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Private Equity Financing And Its Kinds

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Introduction

Entrepreneurs across the world come up with new business ideas on a daily basis. However, the operationalization of these ideas presents a big challenge to the entrepreneurs due to the problem of obtaining funding. Most of the financing firms usually shy away from new ideas due to a high level of uncertainty and lack of past evidence on the potential of these ideas from the market data (Association of Chartered Certified Accountants (Great Britain), 2014). Seed financing which involves a pool of funds from the business owners, family and friends is the most common source of funds for businesses during the early stages of operations (Cinnamon, Helweg-Larsen, & Cinnamon, 2010). Nevertheless, business angels and venture capitalists have become increasingly involved with the operationalization of new business ideas. To the investor, business angels and venture capitalists as a source of finance comes with varied benefits, costs and risks (Γkeka, 2010). This paper therefore evaluates various sources of capital for a new business in order to aid the investor in deciding between venture capital and business angels as the main source of finance for the business.

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Discussion

Importance of financial liquidity for a new start up

Basically, financial liquidity refers to the ease with which a company or firm can convert its assets into cash (Banks, 2005). Despite the quantity of the business that the company or an individual may own, it will be in trouble if these assets cannot be converted into cash so as to meet day to day operational obligations. For instance, Banks (2005) highlighted that the company will not be in a position to honor credit obligations and will also affect its capacity to replenish its stocks. Moreover, the financial liquidity of a firm aids an investor in making the decision on the types of stocks to buy or to invest in the business idea. In this regard, companies can use various forms of liquidity ratios to gauge its capability to honor debt settlements and also decide the viable source of capital for the business (Association of Chartered Certified Accountants (Great Britain), 2014). Financial liquidity is, therefore, a reliable determinant of the company’s health and level of financial stability.

The level of financial liquidity of the company is also very important in analyzing the performance of the company. Depending on the type of business and the industry, high level of financial liquidity may also impact negatively on other business performance measures such as return on capital employed and return on equity (Banks, 2005; Maverick, 2015). These other two measures show the financial performance of the company in terms of efficiency and profitability. In such a case, high level of financial liquidity may show that the company is not operating at the optimum level. In financial management, the company must, therefore, determine the level of liquid assets to maintain given the type of business. Banks (2005) outlined that the company should, therefore, have liquid assets or cash due to the uncertainty about the expenditures, to help in negotiating better terms for goods and services and to be able to take advantage of the opportunities presented by the market.

Private equity supply chain

Private is sometimes referred to as private capital and the term is used to describe funds which are used to finance long-term investment decisions (Morris, McKay & Oates, 2009). According to Morris, McKay and Oates (2009), private equity is also used to refer to funds available to private firms which are not listed on the stock exchange i.e. equity securities and debt. The market for private equity can be divided into three categories of a private equity firm, venture capital firm and business angels. However, the operations of these fund providers differ as well as the timing of their involvement with the business (Morris, McKay & Oates, 2009). For instance, venture capital and business angels invest directly into the idea while private equity firms may wish to get a controlling stake in the new company so as they may be able to influence the investment decisions at the company. On the other hand venture, capitalists prefer growth capital investments while business angels can invest in an idea at the early stage.

According to Fuentes and Dresdner (2013), private equity market differs slightly from the hedge funds market in that the target of private equity market include the young, growing and emerging companies while hedge funds are mainly involved in the equity market for established firms. Furthermore, hedge funds focus mainly on short and medium term liquid securities while the private equity firms lay emphasis on long-term strategies of private companies while at the same time influencing how these companies operate (Fuentes & Dresdner, 2013). Private equity firms avail funds to private companies through complete takeovers, proving growth capital to existing firms or providing funds to start-ups without bargaining for a controlling stake. Lastly, these private equity firms are also interested in asset management of the company as opposed to hedge funds which focus on risk management.

Seed financing

According to Caselli (2010), seed financing can be simply defined as the initial capital used to starting a business. During the idea or conceptual stages, the amount of money needed is usually small thus the company founders can use their personal savings, friends and family contributions at this stage of business development. Some books and articles, therefore, define seed funding as the earliest round of capital for a new firm (Caselli, 2010; Gallo & Kenyon-Rouvinez, 2005). At this stage of business development, banks and venture capitalists usually shy away from these ideas due to the high risks involved.

Early stage financing/business angels rounds

Early stage funding for a start-up business can be described as the round where the business is poised to start receiving substantial financing. This stage is commonly divided into two phases of series A and series B financing (Jansen, 2015). The aim of early stage financing is, therefore, to ensure that the company can effectively operate in a way that it can meet its medium term and long term goals. The financiers at this stage are mainly angel investors, venture capitalists, and private equity funds. Private equity funds refer to a pool of funds from different investors who target high growth companies while business angels are usually wealthy investors who prefer to put their money on startup companies (Zhang & Cueto, 2015). Lastly, venture capitalists can help the company to grow faster by bringing experience and industry contacts.

Later-stage financing/ alphabet rounds

Some experts noted that Series A and B rounds of financing may be sufficient to ensure that the company is financially stable and can operate its own cash flow. However, in most cases series C rounds (later stage financing) may be required to enhance the company’s financial strength and ensure it operate effectively. According to Nanka-Bruce (2010), venture capital is usually associated with this round of financing. At this stage, venture capitalists can be sure that the company will earn returns on their investments. Alphabet rounds of financing can therefore be defined as the stage in the business development where investors and venture capital are willing to fund those businesses with little operational histories. Here, investors and venture capitalists are usually expecting larger future gains from their investments (Aisner, 2000). These investors usually commit funds to these relatively new companies to aid in expansion activities or to replenish the declining seed capital. In some cases, a venture capital invests for a short period of time on a business hoping to cash out to a private equity firm or through an initial public offering.

Venture capital market

Venture capital market is a subdivision of the private equity market and the firms and individual financiers in this market usually target young firms or businesses. These funds are mainly for early stage development of businesses or for the expansion of the business. According to Sharma (2013), venture capitalists usually finance these less mature businesses based on the belief that they will be able to generate stable revenue streams in the future. This market is characterized by two types of financiers i.e. angel investors and venture capital firms. Usually, small businesses do not attract investments from large venture capital firms. In this case, wealthy individuals popularly known as angels usually get involved in bridging this gap left by private equity firms and venture capitalists.

Venture capital firms

Venture capital firms are the main component of the venture capital market. These firms are usually involved in the financing of startups and new businesses with high potential for growth and returns. Venture capital firms are also a target of investors seeking funds to finance their expansion activities, buyouts or product development (Sarimah & Abd, 2008). Unlike other sources of early-stage business financing, venture capital firms usually focus on firms with huge capital requirements in some cases above £250,000. Though they may not be involved in the day to day operations of the new company, venture capital firms usually avail advice or expertise to assist the company in management or take part control of the startup company (Sharma, 2013). Venture capital funders also come with a well-defined strategy for an exit that will ensure that they benefit from their investments.

Venture capital firms invest in a company in three forms i.e. equity, participating debentures and conditional loans. Equity financing means that the firm gains a controlling stake in the company by purchasing a portion of the shares. Equity financing also allows venture capital firm to participate in the management and decision-making within the firm. Participating debentures refer to long term loans which generate a constant annual rate of interest until maturity. Upon the maturity of the debenture or loan, the company is under obligation to pay back the entire principal back to the venture capital firm. Rich (2014) noted that venture capital firm can also offer financing to the start-up firm in the form of a conditional loan that attracts a certain amount of interest. This loan must be paid within the realms of the terms agreed between the venture capitalist and the startup company. However, participatory debentures and conditioned loans do not offer controlling stake to the venture capital.

Some of the most common features of venture capital investments include a high level of uncertainty, low financial liquidity, long term investments and equity participation and capital gains. Subsequently, financing expansion projects and funding new acquisitions are the main areas which attract the participation of venture capitalists. Piros and Pinto (2013) outlined that start up firms’ gains hugely from using venture capital financing. In this method of financing, the company benefits from management expertise and a wealth of experience offered by the venture capital firm’s experts. Unlike other sources of start-up financing, venture capitalists can provide huge sums of funds to the company. In other forms of venture capitalization, like equity participation, the business is under no obligation to pay back the money. Additionally, venture capital assists the firm in business intelligence by availing valuable information and technical assistance to the business.

Venture capitalists avail numerous benefits to the business from capital to management assistance. However, venture capital financing also has weaknesses that may impact differently on the business. One of the major disadvantages of venture capital is the loss of autonomy and control by the business owners since most of the venture capitalist requires an exchange of finance with control or equity stake (Piros & Pinto, 2013). Furthermore, the process of identifying and assessing venture capital is usually arduous and takes a lot of time. According to Aisner (2000), other disadvantages of venture capital are that it is a highly uncertain source of finance and its benefits can only be obtained only in the long run.

Business angels

Another important component of the venture capital market is the business angels. Unlike venture capital or private equity firms, business angels refer to specific individuals who invest their own money in the new businesses. In some cases, these individuals instruct limited liability companies, trusts or businesses in which they have interests to invest in the startup (Reuvid, 2011). Angel financing can be said to bridge the gap between seed financing and the venture capital firms. Wadecki (2012) outlined angel financing is preferred by most start-ups since they do not come with many conditions like the venture capital firms. Additionally, business angels are usually ready to provide low amounts to high amounts of capital depending on the capital requirements of the business. However, similar to venture capital, business angels usually target high growth businesses where they can realize high returns.

According to Sharma (2010), obtaining funds from venture capital or business angels is usually relatively complex. The startup firm must, therefore, ensure that they present their business case well and the valuation of the firm is realistic. Some of the requirements for a new business or company to obtain funding from business angels include latest audited accounts of the business, strong evidence of business current performance, forecasts of profits and losses, bank statements and profiles of partners among others (Sharma, 2010). Unlike venture capital firms, business angels prefer to invest in industries which they are familiar with and feel that they can add value to the company. In developing the business case, the entrepreneur must, therefore, explain to the angels what they will gain from their investments and the capacity of the management team to implement the business plan.

In order for the agreement with the business angels to be finalized, it can take up to several months. During this period, the partners or the entrepreneur must present legal documents in order to access the funds. Most business angels’ negotiation will be legally binding when documents such as shareholders’ agreement, investment agreement, service agreements and other contracts have been affected (Shim & Siegel, 2000). Other documents that must be produced in this agreement include articles of association, share options, memorandum of association and the disclosure letter among other relevant business operation documents.

Compared to venture capital, business angels/angel financing is relatively accessible and comes with less conditions. In this regard, angel financing benefits the start up business in numerous ways. Since the business deals with individuals, investment decision making is usually faster compared to other forms of private equity financing (Danmayr, 2013). Additionally, business angels do not require the business to avail any form of collateral or asset security. Angel financing also ensure greater management and financial discipline by the start up due to increased outside scrutiny. Lastly, there are no interests to be paid in the case of angel financing (Nibusinessinfo.co.uk, 2016). Like any other form of financing, angel financing has some drawbacks. For instance, angel financing was found to be unsuitable for very low or very high capital requirements. Additionally, it requires the new business to give up a portion of their shares in the business and it can also take long for the new business to get an angel investor (Alcoforado Farinha & Santos, 2012). Lastly, business angels offer less technical and structural support to the startup company compared to venture capital firms.

Conclusion

This paper sought to examine various forms of private equity financing for a start-up company. The type of investor depended on the stage of business development. For instance, seed financing is preferred at the earliest stage of start up while angel financing was used mainly at the early stages of financing. Furthermore, venture capital firms were found to have provided funds to businesses at the early stages of financing and those at the later stages. Compared to venture capital, business angels were found to be effective in providing a relatively low level of capital but were usually higher than seed financing. Business angels were also found to be faster in decision making. In a nutshell, business angels will be more effective for businesses whose capital requirements range from $10000 to $500000 while the company can consider venture capital if the capital requirement is higher than $500000.

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