Choosing a Type of Equity Financing: A Cash Course

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.”

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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.

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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.

Only one or two angels at a time typically invest in a company. They may own more than half of your firm but won’t help run it day-to-day, although they may serve as advisors on your board. They also bring know-how and contacts along with the capital. Because of their reputations, their participation usually lends an aura of success to the company, Cowen says, which can open doors and create more opportunities for financing.

* Warrants: An ownership option often attached to loans, these are sometimes used by financial institutions or angels seeking to earn more than simple interest. Those issuing them don’t help run the company, take less than 50% ownership and wait for a greater return upon acquisition or a public offering.

Basically, the lender receives an option to buy shares of the company (common or preferred stock) at a certain price. You, as the business owner, pay back your loan plus interest, and if your company prospers, you could end up selling a part of your company to the lender as well.

Warrants can also be part of a licensing deal. A small company can receive the right to distribute products from a larger company in return for the larger company receiving the right to own stock in the smaller company.

* Private Placements: These occur when a company privately sells stocks, bonds or other securities directly to an institutional investor, such as an insurance company. Such deals, which can be debt or equity, are not registered with the Securities and Exchange Commission or publicly traded on Wall Street. The securities in a private placement are usually illiquid, meaning they don’t trade, and investors usually agree to hold the securities for a certain period.

* Direct Public Offerings: This method of financing is technically a public offering, but fewer documents must be prepared. However, limitations exist on the number of individuals who can become owners--35 under certain federal regulations--and only qualified investors, with specific net assets and income, can participate.

Although investors don’t run the company, a board of directors makes management decisions. If you hold majority ownership, you may still run the company. Otherwise, decisions are made by the board and whoever it designates as the operating manager.

The SEC has several categories of small-stock offerings that are exempt from normal registration requirements, including a Small Corporate Offering Registration, wherein a company can register with the state to raise up to $1 million. Other federal programs with differing requirements allow up to $5 million or an unlimited sum to be raised.

* Venture Capital: Venture capitalists raise large pools of money to invest in early-stage, fast-growing companies. They invest money for institutions, pension funds or wealthy individuals.

Venture capitalists focus on high-risk, high-return deals--25% to 40% compounded annual returns--in companies that can return the investment in five to seven years.

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Venture capitalists can be “active,” meaning they will want to take an active role in your company, sitting on the board or handpicking a new CEO, or “passive,” meaning they won’t tell you what to do. They often bring financial sophistication to a company, and industry expertise if they specialize in a certain area.

* Initial Public Offering: Companies seeking cash for expansion or to develop a new product are candidates to issue an IPO, a first-time offering of stock to public investors. For many companies, this is the first time a value is placed on the entire company, and it allows the original investors to get their money back.

Going public can mean significant changes. “Information that was kept secret is now public,” Esparza says. Registration with the SEC is required, along with detailed annual reports. Entrepreneurs must learn to speak the language of Wall Street and meet the demands of analysts and investors.

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Investors are paid back with returns (dividends) on their shares as the company prospers. But earlier investors, such as angels or venture capitalists, may have to wait a year or longer before they sell their shares and make their money back. Federal regulations preclude them from selling for at least a year after a company goes public.

All of these financing methods, as well as debt financing, have varying entrance requirements, deal structures and returns. Small-business owners generally use more than one of these financing mechanisms, in no set order. They may also use other vehicles as growth occurs.

Knowledge of your financing options, as well as ways to tighten your company’s finances and operations, will strengthen your business by giving you more resources, Esparza says. And that’s crucial to survival, success and growth.

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Entrepreneurship 101

Chapter 4: HOW TO FINANCE YOUR BUSINESS

- How the Money Works in Your Business

- Taking On Debt: Small Loans

- Taking On debt: Big Loans

- Taking On Debt: Non-Loan Sources

- Giving Up Equity

The Bottom Line

“Entrepreneurship 101” is a tutorial on how to choose, start, finance, plan and grow a business. The program, written by Times staff writer Vicki Torres, was developed by Debra Esparza, a faculty member at the Entrepreneur Program of the Marshall School of Business, USC. Esparza also heads the USC’s Business Expansion Network, a community and economic development that has counseled more than 5,000 small business owners in the Los Angeles area over the last six years. BEN provides help with financing, business planning, accounting, marketing and other aspects. The tutorial also can be found on The Times’ small-business Web site at https://www.latimes.com/smallbiz.