There are various ways in which entrepreneurs can raise money for business, to start up or for expansion, the most obvious and widely used channels being – own or family funds followed by bank loans.
But if you have an absolutely brilliant business or business plan, one which is most likely to generate a high return on equity for its owners, then there is a third option available to you. This option is to invite others to become part owner in your business in return for their capital. Naturally, for an investor this is far more risky than it would be for a financial institution giving out a loan. This is because what an investor gets in return for his capital is equity – part ownership in the business. That’s all. No security, no collateral, unlike the financial institution.
A lot of young and old companies want to take the equity way to raise money for business. Before I get to how this is done, I think it is important to point out 2 things:
- Unless you have a profitable or potentially profitable venture and a pressing need for capital; it is not advisable to raise equity from third parties, you will become bound by a lot more regulation, more people will start having a say in your business and you will be diluting your own share in a profitable venture.
- Often, I meet business owners who want to raise money from other investors because they are not sure of their business plans. Their approach is anything but noble – “Let’s try this out with somebody else’s capital”. If this is what you have on your mind, you will be wasting a few precious year’s of your life and invariable regret this decision later. If you think you are a great at marketing and you will talk investors into buying your plan, then maybe you should get a job in marketing.
At what stage should you raise money for business?
To go back to what I had said earlier, look for more money when either one of the below 2 statements are true:
a) You have an innovative idea or a unique business plan, but you lack capital to fund it.
b) Your business is growing and will continue to generate a rate of high return. You need capital to expand your business so that the overall revenue and profitability increases. To give you an example of such a situation – you make glass bottles from 2 factories with a total installed capacity of 800,000 bottles a month. All of them get consumed and you still have buy orders for 900,000 more bottles but no supply to sell more bottles. You want to set up 4 new factories to expand. Setting new factories will take tremendous amount of capital. This is an ideal time to divest part of your business to expand and have 6 factories.
Public vs. Private Equity
In general terms, in the above (a) scenario, you are more likely to raise private equity while in scenario (b), you could hope to raise public money via an IPO. Besides regulatory issues, the big reason for this is that it is easier to convince a big investor (i.e. private equity firm) that your unique or innovative business idea will do well than convincing the same to the wider public. Further, you will of course like to guard your unique idea than to disclose it in an offer document and announce it to the world.
Private equity is sale of a part of your business to an identifiable group of private investors.
On the other hand, public equity is raised by way of an Initial Public Offering (IPO) where shares of your business will be sold to the wider public. The shares, each representing a fractional ownership in your business become tradable and are listed on a regulated exchange. Every day the owners in the business will change as the shares are bought and sold.
You are more likely to raise private equity for well established businesses (like in scenario (b) above) but almost never will you be able to do an IPO, based purely on a unique or innovative idea with no prior business history.
Again, both avenues pose certain challenges. The biggest one in case of private equity being – ‘valuation’. How do you value an idea? On the other hand, for public listing, the regulatory requirements are fairly elaborate which you can briefly read about below.
How does Private Equity Funding Work
- You sell a certain percentage of your business (i.e. a minority or a majority stake) in return of capital. Let’s say you get 10 Cr. for 60% of equity in your business.
- You enter into an agreement whereby you agree / expect to generate a certain percentage of return on the invested amount of 10 Cr within a given period of time. In the above scenario, you expect to generate a 20% annualized return on the invested amount of Rs. 10 Cr, for 10 years.
Note: The Internal Rate of Return or the IRR as it is commonly referred to in private equity transactions could be calculated in many different ways. For example Rs 10 Cr, generating 20% annually for a period of 10 years will return a sum of Rs. 61 Cr at the end of the 10th year, based on yearly compounding). The commitment under the agreement may require this amount at the end of year 10, instead of periodic payments or at certain intervals.
- 3. What falls on the IRR? Put simply, as and when you generate the IRR, you may get your equity / shareholding in the business, back from the private equity firm. How this exactly works again depends on the deal structure.
A theoretical definition of Internal rate of return (IRR) – The rate at which the net present value of all future cash flows equal zero. Follow the link to understand present value of future cash flows.
In short – Once you make the agreed IRR for the investor, you will get back your stake in the business.
Many enterprising businessmen of our country look at private equity as a way to sell stake in their business in return for capital. Pocketing the capital and then abandoning the business. This is not a god thing. Remember that most private equity firms will conduct a thorough due diligence of your business before buying out any stake from you. Not only will you fail, you will also ruin whatever standing you have in the market and the possibility of accessing capital markets ever again in future.
How Does Public Listing Work
Raising money in an IPO is a lot more cumbersome project and tedious from a regulatory standpoint. It can take up to 3-4 months at minimum, to raise money this way. Further, someone desirous of getting his business listed will have to appoint a merchant banker, a team of lawyers and auditors and enter into agreements with stock exchanges for ongoing compliances and with share registrars and depositories for de-materialization of shares.
Other eligibility requirements for raising funds via an IPO:
- The business must have a history – assets of at least Rs. 3 Cr in each of the preceding three financial years.
- Net worth of at least 1 Cr in each of the preceding three financial years.
- Must have generated an operating profit of 15 Cr in 3 out of the preceding 5 years.
- Must have at least 1000 prospective allottees.
- File detailed offer document mentioning basic business model, objects of the issue, risks involved with the business etc with the stock exchanges and with SEBI for approval.
- Find large institutional investors willing to buy a large portion of the offering – called anchor investors.
- For the issue to be successful, 90% of the total amount of money proposed to be raised must be raised at the close of the book building process.
These days even smaller businesses can raise money via IPO. The BSE Small & Medium Exchange (SME) enables a company to raise capital via an IPO if it has a maximum post-issue paid up capital of up to Rs. 25 Cr.
There are many different ways not only of structuring the deal but also of raising money for your business in the first place. For example, often private equity funding agreements have a clause giving the PE investor an option to exit by selling his stake on a stock exchange after a certain point of time, or at the happening of an event. The company is then listed and such investor sells his stake to public in an IPO.
If you have any queries about the content above, or if you would like to discuss your business plan or money raising options available to you, please write in to me at – firstname.lastname@example.org or call for an informal chat.
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