital firms
Venture capital (VC) firms manage funds set aside to invest in new businesses. Modern VC firms tend to be most interested in young high-growth companies like tech startups. They usually make high-value investments (think millions of dollars) and expect to be either a part of the management team or have a seat on the company’s board of directors. They sometimes even take an active role in the operations of the business. Like angels, they are looking for companies that can scale and grow quickly with additional capital and make their return as a result of a liquidity event of some kind.
What are equity investors looking for?
In addition to being scalable, investors might not be looking at your credit profile, but they are looking at your track record and performance to determine whether or not they’ll invest in your business.
- They are looking for leadership. Most investors are really investing in the entrepreneur as much as the company itself. The product and what it does is certainly important, but the investors want to know you, your team and whether or not you have what it takes to leverage their investment into a wildly successful company.
- They want to see management experience. Investors want to know you have the ability to build a team capable of meeting objectives or can learn how to do it very quickly. If you can demonstrate that you have the ability to build and lead a successful team, you’ll be more successful convincing an investor to invest in you.
- They want market understanding and experience. Do you have experience in your niche? Investors need confidence that you have a clear understanding of the competitive landscape, a good idea of what your customers, or potential customers, are looking for and that you understand the challenges associated with the space.
- They want to know that you can execute. Nothing else matters if you can’t demonstrate a track record of getting things done. Can you execute a marketing plan? Can you build a sales team? Knowing where you need the extra help to execute and leverage the expertise of others who have complimentary skills will give you credibility with an investor.
Admittedly, very few people possess all of these skills, but investors need to know that you have the ability to pull an effective team together to accomplish some very real growth objectives in, what investors hope will be, a very short time.
Working with equity financing also carries with it some pretty explicit implications. Investors are willing to invest in your business for a percentage of ownership equity and the expectation of a sale, a public offering or some other kind of liquidity event. In fact, most investors want to understand what that exit plan is before they invest.
If your goal is to build a privately held company that will provide a living for you and your family for years to come and you have no plan to sell or otherwise exit, your business might not be a good candidate for equity financing — even if it is very scalable. An exit or liquidity event, rather than periodic loan payments, is how these investors get paid.
Originally published July 7, 2021.