Equity Financing Alternatives for Small Business: A Review of Best Practices in the United States

6. SME Stages of Growth

6.1 Stage 1: Seed

All businesses start with an idea. The germination of these ideas into a comprehensive vision of a viable company is called the seed stage of a business. During this stage prototypes are built, market opportunities are assessed, ideas are exchanged between trusted friends and family, and the entrepreneur makes a final decision as to whether or not he will dedicate most of his time towards developing the new venture.

Seed stage equity financing primarily comes from the entrepreneur, family, and friends — type I private investors. This type of financing is often called "love money", as it is seldom invested based of the idea itself but due to the relationship the investor has with the entrepreneur. During the seed stage the majority of expenses will be incurred developing prototypes and conducting market research. However, there are many situations in which seed stage financing requirements are well beyond the means of an entrepreneur and his local network. In these situations the most likely option for equity investment comes from angels and type II private investors, which include past business acquaintances, friends of friends, and others. While both type II private investors and angels will likely be wealthy individuals or business owners with the means to invest in the new venture, angels are different in that they actively seek equity investment opportunities. In fact, with the widespread use of information technology angels are becoming more like Venture Capital firms. The advent of online screening functions, angel networks and the proactive search for high quality investments are three key factors that separate angels from type II private investors. These differences will be discussed further in section 7. Regardless of the type of investor targeted, at this point the entrepreneur will need to have some form of a business plan prepared along with financial projections for the business. Investors outside of the immediate circle of family and friends will require information regarding market size, trends, details of the technology, identification of customers, etc. Most angels will require a comprehensive business plan and executive summary. In addition to a written plan, the entrepreneur will have to possess excellent verbal skills in order to communicate his vision to potential investors.

6.2 Stage 2: Start-up

Once the initial research, idea formulation, and prototypes have been completed then it is time to start the business. During this stage the entrepreneur's vision will become a functioning organization. The entrepreneur will have to find a home for the business, hire employees (and possibly additional management), order inventories, secure suppliers, commence marketing efforts and so on.

For most entrepreneurs, securing equity financing during this stage is still quite difficult. The company does not yet have a base of customers and has not yet earned a profit. It is a very risky time for a new venture. Similar to the seed stage of growth, angels and private investors will be targets for investment funds. However, another group of investors, venture capitalists, can now be considered. It will now be more important than ever to have a well developed business plan. In addition, the entrepreneur will likely need the services of an experienced lawyer and an accountant, especially when attempting to the value the company in order to acquire equity financing.

6.3 Stage 3: First Expansion

In this model the first expansion occurs due to the company's rapid growth. The entrepreneur needs additional working capital and/or capital investment to address growing sales of the company. Additional employees are hired, the production process is enlarged and new markets beyond the local setting are targeted. Average investments range from 3 to 5 million. If the entrepreneur can prove positive earnings and an established customer base, the chances for private, angel and venture capital equity investment will be increased dramatically.

6.4 Stage 4: Second Expansion

Second expansion usually involves a company growing at an extremely rapid pace with a robust technology and a rapidly growing potential market. Although not always the case, the entrepreneur may envision transforming the business from a small concern to a large corporation. Additional funds are required to develop new products and/or enter new international markets. Again, production facilities, marketing budgets and other areas of the business may need to be enlarged in order to address the firm's high growth potential, Second expansion investments range from 5 to 20 million. With a successful history and high potential for the future, equity financing options will begin to increase. Banks and corporate investors will also become targets for additional funds.

6.5 Stage 5: Initial Public Offering

A successful SME (although it may no longer be an SME) can finance its growth by acquiring funds from the public through an IPO. However, many companies never reach this stage of growth by choice. The numerous regulations and procedures that must be followed are not appealing to many entrepreneurs. Although business owners will have an opportunity to cash out some of their equity in the secondary markets, they must also be ready to give up some control of the business. Periodic reports of business activities have to be supplied to shareholders, which may affect any perceived competitive advantage associated with the company's private information. Also, other activities such as sales of stock by executives must be reported to a securities exchange commission. The size of the investment may range from 5 million to well over 100 million.

In the United States there are alternatives to "going IPO" in regards to attracting equity investments from the public. Small businesses can access public capital by selling state-registered securities to the general public. This process is called a Direct Public Offering (DPO). DPO's will be discussed in detail in further sections of this report.

Acquisition
In many cases successful SMEs in high growth industries are acquired by larger organizations. While this provides growth capital and an exit strategy for an entrepreneur, in most circumstances the company will cease to be an SME.