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Choosing a Type of Equity Financing: A Cash Course

August 05, 1998

Venture capital--backing of $1 million or more by professional investing firms or wealthy individuals--is a prize envisioned by many small-business owners. But it's a small piece of the funding out there and not the answer for most small companies.

Venture capitalists demand high return on their investments, and most small businesses can't meet their requirements, small-business consultant Debra Esparza says. Small companies typically rely on other forms of equity financing.

All equity financing involves giving up some degree of ownership and/or control in exchange for money. Keeping 10% of a big business might seem better than owning 100% of a small business, Esparza says, but before making a decision you need to consider your emotions and financial future.

Can you easily give up part of your business after spending your time, sweat, money and energy creating it? Can you bear not being in charge anymore? Will you feel less fulfilled?

With a change in the ownership structure, communication becomes crucial. Even if you keep all management responsibility, you will be required to discuss your company's tactics and strategies with your new co-owners.

Once you've accepted these changes, you must address three basic questions before seeking equity financing:

* How much management control are you willing to give up?

* What amount of return on the investors' money will your business generate?

* How will the investors receive a return on their money and end the arrangement?

The answers determine which type of financing outlined below you will seek.

In general, businesses seeking equity capital start with partnerships, the simplest method. The original owners generally keep a large part of ownership and control.

The other end of the equity spectrum is a public offering, at which point the company founder may have little ownership and even less management control.

The following explanations are generalizations. Every deal is different.

* Partnerships: These arrangements include working partnerships, investor relationships and strategic partnerships, says Peter Cowen of the Westwood-based early-stage investment advisory firm Peter Cowen & Associates.

In a typical partnership, the structure is simple: New investors actively work in your company and the investment is small, $5,000 to $50,000.

But even the simplest partnership should have a written agreement outlining basic information such as the amount to be invested; the percentage of ownership by each party; the degree to which each will bear management responsibilities; salaries or perks; terms of exit, such as the selling price and whether a partner would sell to the remaining owners or to third parties. Another consideration is what will happen if one of the partners dies. Does ownership pass to heirs of the deceased or remain with the surviving partners?

"Most partnerships get in trouble because of a lack of communication," Esparza says. "The company may get to a decision point and, without talking to each other, each party may pursue what they think is the right tactic."


By contrast, partnerships set up primarily for investing usually involve little exercise of control by new partners, whose focus is a return on their money. In strategic partnerships, new partners may already own other companies, and the new partnership allows them to develop equipment, products or a market to enhance the other businesses.

In all partnerships, the investment is not easily convertible to cash. In effect, the investment is a loan, with the new partner receiving the principal plus interest over a specified period, along with part of your company, Cowen says. Companies not going public or expecting to be acquired soon are best suited for partnerships.

* Angels: These wealthy individuals who are willing to put money in your company are likely to be friends and family members. In 1997, $40 billion of the nationwide venture capital pool of $50 billion came from friends and family. Typically, these angels don't help run your company and are more willing to wait for a return on their money.


Another angel pool consists of successful entrepreneurs who recognize potential in other companies and are willing to invest $100,000 to $2 million or more in your company. These investors are often motivated by passion and interest in a specific industry or belief in a certain individual. They prefer start-ups, want high returns on their money and expect to get their money back after a certain time through a public offering or acquisition.

These high-net-worth individuals are not listed in directories but are found through networking and personal introductions.

"There are a lot more angels out there than ever before, but most are not walking around with their wings on," Cowen says.

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