by Mark Rambler, President, COO and Co-Founder
One of our small business borrowers is an up-and-coming, tech-savvy platform that connects creative content providers to established brands. In my initial conversation regarding funding options with the owner (we’ll call him Tom), we discussed the relative merits and limitations of borrowing funds vs. selling equity to raise the capital he needed to grow. In the end, Tom ended up taking out a loan with our company, Credibility Capital, but for other small businesses selling equity may be a solid option depending on a variety of factors.
The first consideration for business owners is whether or not they can attract equity investors to raise the capital they need. While most larger companies have sold shares at some point in their lifecycles, it can be considerably more challenging to convince someone to buy equity in a small business. An equity investor will want to know when she will get her money back and at what return, two factors that are dictated by a realization event such as dividends, recapitalizations, a sale of the business or even an initial public offering. These events are notoriously difficult to predict and tend to be rare, but are most likely to occur for businesses that that are on a clear growth path or that generate sufficient cash flow to support scheduled distributions to equity owners.
For businesses that can effectively attract equity investors, selling equity to fund growth is a good option. While some debt is no doubt a great way to leverage assets to access additional capital, too much debt can lead to burdensome debt obligations that can be a major drain on a business. In some cases, if a company can’t make payments on its debt obligations, the lenders may foreclose on the business. Equity funding frees companies from those repayment obligations.
Another advantage of selling equity is an increase in the number of stakeholders who are incentivized to make the business successful. Each equity owner brings unique experience, diverse skills and a vast network to the table, all of which can add tangible value to the company’s day-to-day operations and future growth potential.
On the flip side, selling equity by definition dilutes the owner’s interest in the company. This dilution could translate into three adverse impacts: 1) the owner stands to gain less value upon a realization event and/or through annual distributions; 2) the owner’s control over business decisions diminishes; and/or 3) the owner may be required to share more detailed information with new equity investors, inviting scrutiny that could slow progress.
From a practical perspective, equity transactions are complex in nature, requiring time and money to structure. Small businesses must first be valued, a difficult exercise that requires extensive research to understand valuation metrics for comparable companies. These valuation metrics are generally not disclosed to the public but business brokers (or investment bankers for larger companies), accountants, or legal counsel can provide insight. Once a valuation is set, the business owner and the equity purchaser must agree on a broad set of terms related to access to financials and other records, input into day-to-day operating decisions, and control over broader strategic company matters.
If after thinking through these considerations a business owner decides to sell equity in her small business, I recommend that she speak to many potential investors because the market for small businesses is illiquid – a broad range of prices and terms may be available. Nolo is a good resource for free information on legal matters and this article in particular is a helpful place to start - Raising Money Through Equity Investments.
If the business owner decides instead that a loan is the right path, I recommend reviewing the Small Business Borrowers’ Bill of Rights to make sure the owner borrows responsibly.