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

7. Equity Financing Agents

7.1 Private Investors

Type I
The first type of private investment comes from friends and family and is often referred to as "love money". The decision to invest does not usually consider the technology or business idea itself, but the investor's prior relationship with the entrepreneur. It must be assumed that in order to provide funding, the type I investor must first have sufficient financial means to do so. Also, the primary reasons for investing usually do not include such considerations as tax incentives. In many cases the investor simply wants the entrepreneur to succeed while the possibility of high returns is a secondary concern.

Type II
There are two key differences between type I and type II private investors. First, type II investors do not usually do not have a close personal relationship with the entrepreneur. The entrepreneur is usually introduced to these individuals through business transactions and networking, or the private investor may have an interest in the SMEs industry. Second, type II investors are more stringent in their investigation of the opportunity and will have much higher expectations of returns. In most cases formal documentation and periodic reporting will be required. Type II private investors are also often confused with angel investors. While there are indeed some similarities — both are wealthy individuals – the primary difference is that type II investors do not proactively seek to invest in small businesses; however, they are targeted by entrepreneurs due to their financial capabilities and/or credibility in the industry. In addition, angels have differentiated themselves further from type II investors through their increased usage of information technology. With the use of online screening and matching services found in most angel networks, angels are now functioning more like venture capital firms. They now have a larger pool of opportunities to select from and have formalized much of the selection process by requiring entrepreneurs to submit online applications and business plans.^{Footnote 5}

7.2 Angels

As stated previously, angels are individuals or small groups of professionals or business people with an active interest in investing in and assisting new ventures. Most often they focus on local companies. These investors are more formal than the type I private investor, and provide more value than the type II private investor. Angels often provide guidance and contacts for the entrepreneur with such groups as banks, suppliers, industry associations and others. The credibility that a reputable angel can provide to a small struggling business often allows the SME to possess a competitive edge during the vulnerable start-up stage of development. Angels will often look for high returns and an exit strategy for their investments. Similar to formal venture capital, they often tie investments to the achievement of milestones and objectives. The key to garnering angel equity investments will be a well developed business plan, exceptional management, a high growth business idea, and an exit strategy for the angel's investment.

All of these types of private investors (type I, type II, and angels) are more readily found in the United States due a business culture that rewards entrepreneurial activity and various government sponsored incentive programs. However, these investors can also be found in Canada. Type I and type II private investors have always been a primary function in equity finance for SME in Canada. Also, small angel networks have begun to form in some parts of the country increasing the prominence of angels in this country. It should be noted that a critical mass of angel networks has not yet been established in this country and entrepreneurs often find it difficult to locate angel investors.

7.3 Venture Capital

Venture capital firms (VCs) allocate funds from private and institutional investors in order to invest in companies that possess high growth potential. VCs typically invest for short terms of three to seven years and expect pre-tax returns from 20 to 40 percent per annum. Unlike angels, VCs primarily invest in existing companies with the expectation of moving the company towards IPO or acquisition — the exit strategies of choice. However, some VCs will invest in start-ups in special circumstances, such as a business with patented technology and a high growth market, or a very experienced management team that is breaking out on its own. VCs very rarely provide investment during the seed stage of a company.

VCs research potential investments more vigorously than other investors and often specialize in a particular segment or industry. During the past few years, venture capital funds have been flowing primarily towards high technology companies. In the second quarter of 1999 sixty percent of all US venture capital went to two high technology sectors: communication and software, with the majority flowing to Internet related companies. Other areas that received venture capital were: consumer retail (13%), bio/medical (10%), business services (9%), semiconductors (4%), computers/peripherals (3%), and other (1%). During the second quarter of 1999 venture capitalists invested $7.6 billion; almost 40% of which was invested in the high technology sector of Silicon Valley^{Footnote 6}. Due to the high expenses of venture capital firms, they usually have a minimum investment in order to justify their due diligence costs. Due to the formal structure of the venture capital operation and the more stringent evaluation process, complete business plans and presentations are compulsory. Also, an existing customer base and a minimum number of years with positive earnings will also be closely considered.

The cost of financing through venture capital firms is usually quite high. Often 30 to 50 percent ownership of the company is the price paid for venture capital funds. Although the VC will not typically get involved in the daily management of the company, it will usually occupy a seat on the board of directors once a deal has been closed. The investment itself can take on many different forms. Primarily it is a straight equity investment; however, it can also involve convertible debt or debt with warranties. Similar to the angel investor, a properly chosen VC firm will also provide additional value in the form of consulting and networking.

7.4 Banks

Banks in the United States offer a variety of equity financing options; however, straight equity investments in seed or start-up companies are very rare. At this stage of growth banks primarily provide fee for service consulting to locate potential equity investors. Once a company has experienced successful growth and is deemed ready to move towards the IPO stage, then banks become more involved in equity financing activities.

7.5 Corporate Investors

Corporate investors include large existing businesses with proven track records. Corporate investors will often finance a successful partner, customer or supplier if the risk-return ratios match corporate policies. For more risky ventures, such as start-ups, many corporations have developed incubation facilities. New innovations within the company, often called intraprenership, are often spun-off into new businesses through such programs.

7.6 Institutional Investors

Institutional investors, such as mutual and pension funds, primarily invest in SMEs by providing funds to venture capital firms. Start-ups and seed companies will rarely receive funds directly from the institutional investor; however some have set up large funds with the purpose of investing in small business. In most cases these funds are set up similar to venture capital firms.

7.7 The Public

The public is the largest potential pool of capital for small business. Due to securities exchange regulations, the public most often can only invest in publicly traded companies registered with the Securities Exchange Commission (SEC). The investment is realized during the public offering. However, the public also indirectly invests in SMEs through mutual and pension funds. In the US there are exemptions to the Securities Act that allow small companies to solicit equity investments from the public without fully registering with the SEC. There are restrictions on the amount of the total investment and in some cases the type of investor that is eligible.