The Pros and Cons of Using Equity Capital

WHAT ARE THE PROS AND CONS OF USING EQUITY CAPITAL?

Before you think about expanding your business, be sure to think about the pros and cons of using equity capital. In that exercise, you must first personally consider and resolve some ethical and very practical issues about the future management of your business before you take the plunge. Resolving the issues that a review of the pros and cons of using equity capital raises can be cathartic and therapeutic.

Here’s just one for you to consider:

Will the loss of 100% control and autonomy to make major decisions affecting your business be offset enough by the fact that equity partners may give you access to a wide-ranging business network that can open doors to commercial opportunities that hitherto were denied or unknown to you?

I didn’t say that these issues would be easy to resolve, they aren’t. The issues raise provocative dilemmas for business owners thinking about raising equity capital. But it is imperative that you come to terms with these issues before you initiate an equity raising program. Once you take the equity capital offered, there is no ‘back button’ to click to reverse the situation. You are stuck in the new situation forever!

Warning: There is a considerable amount of information here concerning the pros and cons of using equity capital to expand your business. I understand how important this information is to you when making up your mind as to who can best help you with the expansion of your business. Consequently, as the guide covers a lot of ground, expect a long read.

The dreams of business expansion

Love the dream? Live the dream! Doesn’t the words ‘equity capital’ invoke fantasies of your business expanding beyond your wildest dreams? Continue the fantasy. Picture yourself three years from now. Where do you think your business will be? Does that picture line up with where you want your business to be in three years time? Are you absolutely, positively sure that your company, as it is operating today and will continue to operate tomorrow, is going to continue to grow at a level that you desire and give you and your family the lifestyle they deserve? Of course, if you are imagining a dramatic increase in your businesses’ profitability, you have to realise that your normal growth over the recent past will probably not be enough for your business to align with your dreams.

Necessity for exponential growth

Exponential growth: the only way to go. The only way that your business can align with your dreams is through exponential growth. Exponential growth is impossible without equity capital. So, to achieve the exponential growth that will move your business from the reality of today to the success of tomorrow that you have imagined, I completely understand why you may be now thinking: ‘Wouldn’t it be wonderful if Graham could help me to raise a million dollars or two in equity capital so I can expand into new markets with new products or services (and at the same time, steal a march on my competitors)?’

Equity raising: the process is complex, time consuming with no guarantees of success

A note of caution 1. Although I would love be involved in bringing such a dream into reality, and secretly hope that it comes to pass, I must stress a serious note of caution to you. You will thank me for it later. The raising and use of equity capital is not an easy task. The process is complex and time-consuming. And there are no guarantees that just because you have an attractive business proposition, that investors will flock to get on board with you. Raising equity capital is simply not like that. So you have to think long and hard about taking the decision to expand your business through the use of equity capital.

A note of caution 2. Before taking the decision to expand your business through the use of equity capital, you must carefully evaluate the relative advantages and disadvantages of using equity capital. This is very important because to follow a course of action based on raising equity capital has many implications for you personally, as well as your business. These implications concern issues that are fundamental to your business future. In this webpage, I will help you work through the issues surrounding the pros and cons of using equity capital to expand your business, so that you will have a much clearer picture as to whether or not you should follow the equity capital path to grow your business.

There’s no reverse gear here. The issue that must be kept in the back of your mind is that once you commit to equity raising and you gain some shareholders and directors, it will be late to say that you don’t like the outcome. There is no going back to the status quo of today.

Equity Capital: the disadvantages

  • Business owners entering into investment (shareholder) agreements with equity partners have to accept that there will be a loss of 100% control and autonomy to make major decisions without any external party input.
  • Commercial secrets are shared with equity partners.
  • Equity partners will expect that the business’s finances will be under constant review, and may want or expect to be involved in day-to-day operations.
  • In some cases, there may be pressure applied by an equity partner to place a stronger emphasis on achieving a high rate of return on their investment, and this may create management conflict if the equity partner’s wishes result in the business departing from the level of expansion set out in the strategic business plan. This issue needs careful discussion with prospective equity partners before an investment (shareholders) agreement is finally settled.
  • Business owners must work within a context where the equity partner can be expected to withdraw from the investment (shareholder) agreement in 3 to 5 years, and take out of the business what the equity partner will call the ‘investment harvest’ (i.e. the equity partner’s profit from the investment). The business must incorporate this objective into its strategic business plan. This circumstance raises a number of important issues. At this time, the investor may sell the shares back to the owner, if the owner has planned for this event, or to a new third party investor.
  • Business owners and equity partners (and where necessary, equity partners’ representatives) must ensure that they have a measure of ‘rapport’ and compatibility. Personality conflicts arising after the settlement of an investment (shareholder) agreement will generally be destructive, if not fatal, to the business.
  • There are often additional costs incurred in the process of taking on an equity partner, such as due diligence costs. This is quite normal.
  • The higher level of financial and management control and the associated reporting requirements resulting from an investment (shareholder) agreement with one or more  equity partners will generally mean the introduction of more sophisticated financial and management reporting systems. Again, this is normal.

Equity Capital: the advantages

  • Equity capital does not require repayment and does not attract interest payments.
  • Equity capital provides an opportunity to fund growth outside the boundaries of your company’s pre-existing available funds, which are usually limited to funds your company has in the bank and funds your company can borrow.
  • Equity capital will usually enable your company to grow at a much higher rate than would otherwise be possible.
  • Equity funding can reduce the exposure of your company to financial risks such as interest rate movements and raw material/inventory price movements.
  • Equity funding will generally improve the sustainable competitive advantage of your company.
  • Equity partners can beneficially provide an independent source of strategic inputs into the direction and management of your company.
  • Equity partners can provide valuable access to a wide-ranging business network that can have a positive influence on business contacts and open doors to commercial opportunities.
  • The higher level of financial and management control and reporting requirements associated with an investment agreement with equity partners will provide more timely and useful information to support management decisions and identify greater efficiencies.
  • The injection of equity capital may help to position your company so as to increase the barriers to entry or market expansion by competitors.
  • The appointment of high profile external directors (who may be the equity partner or an equity partner’s representative) will generally provide added strategic value and market profile, which may lead to new business opportunities and/or strategic alliances.
  • Business enterprises with equity partners have a higher level of business credibility and are therefore more highly rated by bankers, thus providing the business enterprise with the opportunity to negotiate better rates and greater access to loan funds or bank overdrafts, if loan funds or bank overdrafts are required for short-term business development reasons at some time in the future.
  • Equity funding leads to a more stable financial structure of the company, which in turn leads to improved credit worthiness and the ability to search for and accept additional growth opportunities.
  • The improved financial standing and increased liquidity that generally arises from the intervention of one or more equity partners provides opportunities for the business enterprise to take advantage of credit terms that may provide payment discounts that improve gross margins.

Equity Capital and You

Tread carefully! As you can see from the two lists above, there are many far-reaching issues that you will have to consider before you commit yourself to a course of action involving raising equity capital. Each point in both lists raises an issue that you must think about carefully.

If your eventual conclusion however is to come down on the side of raising equity capital, then that is the point at which we will have to have a very serious discussion. At that point, you must call me on 61 (0) 404 702 644.

Yours sincerely,

Graham  Segal

Chiron! the business doctor.™ ... relieves business pain!™ 

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© Graham Segal, Author. March 2013. All Rights Reserved

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This website and the associated webpages content are produced by Graham Segal trading as Chiron! the business doctor.™. They are licensed under a Creative Commons Attribution-NonCommercial-NoDerivs 3.0 Unported License based on Graham's work at http://chironthebusinessdoctor.com.

Date this webpage last reviewed/updated: 5 May 2013

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