Introduction to equity investment
Posted on 03/04/2019
Selling shares in your company
A company is a separate entity, with it is its own legal body. We divide this company into separate amounts and call these shares. A company can have any number of shares. It can be anything from one share, say a single person consultancy owned by the consultant, through to several million shares, such as a multinational. These shares can be bought and sold. A place where shares are bought and sold, is known as a stock exchange. Any share that can be sold or bought on a stock exchange is known as a Public share, as in members of the public can buy them. Other shares, are called private, as they can only be sold privately.
The journey from creation to public flotation has a number of funding stages sometimes referred to as the funding escalator. This is a simplified view and of course there are exceptions, but it gives you an idea of the types of funding available and the expectations of those funders from their investments.
At creation, your company is likely to be pre-product and pre-customer. You will have a lean operation and your vision and enthusiasm will be the main driving force. We call this stage bootstrapping. The three candidates that you can ask for support are; Family, dear friends and yourself. You are probably paying yourself less than you are worth to save and cover other costs. This funding helps you explore what the product is, who your customers are and what is the market opportunity. With this information, you are in a stronger position for the next stage, angel investors.
Investment from angels will generally be the first money that is more formally taken. It will include legal paper work, a process of sanity checking, called due diligence and generally a more probing nature that your family and friends were unlikely to have demonstrated. Angel money is generally used to complete the product and take it to market.
The next step is usually venture capital and corporate capital. These people are investing other people’s money, for example this might be long term money from an insurance company or retained profits from a large company.
The final step is for the investor to see a return on their investment. This can be done by selling to a company, known as a trade sale, or via an IPO, Initial Public Offering.
Lets look at these in more detail…
Angel investors are generally high net worth individuals investing their own disposable finance. Making investments into an early stage company is risky business, so the law in the UK requires them to only invest in companies subject to two conditions. The rules change from time to time, but at the start of 2018 Angels had to declare that they had, during the financial year immediately preceding the date in question, an annual income to the value of £100,000 or more; or they held, throughout the financial year immediately preceding the date in question, net assets to the value of £250,000 or more. Net assets for these purposes do not include things like their primary house, insurance products or pensions products. Alternatively, an angel investor can be someone who has self-declared themselves as a sophisticated investor. This means that they have the expertise, knowledge and information to understand the risks they undertake.
Because angels have an understanding of the risk, they are often prepared to consider investments at an earlier stage than more formal organisations. They will reduce the risk by using their experience to solve problems and spread this risk by sharing investments with other angels. Where more than one angel invests, this is known as syndication.
To attract angels to invest in early stage companies, rather than invest elsewhere, the government gives tax breaks in the UK through the Seed Enterprise Investment Scheme and Enterprise Investment Scheme.
Venture Capital, VCs
Investments made through Venture Capital is with money that is invested on behalf of someone else. The VC needs to demonstrate to their funders that they are making good use of the money trusted to them.
To provide a simplified example, most VCs are given money to invest for a set period of time, typically ten years. This money could be from, for example, an insurance company. The VC will invest in various companies and at the end of the ten years, will be looking to covert the assets back into cash. The profits from the investments will then be shared between the money supplier and the fund managers. When looking at funds to invest in your business, see whether the fund is still investing in new opportunities.
You may come across VCs who invest the money they make back into the fund they have been asked to manage. This is known as an evergreen fund and has no end date. Often, they are started with public money to meet certain strategic aims. With all VCs get to understand the aims provided by their stakeholders and what drives their investment decision.
This is similar to a VC except the money comes from a large company. The investment decisions tend to consider how the start-up can help the parent company, in addition to a simple return on investment. Corporate Venture can be done in a variety of ways, some companies treat the money at arm’s length, essentially as a Venture Capital company, complete with the typical ten year fund, others treat it as an internal operation with the investment treated as part of the balance sheet. The later does not have the ten year aspect to the fund, so as long as you are supporting the corporate strategic objectives they are unlikely to sell or disinvest in you.
You may hear phrases such as Series A, Series B and Series C. Each round has a specific aim. These are…
Series A: used to develop the product and fund the first customer use, or move it into new markets.
Series B: used to build the company, where most of the money will be going into non-technical elements, such as sales and marketing.
Series C: used to scale up, really pushing the growth boundaries.
This is usually used in the early stage of a company’s growth when it is hard to put a firm valuation on a company. Instead of an investor buying shared today when the value is difficult to define, the investor will lend money to the company with the right to convert that loan into shares at a later date when the valuation of the company is easier to calculate.
Return on Investment
After all the money has been invested and the company is growing, the investors will be looking to be rewarded for the risk they took, by converting their shares back into cash. Possible scenarios are for the company to float on the stock exchange or by selling their shares to another company, or in some circumstances an investment fund, through a trade sale.
Even at an early stage of raising investment, have an idea of what the most likely exit scenario will be for the incoming investor.
For useful sources of information, check out…
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