In the first post in this series we looked at debt financing. Borrowing money has its advantages, but it also has disadvantages. Loan repayments increase the fixed costs of a business, thereby increasing its risk and the volatility of its returns. For this reason, entrepreneurs are often reluctant to leverage a business to too great an extent, and decide not to borrow to the absolute maximum level. In other cases the entrepreneur may simply be faced with the reality that all available debt financing + entrepreneur’s own funds will fall short of the required purchase price. In this case the entrepreneur can seek equity investment for a proportion of the funds. This means that he or she gives up an ownership stake in the business to an investor in return for money. This investment doesn’t add any debt to the business and no interest is payable, but the entrepreneur’s proportion of ownership in the business is reduced.
Sources of Equity Financing
Not counting family & friends, it is more difficult to find equity investors than it is to secure debt financing for a business purchase. But there are options available depending on your circumstances and the nature of the deal you are seeking to finance.
Private Sector Investors
Firstly we should rule-out a few options. Many private investors prefer to make equity investments into start-ups rather than funding the purchase of existing businesses – this is certainly the case for most angel investors. This preference is driven not only by the tax incentives offered to them via the Enterprise Investment Scheme (EIS) for these kinds of investments, but because of the return they hope to make. Typically they will invest in a large number of start-up businesses expecting to lose money on almost all of them, with success in only one or two outweighing the loss in 20-50 others. The huge (5,000-10,000%) returns required by these investors makes them more suited to risky start-ups aiming at moon shots, rather than investors targeting the purchase of only one or a few businesses.
Equity crowdfunding is a relatively new investment class where many individual investors each contribute smaller amounts than a typical angel investor (investments can be as low as the hundreds of pounds), in exchange for equity. But like angel investing, this investment class is aimed at funding the growth of start-up businesses, rather than funding the purchase of a single business.
Private equity firms do invest in the purchase of a single business, with the intention of increasing its profitability and (typically) selling it again within a few years. They also fund a type of deal structure known as a roll-up: this is the acquisition and combination of multiple businesses with the intention of selling the larger entity (sometimes by listing it on the stock exchange). However, in both cases the deal values are usually in the tens of millions of pounds and upwards – private equity investors are not interested in small purchases.
There is a private equity structure that is suitable to entrepreneurs looking to purchase a business, but it is rare, especially in the UK: the search fund. These funds will back an entrepreneur with a plan to buy an existing business, by providing funds in exchange for equity in the business. In some cases they will even pay the entrepreneur a salary during the search process, which can take up to two years. An entrepreneur might find a suitable business in the £2-10m deal value range, with the intention of funding 70% with debt and 30% with equity. In brief, the search fund will provide the equity financing for the 30% not financed by debt (and not financed by the entrepreneur’s own funds), in exchange for equity in the business. This equity stake will usually outweigh the entrepreneur’s own stake, but it will allow the purchase of a large, stable business that the entrepreneur would not have been able to buy on his own. Unfortunately search funds are still relatively uncommon, even in the US, and much more so in the UK.
If you can’t raise sufficient funds for the purchase of a business yourself, you can consider taking on a business partner, each contributing funds and sharing equity. Like other equity financing sources, this route involves sharing ownership in the business. But unlike passive equity investors (including early “friends and family” investors), a business partner will be working in the business with you – contributing their labour, not just their money. Obviously the choice to take on a business partner involves many more considerations than simply sharing cost, risk and equity. For many people the idea of sharing control with a partner is unthinkable, whereas those who are actively looking for a business partner have the challenge of finding the right person. But in some cases this can be the most successful way to take over a business, both from a funding perspective and in terms of actually operating the business after the purchase.
The best examples of successful partnerships acquiring businesses are often management buy-outs (MBOs), where senior employees at a company acquire the business from its owners. In these cases it is typical for more than one partner to be required to raise sufficient funds for the purchase. But more importantly, these executives will have had experience in working together already, and will have a clear understanding of how the roles and responsibilities will be divided following the takeover. With an existing track-record of already managing the business, and a clear plan going forward, these investments present relatively less risk to outside investors and are often able to attract both debt and equity financing.
Reality: Combined Funding Sources
Most acquisitions are funded by a combination of sources, which can include both debt and equity. The actual breakdown varies depending on the individual circumstances of course. The best case scenario for the entrepreneur is to be able to fund the business entirely with unsecured debt at a low interest rate (with the entire purchase price dependent on an earn-out in the dream scenario). But in reality this is usually not possible, especially for larger investments.
For example, the purchase of a new franchise with a total price of £45,000 might be funded with £15,000 of the entrepreneur’s own funds and £30,000 in unsecured borrowing from one of the major banks. On the other hand, a £500,000 acquisition might be structured with 50% payment to the seller at deal closing and 50% over the following 24 months, subject to an earn-out. The entrepreneur might fund this with £100,000 in cash (eg: from selling an investment property), a £150,000 secured loan against the fixed assets of the target company, a £150,000 mortgage against his own home and £100,000 in earnings from the business itself over the following 24 months, assuming the earn-out milestones are reached.
In another scenario, an entrepreneur might be able to raise £30,000 of a £100,000 purchase price via unsecured debt. Her family members might contribute £20,000 as an equity investment (for 20% of the business*), or this might be a loan. The vendor has agreed to an earn-out arrangement where £25,000 of the price is based on performance over 12 months, but he insists on seeing “proof of funds” in advance, meaning that she cannot rely on paying this proportion simply out of the earnings of the business. The final £50,000 could be funded by an equity release loan against her home, structured in a way that allows the funds to be drawn gradually. This way she can draw down £25,000 from this loan at deal closing in order to pay the full £75,000 up-front payment to the vendor, who will be satisfied that she has the remaining £25,000 funds available to pay the outstanding balance in a year. She would only draw down the remaining £25,000 (or part of it), if she needs to – preferring to use earnings from the business to pay the outstanding amount to the vendor if possible, assuming all milestones are met.
These examples are over-simplified – the exact details of the deal matter enormously and the deal terms require careful attention from finance and legal advisors – but the principle is to illustrate some combinations of financing sources that would be used to structure these deals.
While there are multiple sources of equity financing in the market, most of them are not suitable to the acquisition of a business. Search funds, which we will explore in more depth in future, are an outstanding option for those few highly-qualified (and well-connected) entrepreneurs able to access them. But the majority of equity investments come from partnerships and passive equity investments from friends & family of the entrepreneur. Since debt financing is not unlimited, equity investments are often essential for the entrepreneur and can make the difference in successfully funding a business purchase. Equity investments come at the cost of shared ownership (and sometimes other contractual obligations), but they can make possible a purchase that would otherwise have been out of reach.
* In the case of an equity investment, the exact amount of equity purchased is open to negotiation of course. We used 20% for simplicity, but a case could be made that since the entrepreneur herself is only risking £50,000 of her own money (since the other £30,000 loan is unsecured, ignoring the impact on her personal credit rating for now), then the family members’ investment represents two-sevenths of the risk and therefore they should receive two-sevenths of the equity, or 28.57%. Alternatively the cash injected by the investors could be considered to be additive to the value of the company, making it worth £120,000, which would reduce their proportional ownership. The entrepreneur could claim that the company is actually worth another amount unrelated to the purchase price (eg: a valuation of £200,000 including their £20,000 cash, which would suggest a 10% ownership stake). All of this can be negotiated. The terms of the agreement governing this equity investment also matter enormously, as stated.