(The following is the second of three articles on supporting local entrepreneurial activity.)
Entrepreneurs require different types of financing. The return investors receive varies based on the risk the investor assumes.
Collateralization and guarantees are, for the most part, synonymous with lending, and banks, insurance companies and other financial institution customarily provide this funding. The owner, usually, does not give up any ownership interest to obtain this loan. Repayment of loans takes priority over equity distributions. Debt is an expense of the company. It is usually paid after operating expenses. Debt is traditionally repaid incrementally and regularly over a predetermined period of time. It is secured by the pledge of assets of the company, other assets apart from the company, and more often than not guarantees provided by the owner and possibly, other equity investors.
Community lenders such as Community Development Financial Institutions (CDFIs) offer more flexible terms when structuring loans to small and growing businesses. Often CDFI investments incorporate Royalty payments. Royalty payments are often the trade-off for more flexible or advantageous loan terms. Royalties provide the investor a share of the business profits. This is paid in addition to the interest charge on the loan.
Equity financing exposes the investor to the most risk. This form of financing involves a sharing of ownership interest. It is the most flexible form of financing for the business owner.
The investor’s return is realized after the company pays all expenses and debt obligations and comes through dividend distributions and/or from the increased value of the investor’s ownership interest, when that ownership share is sold. In the event the business is liquidated, the investor receives a proportionate share in the liquidated value of the remaining assets once superior obligations are satisfied.
Seed funders, angel investors and venture investors are essentially all equity investors. Each may choose to get involved at various stages of a businesses’ growth. Some choose not to invest in businesses until they achieve a size defined by sales or capitalization. Theses investors are looking to the business concept to create value and the entrepreneur’s ability to execute on that business concept.
Seed funding is the earliest form of equity financing and is the initial investment that helps the business get started. Usually this is the entrepreneur’s own funds, amounts received from ‘friends and family’ and/ or it may be ‘sweat equity’. This term refers to the non-monetary investment the owners contribute to the business venture. Knowing that the entrepreneur is fully committed and has made an investment in the business is important to subsequent investors. All new and growing businesses confront challenges. The owner’s investment is, therefore, a tangible evidence of commitment to the initiative. It keeps the owner at risk and offers assurance that every effort will be made to push through the difficult periods that invariably lie ahead.
Venture investors are attracted by the opportunity to receive outsized returns from a successful business venture. The investor trades the risk associated with investing in the early stage of a business’s growth for the upside return potential from that investment. This almost by definition limits the universe of businesses that are likely to be offered this type of financing. The most likely beneficiaries are business having significant growth potential within a relatively short period of time.
The strength of the business and its marketing plan is of critical importance to the equity investor. Equity investors place considerable emphasis on the market and competition analysis presented in the business plan along with the projected revenues and spending, marketing strategy and a discussion of the management’s team’s ability to execute the business plan.
That business plan is similarly of interest to a loan provider; however, collateral and guarantees reduce the criticality of as an in-depth understanding of all aspects of the business venture as is required by the equity investor.
A business plan that is satisfactory to a loan investor may well fall short of providing sufficient information for a potential equity investor.