Written by James Ross, Facilitator for North Chilterns & Oxford
A question I get asked all the time is: "What is the best way to raise finance as an SME?" It seems that the area most business owners know and think of first is finding a strategic investor and raising money by giving away equity in the company.
Invariably, this is a bad idea for the following reasons:
Loss of control: You are no longer the sole decision maker, and you have other people to agree with strategic decisions.
Unfavourable Valuation: More often than not, giving away equity at an earlier stage of your journey means you are giving away far more of the company as you are getting investors in early.
Long-term commitment: Once you have an equity partner, you have them for life (unless you buy them out later, which can be very costly).
*The main exception is if the investor can open doors or propel the company forward that you as an owner cannot, in which case it may be a good strategic option.
So, if raising equity is generally a bad idea, how can I raise finance?
Debt Financing
The best way to raise finance is through fixed-term debt, as the interest is often not material (and tax-deductible), and you are still fully in control of the company.
Director Loan: Either using personal funds or if the business is less than two years old, you can get a government-backed Director loan for £25k per Director at 6%.
Friends and Family: Friends and family can be a great source of finance. You can offer them a commercial rate of interest that they would not get from a Bank, and you can parcel it up into smaller loan amounts, which can quickly add up to meaningful finance. Structure the loan for 2 - 5 years with a no-penalty early repayment clause if you want to pay it back early.
Strategic Loan Partner: Many companies have trapped liquidity that they don't want to release for tax reasons. If you perform a circle of influence exercise across business owners, you know and ask around if anyone is looking for a business-to-business loan at commercial rates of interest.
Other forms of Finance
Grants: You may be eligible for rural grants or innovation grants; however, be prepared for plenty of red tape.
Joint Ventures and Partnerships: Form strategic partnerships or joint ventures with complementary businesses to access additional resources, expertise, and financing opportunities.
Invoice Financing and Factoring: Use invoice financing or factoring to improve cash flow by selling accounts receivable to a third party at a discount. This provides immediate access to funds tied up in unpaid invoices.
(Author admission: I am not a huge fan of this idea, but it is still better than giving away equity.)
In conclusion, there are many more ways to raise finance as an SME owner than you may initially think, and this money can make a huge difference to your company if spent wisely. My advice is always to consider your options before giving away that precious equity in your company!
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FAQs
Loss of control: You are no longer the sole decision maker, and you have other people to agree with strategic decisions. Unfavourable Valuation: More often than not, giving away equity at an earlier stage of your journey means you are giving away far more of the company as you are getting investors in early.
Why should you never give up equity? ›
You Lose Control: When you give up equity in your startup, you are giving up control of the company. You will no longer be able to make decisions about how funds are spent, who is hired and fired, or how the company is managed.
What are the cons of giving up equity? ›
Of course, there are also some drawbacks to giving up equity. The most obvious is that you'll have less control over your company. If you give up too much equity, you could find yourself pushed out of the decision-making process entirely. Another downside is that giving up equity can dilute the value of your shares.
What are the problems with SME finance? ›
SMEs tend to be informal, young, have less publicly available information, and operate in unfamiliar sectors, all of which results in higher information asymmetries and risk, discouraging bank lending. Many times, these firms also do not have enough assets that can be used as collateral.
What are the disadvantages of issuing equity? ›
Equity Financing also has some disadvantages as compared to other methods of raising capital, including: The company gives up a portion of ownership. Leaders may be forced to consult with investors when making a decision. Equity typically costs more than debt financing due to higher risk.
Can you raise money without giving up equity? ›
Instead, you can often get non-dilutive financing from government grants or other sources that don't require giving up any equity. Finally, non-dilutive financing can often cover a broader range of expenses than dilutive financing, making it a more flexible option for businesses.
How much equity is too much to give away? ›
So, my advice is to think very carefully about what you 'spend' your equity on and try and part with as little as possible. A good benchmark is to reserve a maximum of 5% for sweat equity deals with advisors, and 10% for sweat equity deals with your first employees.
What is the bad side of equity release? ›
You won't be able to take out another loan against your house. Once you have an equity release plan in place, you won't be able to use your home as security for any additional loans. However you might be able to release further equity at a later date with your existing provider if there is more available in your home.
What happens when you give away equity? ›
Equity represents ownership in your business, and when you give it away, you are essentially giving up some of the control over your business. This is especially true if you give away large amounts of equity.
Should I give up equity in my startup? ›
Its important to weigh all of your options and consider all of the potential risks before making any move. If done correctly, giving up equity can be an effective way to secure additional funding and expertise for your company; however, it can also lead to losses of control and profits if done incorrectly.
SMEs may lack the necessary collateral to meet the requirements of traditional lenders. Banks often require tangible assets as collateral, which many SMEs do not possess. This limits their ability to secure loans based on traditional lending criteria.
What are the pros and cons of SMEs? ›
Pros and Cons of Small and Medium Enterprises (SME'S)
- They're closer to their clients. ...
- They're flexible. ...
- They can make all the more likely to get recognized. ...
- They make decisions quicker. ...
- It is easy to connect the staff to the organization. ...
- They have more hardships to find down financing.
Financial mismanagement and lack of budgeting
Financial mismanagement and lack of budgeting are pivotal reasons small businesses, particularly in retail, face failure. Effective cash flow management is crucial.
Why is issuing equity a negative signal? ›
Since EPS is a closely watched metric that company executives, investors, and analysts use to forecast a company's expected profitability, any change in EPS is noteworthy. As a result, additional equity financing can carry a negative connotation in the markets since it lowers EPS.
What are the negative effects of equity financing? ›
The main disadvantage to equity financing is that company owners must give up a portion of their ownership and dilute their control. If the company becomes profitable and successful in the future, a certain percentage of company profits must also be given to shareholders in the form of dividends.
Why do firms avoid issuing equity? ›
Question: According to the pecking order theory of capital structure, why do firms avoid issuing equity? Because fees associated with issuing new equity are so high Because they want to avoid dilution of earnings per.
Why is it good to have equity? ›
Why Is Building Equity Important? Building equity increases the amount of money homeowners have in their homes that they may be able to use now or in the future. You can borrow from your equity as a loan, invest it, build long-term wealth or sell your home for more than you owe and keep the difference.
Why is too much equity bad? ›
1 Dilution of ownership
One of the main risks of using too much equity financing is that it can dilute the ownership and control of the original founders and shareholders.
Why is owning equity important? ›
Equity is important because it represents the value of an investor's stake in a company, represented by the proportion of its shares. Owning stock in a company gives shareholders the potential for capital gains and dividends.
What are the benefits of raising equity? ›
Advantages of equity finance
Investors only realise their investment if the business is doing well, eg through stock market flotation or a sale to new investors. You will not have to keep up with costs of servicing bank loans or debt finance, allowing you to use the capital for business activities.
