Initial Steps in Raising Equity for a Business

Many of you might have asked yourself, how do I start a business? How to fund a business? How difficult is it to start a business? Well, to answer that, let’s go through all the initial steps in raising equity for a business. By the end of this article, you’ll know how business evolves and what it takes to fund a business.

Our story begins with you, a passionate entrepreneur with a great business idea – to open a pizzeria with unique dough and delicious flavor that only you know the recipe. You are fully confident that the business will be successful and eager to launch the business.

However, your savings are not enough to fund the business by yourselves. Furthermore, you have a family, kids, a mortgage. And besides, most of your savings are supposed to fund the college for the kids. You can’t risk it. You went to the banks and they wanted a terrifying interest on your loan or maybe they didn’t even agree to give you any loan.

One evening, you share your two best friends with your idea, and they, who know how good your pizzas are and notice the determination and eagerness in you, decide to invest in your vision. So currently, you have yourself and two of your friends who are investing at the pre-revenue stage, which means they took a blind bet on your idea. These investors, who invest in this early stage, are called Angel investors. The money they gave you is not a loan, it is an investment they made in your company.

Totally, you and your friends (the “angels”) were able to raise $200,000. This initial money is called The Seed Fund. This money won’t be sitting in your personal bank account, but instead, it will be sitting in your company’s bank account. When the money hits the company’s bank account, the money will be referred to as the initial share capital of the company.

In this current state, the only asset the company has is its cash, worth $200,000. This means the current value of the company is also $200,000. This is called the company’s valuation. It will change as things start to move, and you’ll buy assets with this cash.

Let’s understand the concept of shares. The idea behind it is quite simple. If the company assumes that each share worth $100, and there is $200,000 as share capital, there must be 2,000 shares ($200,000 of the company/$100 per share). The $100 for share is called Face Value of the share. A very important decision the entrepreneur has to make when he forms a company is the number of shares he would like to offer. These shares are referred to as Authorized Stock. Let us assume you decide on a total of 500,000 authorized shares, but for now, you issue only 2,000 of them to split between you and your two friends.

The current state of shareholding in the Pizzeria:

Name of Share HolderNo. of Shares% Holding
You1,00050%
Angel 150025%
Angel 250025%
Total2,000100%

Now that you have a good company structure and a healthy seed fund, you start your business operations.

 

After two years since you started, your business doing well. People like your pizza, the word has been spread and people come from far to eat at your place. You are no longer a rookie business owner, but a knowledgeable and confident one. Backed by your confidence, you now want to expand your Pizzeria by adding 2 more branches in the near cities. You realize this business expansion will cost you $500,000.

Now you are in a much better position compared to where you were two years ago. Now you have a business that generates revenues. The healthy inflow of revenue indicates about the business and its potential. As you grew during these 2 years, you got to know more people, financials and investors. You contact them, and one of them shows great interest in your business. He agrees to give you these $500,000 for 20% of your company. Usually, these investors, who invest in such early stages of businesses are called Venture Capitalists (VC). The money the business gets at this stage is called Series A funding.

After a little math, we get this current state of shareholding in the Pizzeria:

Name of Share HolderNo. of Shares% Holding
You1,00040%
Angel 150020%
Angel 250020%
Venture Capitalist50020%
Total2,500100%

The math: Now the initial investors (you and your 2 friends) shares were diluted, from 100% of the company to 80%. This means the VC will have the remaining 20%. In order to do that, we should issue more 500 shares, bringing us to a total of 2,500 shares.

You should note something very important by that VC investment. By investing $500,000 for 20% in your business, the VC has valued your business at $2,500,000! This is 12.5 times the initial valuation of $200,000 when you have just started. A good business plan and a healthy revenue stream will make a business prosper.

What about the money you and your friends have invested two years ago?

Name of Share HolderInitial ShareholdingInitial ValuationShareholding after 2 YearsValuation after 2 YearsYield
You50%$100,00040%$1,000,000900%
Angel 125%$50,00020%$500,000900%
Angel 225%$50,00020%$500,000900%
VC20%$500,000

 

5 more years pass, and your company is doing great. Popularity grows, the reviews are positive, the management gets more efficient. Revenues keep growing. You decide to go national. To support this expenditure, you need more money.  This kind of expenditure of a business is called “Capital Expenditure”, or in short – CAPEX.

The management estimates the CAPEX to be $5,000,000. The options to raise this money to fund the CAPEX requirements are:

  1. The company has made some profits over the last few years. A part of the CAPEX requirements can be funded through the profits. This is also called funding through internal accruals.
  2. The company can raise another round of VC funding, by issuing more shares – this will be called Series B funding.
  3. The company can approach a bank and seek a loan. The bank obviously will be happy now to tender this loan, as the company has been doing great. Funding by a loan is called “Debt”.

You decide to take advantage of all three options to raise the funds for the CAPEX. $1,000,000 you fund through internal accruals. $1,000,000 through issuing series B and raise the remaining $3,000,000 through a loan by the bank.

Finance advisors valued the issuing of series B $1,000,000, to worth 10% of your equity. This means they value your company for $10,000,000!

After a little math, we get this current state of shareholding in your company:

Name of Share HolderNo. of Shares% Holding

Value

You1,00036%$3,600,000
Angel 150018%$1,800,000
Angel 250018%$1,800,000
Venture Capitalist A50018%$1,800,000
Venture Capitalist B27810%$1,000,000
Total2,778100%$10,000,000

 

This wealth creation is what happens to entrepreneurs who have great business foundations. Who understands the importance of the right funding, combined with the right management.

Few years pass by and the company still shining. The ambitions to grow still there, and the next stage is to branch out across the country, becoming world- wide. The new CAPEX requirement for this development is estimated at $10,000,000. Let assume the company doesn’t want to raise money through debt because of the interest burden. You decide to go for Series C funding. You can’t approach a typical VC as you did before, because VC funding is usually for “small” funding. Here you must use Private Equity (PE) investors.

PE investors are highly qualified, have an excellent professional background and invest large amounts of money. Their objective is not only to provide the capital but also make sure the company steers in the right way through placing their own people on the company’s board. Assuming they agree to get 20% for their $10,000,000 investing, they are actually valuing your company at $50,000,000.

After a little math, we get this current state of shareholding in your company:

Name of Share HolderNo. of Shares% HoldingValue
You1,00030%$15,000,000
Angel 150014%$7,000,000
Angel 250014%$7,000,000
Venture Capitalist A50014%$7,000,000
Venture Capitalist B2788%$4,000,000
PE Series C55520%$10,000,000
Total3,333100%$50,000,000

 

Usually, PE fund large CAPEX requirements. They do not invest in the early stages of business but prefer to invest in a business which is in operation for a few years and has enough information to analyze.

The company has progressed above expectations. People love it, the revenues are skyrocketing and entrepreneurs all over the world want to open franchises of your Pizzeria. You decide to expand the brand even further, invest in real estate too and compete with “Pizza Hut” and “Dominos” wherever they are in the globe. In order to fund that huge CAPEX requirement, which is estimated at $30,000,000, the company has these options on the table:

  1. Raise Series D from another PE fund.
  2. Fund the CAPEX through internal accruals.
  3. Raise debt from the banks.
  4. Issue a bond (another way of raising a debt).
  5. File for an Initial Public Offer (IPO) by issuing more shares.

Let us assume you decide to fund the CAPEX through internal accruals and through filing for an IPO. When a company files for an IPO, they actually offer their shares to the public. The public then decides to subscribe to the shares if they wish by paying a certain price. Because this is the first time your company is offering its shares, it is called “Initial Public Offer”.

The questions you might ask yourself now are:

  • Why not filing for IPO in the first place, when we were at Series A, B, and C?
  • What would happen to the existing shareholders after the IPO?
  • What does the public want to know before they invest in a company?
  • What happens after the company goes public?
  • Why did the company decide to file for an IPO? What drives companies to go public?

We will answer these questions in the next articles.

# Summary

  • It is important for a business to have a strong foundation.
  • The early investors in a business, in the pre-revenue stage, are called Angel Investors. They take the maximum risk, as much as you, the entrepreneur.
  • The money the angel investors give is called the Seed Fund.
  • The Valuation of a company signifies how much the company is valued at. It is considered by the company’s assets and liabilities.
  • Venture Capitalists don’t take as much risk as Angel investors, although they invest at early stages of a business. The VC is usually somewhere in between an angel and private equity investors.
  • Capital Expenditure, CAPEX, is the money the company spends on business expansion.
  • Series A, B, C, etc. are the funding the company seeks as it evolves.
  • Private Equity, PE firms, invest large sums of money and at a more mature stage of the business, and so have a lower risk compared to VC or angels.
  • Typically, PE firms would like to deploy their own people on the board of the company to ensure the business moves in the right direction.
  • Authorized Stock is the maximum number of shares the company can issue.
  • Initial Public Offer, IPO, is a way of which a company can raise fund from the public.

 

 

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