Let’s say we have two chemists interested in developing an isotonic car wash solution and they’re calling it “Waterless Wash.” The pair developed the formula and even got the requisite patent. To manufacture and retail this product in mass, however, they will need a huge influx of cash. At this point in the company’s life, there are two owners faced with an important question: how will they get the capital to expand their business?
While there are many ways businesses can raise capital, outside funding generally comes in two forms: taking out debt versus issuing equity.
Taking out debt generally does not impact business ownership. Instead, businesses or the business owner personally can take out a loan. In contrast, by definition, issuing equity in a company changes its ownership. Another substantial advantage of selling equity in a company rather than taking on debt is that the founders do not have to take out a loan personally; thus, the founders reduce the risk of their personal potential financial downside if the business fails. On the flip side of the same coin, by selling a portion of the company, the founders reduce some of their upside if the company eventually succeeds. The risk shifts to the investor and their investment comes at a price.
While many entrepreneurs are likely somewhat familiar with the concept of how initial public offerings raise money for companies, they may be less familiar with the how private equity companies invest in private companies. A vast majority of American companies are private and will never go public. Even for companies that eventually go public, for research and development (“r&d”) and the development of the requisite financial reputation takes years. For example, it took AirBNB twelve years from its founding in 2008 to turn public in 2020; between 2008 and 2020, it received many influxes of cash form private equity companies.
Business owners interested in selling equity in their business will likely go to angel investors, venture capital firms, or private equity companies to raise this capital. While the distinctions between the three groups of investors are not always clear, they operate at different places on the “risk spectrum” depending where a business is in terms of product development, size of investment needed, expected return of investment, and risk of investment.
An angel investor specializes in offering financial backing to start-ups. Their name—angel investors—is for good reason: angels invest in young companies that could not obtain funds otherwise—including taking on debt. While it may be attractive for an entrepreneur to sell ownership during the business’s infancy to raise "easy" capital, this option may underestimate the value of the company and leave the founders in an undervalued financial position.
There are more trade-offs the business owner should be aware when dealing with potential investors. These business owners often have no choice but to sell large portions of equity, often twenty to fifty percent. To safeguard their investments, angel investors will often require companies to form a board, have seats on said board, and bring in their own consultants to help manage the company. While some entrepreneurs welcome the expertise, others resent the control.
Additionally, angel investors may require continuity of management and thereby require the founders of the business to contribute personally to the business. In fact, one of the most important factors angel investors look at when investing are the people in the business; without a strong team, a business is unlikely to attract angel investors.
Venture capital and private equity firms target their investments at more established businesses. Typically, by the time a company seeks money from private equity they are profitable and have a steady cash flow (thereby excluding most start-ups and many other businesses). Most private equity companies are looking to invest and exit within a few years to make a profit. Private equity companies will often invest massive amounts of money, and therefore, like angel investors, business owners will often have to relinquish some control of their business—which at this point, the business owner spent years building.
Moreover, private equity companies are interested in the bottom line value of a company and not much else. They are not likely living in the community where the business is based nor dealing with other suppliers, vendors, or suppliers of the business. Again, this type of management may appeal to some business owners and not others.
To illustrate crudely, an angel investor may value the hypothetical company Waterless Wash at $2 million. The angel could invest $1 million for 50% of the shares in the company. If Waterless Wash continues to grow and turns public in a few years and at that time is valued at $100 million, the angel investor could sell all their shares in the company and make roughly $50 million; the original chemist pair, would only make $25 million each (if they sell all their shares) despite the patent and business being entirely their idea. Of course, 25% of something is worth more than 100% of nothing. This simple calculation, however, does not illustrate the control relinquished by the founders nor the intangible qualities of a business.
It is impossible to know for certain the precise moment to sell equity in a business. Taking on a loan requires the business owner to take on personal financial risk. However, selling equity limits the potential financial upside and forces the business owner to relinquish control over the business. With that in mind, business owners should wait until the cash is necessary for an expansion and they have a strong management team. By waiting, even just a little bit, the business may be valued higher and will have more negotiation power when dealing with potential investors.
Database on taking start-ups public: https://about.crunchbase.com/blog/startup-exit/
AirBNB's private equity deal: https://www.reuters.com/article/us-airbnb-debt/airbnbs-new-1-billion-investment-comes-at-lower-valuation-sources-idUSKBN21P3IM
Questions to ask before taking your company public: https://www.entrepreneur.com/article/227487
Pros & Cons of dealing with an angel investor: https://www.startupgrind.com/blog/pros-and-cons-of-using-an-angel-investor-to-fund-a-startup/
A guide to angel investors, private equity, and venture capitalists: https://corporatefinanceinstitute.com/resources/careers/jobs/private-equity-vs-venture-capital-vs-angel-seed/
Zoe, great post! You did a great job summarizing risks and rewards and the timeline of different kinds of investments. I certainly did not understand the differences between those three groups as well as I do now having read your post. I really enjoyed that you carried through your explanation of the material to your hypothetical. I am sure determining when to give up some (and possibly a lot of) ownership is a huge consideration and entrepreneurs should understand the points you made before trying to wade into the world of equity financing.
Zoe, Great job breaking down the benefits and risks associated with each type of financing. As a reader, I really appreciated you carrying the "waterless wash" example throughout the post. It made it easier to understand the impact when considering the same business throughout. You made an incredibly important point that 25% of something is better than 100% of nothing. I think this is something that while simple in theory, is very hard to remember when actually confronted with the decision.
Zoe,
I like how you laid out the differences between the areas where entrepreneurs can raise capital. Your blog is very well written and easy to understand. The pictures you used definitely help illustrate the points you are trying to make, i.e., risk assessment amongst the different areas of raising capital. Many people don't understand the differences between the various stages of raising capital used when starting a business. Your blog post will help entrepreneurs successfully decide how much equity they should sell off to raise capital. Thanks for the informative post!
- Campbell Goin