Very simply put, equity deals involve giving away a percentage ownership of your business in return for funding, resources or skills. How these deals are structured can take a variety of different forms, but the basic principle is the same: equity is given away in order to gain the things that will help take the business forward to the next growth level. Because most entrepreneurial businesses are almost perpetually cash-strapped, they either can’t afford to buy in the skills and resources needed, or they can’t access the funding required to grow. In many instances, the only thing they possess is the equity in the business and this is used as a means of exchange for what they need but cannot access through other means.
It’s a common misconception that equity deals only involve funding. While funding is what most entrepreneurs lack, resources and skills are equally common reasons for giving away a share of the business. For example, this might involve taking on a partner who brings to the table certain skills that the owner does not possess but which are needed to take the business forward. Alternatively, one might give away equity in return for resources such as equipment or contacts. Someone who can open doors to the right deals can be of immense value to a business and many entrepreneurs choose to give away equity to a person who brings such benefits to the table.
Equity changes through the business life-cycle
Pavlo Phitides, CEO of business incubation company, Aurik, explains that the equity needs and deals change as the business moves through different business development life stages.
“In the start-up phase, businesses are typically under-resourced but they need skills to cement solid foundations and get sales going. Entrepreneurs are often strong in their particular ‘subject’ area but weak in others like marketing or financial management. So they are faced with a number of options: They can try to muddle through their weak areas alone, however this often comes back to bite the business. They can hire someone who has the strengths they don’t possess, but being under-resourced presents a problem because they can’t pay market-related salaries for good talent. Or they bring in a partner who possesses those skills and give that person equity in the business.”
In the growth stage of the business, equity needs change. “Businesses can either grow organically, which is appropriate for certain businesses but can be frustrating and slow, or they can grow aggressively but for this they typically need funding,” says Phitides.
There are two key funding options: debt funding and equity funding. “You need assets to secure debt funding and you need to be able to pay back the loan as well as the interest on a monthly basis. Equity funding on the other hand means you don’t need to dedicate a certain amount of money every month – at a time when money is most needed in the business – to service interest and repayments,” explains Phitides. Of course, many entrepreneurial businesses simply can’t access debt funding, so equity funding is the only option available to them, unless they are able to raise capital on their own.
Before you take the leap…
This last point is an important one. “Giving away equity is akin to giving away your future wealth. Entrepreneurs often don’t realise this. They are so desperate for the money now, that they don’t properly explore all alternative options,” says Phitides. Before you rush into an equity deal, you need to make sure you’ve asked yourself some important questions, he says.
Most important of all is to determine whether the skills, resources or funding you think you need is really critical to the future of the business. Many successful businesses manage without funding, particularly in the early stages – ask yourself if it’s not possible for you to do the same.
If you’re looking for a certain skills set but can’t afford to pay a salary for the right person, it might be worth exploring the possibility of paying a once-off fee to get what you need. In other words, you might choose to bite the bullet and pay a marketer to put together a marketing plan for you, rather than taking on a partner with marketing expertise and giving them equity in return. Serial entrepreneur and investor, Vinny Lingham says, “I generally don’t recommend giving away equity for once-off transactions. If someone does a referral for you but there is no long-term relationship, equity shouldn’t be given away – rather pay cash if possible, or give a payable note for a future date with interest.”
Phitides agrees: “The value that the person brings should be ongoing. If not, you might find yourself five years down the line and feeling very resentful about the fact that someone owns 25% of your now highly-valued business, in which they do nothing, just because they gave you a marketing plan when you needed one in the early stages. I have seen this kind of deal lead to lots of bitterness, unhappiness and conflict.”
This is not to say that giving away equity is a bad idea in itself. “Often, it’s unavoidable. My view, however, is that it’s only a bad idea if you haven’t explored all alternative options and if you haven’t properly considered the consequences of the deal – and made up your mind about whether you can live with them or not,” says Phitides.
How it will change your business
Make no mistake, an equity deal has immediate and long-term consequences. “Once the deal is done, your business is seldom the same,” says entrepreneur Howard Blake, chairman of Blake & Associates. “Entrepreneurs thrive on their independence and own leadership style in achieving their objectives. They find it challenging and stifling being confronted by the endless compliance and governance requirements of outside shareholders. Innocence lost is never regained, in a sense,” he adds.
Bear in mind that investors will want to see structures and systems put in place, and will expect regular detailed reports on the business’s activities. If you don’t have the stomach for this – and many entrepreneurs don’t – then you don’t have the stomach for such an equity deal. Phitides adds an interesting point. “Often, the reason that entrepreneurs aren’t meeting their goals is because they can’t work within the parameters of the investors. Frustrated or stifled, they lose enthusiasm and passion and deliver a lack-lustre performance where once they excelled.”
Whether you exchange equity for an active partner in the business, or a ‘silent’ shareholder, the fact remains that you give away a degree of autonomy when you give away equity. You will, to some extent, be answerable to others for the decisions you make. “Your funder will want things rolled out and achieved as forecast in the business plan you presented and as agreed when you struck the deal. But I have never seen a business achieve its forecasted plan – ever – and this can leave entrepreneurs in an impossible position,” says Phitides. Depending on the deal, investors may become punitive. “The deal may allow them to increase their equity share because you have failed to deliver what was required and agreed, so you find yourself incrementally losing more and more ownership” he explains.
This brings us to some of the common mistakes entrepreneurs make when doing an equity deal. “One of the worst and most damaging mistakes is that they don’t formalise the agreement, setting out clearly the expectations, deliverables and consequences. My advice is to watch The Social Network on the Facebook story before you go into any kind of partnership,” says Phitides, adding that most entrepreneurs don’t formalise their contracts because they lack money for a lawyer. “Things are agreed verbally but are hardly ever written down, and it leads to endless problems and conflict,” he says.
Another common mistake is for entrepreneurs to take on partners for the wrong reasons. Just because you like and trust someone doesn’t make them an ideal business partner. “When you’re starting out I suggest you find one partner to start the business with. One of you should have technical or product skills and the other should be business or marketing focused, for example,” says Lingham. It’s comforting to go into business with a partner who is similar to you, but what’s actually needed is someone who has complementary, but different, strengths and skills. “If you both enjoy sales and marketing, the operational and financial side of the business will get neglected,” says Phitides.
“Being too generous or too greedy is another pitfall,” says Lingham.
While you might believe that your business will be valued at R1 billion in five years’ time, remember that this is only a projection. Any investor who does an equity deal is taking a risk, so bear this in mind when you find yourself becoming greedy. On the other hand, don’t undervalue your business to the extent that you give away so much and find yourself five years down the line owning only 6% of something really valuable that you’ve put your heart and soul into building.
Valuing the business
One of the most difficult aspects of doing an equity deal is how to value the business, not only on paper but in your own mind. After all, you need to have a sense of what the business is worth to know what your top and bottom end will be for any equity deal. Vinny Lingham discusses how to weigh the decision: “If you bring on a partner or investor, you need to determine if the equity you are giving them will deliver a greater return on your existing equity than not having them will do. Let’s assume you have a business that is worth R1 million and that you own 100%. You give 50% to an investor who puts R1 million into the business. So you now have 50% of the business, but it’s now worth R2 million. In theory this puts you back in the same position, of ‘owning’ a share worth R1 million. But, if you are able to use the cash to double the value of the business to R4 million then your 50% is worth R2 million and you’re ahead. The question to always ask yourself is, ’By taking on this partner, can I grow the business so that my new percentage of the grown business will be worth more than I have now?’”
What makes for a good equity partner?
Pavlo Phitides’ insight into what to look for in an equity partner:
- An ongoing contribution in one or, ideally, all of the following: funding, skills, resources and relationships.
- Someone who buys into and supports your vision. While you will be answerable to them to some extent, their involvement shouldn’t quell or interfere with your passion. It is this, after all, that drives the entrepreneur’s tenacity and allows them to stick with it when the going gets tough.
- Patience. Nothing ever goes according to plan and it may well take longer than expected for an investor to see returns from an entrepreneurial enterprise.
Advice on equity contracts
If you can’t afford a lawyer to put together your equity contract (and many businesses can’t) Phitides recommends you put together a deal sheet.
“This should include who gets what percentage for what contribution, what each person needs to do in the business and what areas they are responsible for, and what the consequences are of not doing these things,” he says.
Access To Finance In SA: What You Need To Know
Finfind’s inaugural SMME Access to Finance Report reveals some of the biggest challenges SMEs face when trying to get finance. Understand the landscape, and you can adjust your business to obtain more finance.
Access to finance is a primary challenge for the majority of SME owners, particularly in the early stages. Without an understanding of the complexities of SME funding and the challenges experienced by both the providers and seekers of finance, it’s impossible to address the obstacles that are hindering increased deal flow.
Many countries have transparent data from lenders on a number of SMEs applying for loans, the reasons they are applying, financing terms, the interest rates, rejection reasons and rates, non-performing loans and factoring volumes. However, this information does not exist in the public domain in South Africa, even though it is crucial for policy-making. There is an urgent need for quality data and increased transparency to map SME’s access to finance and understand their funding challenges so that practical solutions can be developed.
Finfind has responded by publishing South Africa’s inaugural SMME Access to Finance Report. As an innovative fintech company that provides SMEs with a free funder matching service and an up-to-date database of over 420 finance products from public and private sector SME funders, Finfind has comprehensive data on the providers and seekers of finance. The report has enabled us to provide valuable insights about SME funding that can benefit policy-makers, funders and organisations involved in SMEs.
Some of the key findings of the report include:
High demand for SME finance
The SME funding gap in South Africa is estimated at between R86 billion and R346 billion per annum. It provides a compelling, largely untapped market opportunity for innovative funders who are able to develop new lending models and risk assessment tools tailored to address the challenges of this complex and burgeoning market.
Funders require new risk assessment models
Banks currently struggle to serve SMEs as they treat business (big and small) as a single market, and apply traditional lending methods that use collateral and conventional financing scorecards as a one-size-fits-all approach. These traditional instruments are detrimental to micro, very small and small businesses securing finance. For funders to close the credit gap, innovative new credit scoring models that enable more accurate risk assessment need to be designed specifically for this target market.
There is a lack of SME credit record data in South Africa
South Africa has comprehensive consumer (personal) credit record data that is well organised and regulated. However, this is not the case for SME credit record data. The credit bureaus in the country have little, and in some cases, no credit history data for SMEs. There is no regulation of SME credit record data, and no standard means of data collection (or a framework for credit records) for SMEs.
This poses a major challenge for SME lenders as they use the credit score in their risk assessments. Funders request credit reports (credit checks) from the credit bureaus to assess a business’s historic credit conduct. In the case of SME lending, funders request the credit report for both the owner and the SME, even though they are two separate legal entities.
The current system does not uphold legislation that distinguishes between the owner and the business, which means that when SMEs apply for finance, lenders rely on the credit records of individual owners to assess the risk of lending. This prejudices SMEs that might be extremely creditworthy but have owners with compromised personal credit scores.
The lack of SME finance readiness is a major hindrance to securing finance
The qualitative research shows that many SMEs are unable to access funding as they cannot provide funders with proof that they are bankable and can afford the finance they are requesting. Funders need to examine the SME’s financial records to determine that the business is viable and to assess their ability to repay the funding. To do this they require access to the SME’s latest financial statements and up-to-date management accounts including income/cash flow projections and outstanding debtors, tax clearance certificate, VAT statements and business plans amongst others.
Financial record-keeping is a major challenge for many SMEs and they are not able to produce these documents. Without these, they are unable to access finance, and are ill-equipped to make sound decisions in their business or properly manage their cash flow. Poor cash flow management often results in SMEs falling behind on VAT and PAYE commitments as they are unaware of what is owed. Many viable businesses are liquidating due to liabilities owed to SARS and other creditors as a result of poor financial record-keeping and an inability to secure funding.
Further to these key findings, the report provides valuable insights into the supply and demand for SME funding. It profiles the SMEs seeking finance by geographic location, turnover, age of business, sector, job creation, financial need and amount of finance required, amongst other key indicators. It also profiles the funders, and considers the supply and demand matches and mismatches, highlighting some of the funding gaps and opportunities in this critical sector.
About the smme access to finance report
Finfind launched the report in partnership with the SA SME Fund and its findings have been made freely available to stakeholders in the SME ecosystem. The report identifies providers and seekers of SME funding in South Africa, and the associated challenges, gaps, opportunities and potential solutions to increase funding success in this vital sector. While ground-breaking in terms of the information it provides, this initial report did not answer all the questions in this complex environment, but provides an excellent start to understanding the landscape.
The report is based on independent analysis of Finfind’s funder and SME finance seeker datasets in 2017, the largest SME access to finance research sample to date. In 2017, Finfind had a total of 126 916 visits to its platform, 81,2% of which were unique visitors. The average time spent on the site was more than five minutes per user.
The report analyses comprehensive data from more than 10 000 SME funding requests that were matched with a base of 148 funders and 328 finance offerings. Comparisons of the Finfind data with data from SARS, GEM SA and StatsSA studies show that the Finfind data is representative of the SME market and that the report findings can be generalised for SMEs in South Africa.
Looking For Funding? Try Manufacturing
There are over 200 national incentives for the industrialisation of South Africa. Can you tap into grant funding to grow your business?
Many people ask me why the focus of public investment in SMEs and business is so heavily weighted on the manufacturing sector?
The reality is that investment in industrialisation results in a multiplier effect in jobs, foreign earnings through exports and increased tax revenues. Countries that focus on industrialisation have proven its potential to stimulate economic growth and address social challenges.
If you’re looking for opportunities and the support needed to realise these opportunities, manufacturing is a good place to start. The Department of Trade and Industry (DTI) offers several manufacturing-based incentives and grants.
Below are the ten key general principles associated with the DTI incentives:
1. Matching concept
DTI grants are based on a ‘matching’ or ‘co-funding’ principle, which requires an applicant to invest a portion of the funds required for the project for which funding is being requested. The DTI will fund a portion of the project qualifying costs (anywhere from 10% to 90% depending on the specific fund) on condition that the applicant can prove a source of the remaining portion. The source of the difference can be debt, equity or any other form of funding.
2. Qualifying/allowable investments or activities
The DTI sets rules for what can be funded by way of a grant (qualifying costs). These may differ based on the incentive, but the general rule is that the main application of grant funding is for plant, machinery, tools and equipment. Land and working capital will not qualify and would form part of the co-funding.
3. Project size
This refers to the full project size and includes all costs involved in implementing the project. All costs include capital expenditure (e.g. plant, machinery, tools and equipment), working capital (e.g. salaries, wages, stock etc.) and other costs including, but not limited to, land, vehicles, business development and certifications.Not all costs will qualify for funding from an incentive.
Projects are evaluated to determine their bankability. The DTI aims to ensure that the principles applied in an application and business plan are realistic and will result in a sustainable business and/or project. In evaluating bankability, the DTI will look at the ability and know-how of the team and will require the applicant to show proof of market.
Proof of market is demonstrated by off-take agreements, purchase orders, contracts or letters of intent.
Incentives are strategic funding and, as such, are not an appropriate source of funding for distressed businesses or businesses with short timeframes. This funding should be viewed as strategic funding. The DTI may provide timelines for processing applications, however, applicants must be prepared for timelines longer than those indicated. Applications may take anywhere from three to 12 months to be processed and approved.
6. Approval prior to investing
Investments made prior to the approval of an application will be non-qualifying investments. This means that an investment made before receipt of an approval from the DTI cannot be recuperated. This will be enforceable even if the investment made formed part of an application that was approved.
7. Milestone based claims
The DTI will make payments based on project milestones as indicated in an application. Each fund may define its own milestone parameters.
8. Rebated claims
Claims are rebated to applicants. This means that an applicant must first invest, in line with its application, and then submit a claim for the approved investment. This principle demonstrates the importance of securing co-funding, which will be used to initiate the project.
9. Tax free grants
Grants awarded and paid are tax-free.
10. Equity substitution in nature
As grants are not repayable, they can be considered equity for purposes of securing debt. Most debt funders require a portion of equity from an applicant to lower the risk of debt. Debt financiers will consider a grant as an equity contribution, allowing applicants to unlock debt that would otherwise not have been available.
6 Steps To Ensuring You Meet Your Funder’s Mandate
Find your funder, approach the right people, and tick all the boxes.
1. Determine why you need funding
According to Quinton Zunga, founder and CEO of RH Bophelo, a special purpose acquisition company with interests in the healthcare sector, many business owners do not understand cash flow and its impact on the operations of a business. “A good idea without enough cash flow is not sustainable,” he says. “You have to prepare the business for the worst-case scenario and ask yourself ‘what if things don’t work out my way? Do I have a plan B?’ Don’t assume you’ll be able to access finance to save the business if your cash flow is poor.”
The reality is that too many business owners apply for funding because their working capital is under strain, customers owe them money or their margins are too low.
“There’s a big difference between funding that will help you grow your business, and trying to plug a self-inflicted cash flow problem,” agrees Kumaran Padayachee, CEO of Spartan SME Finance, an alternative funder.
The key to growth funding can be summarised in one sentence: Will this help me make money? If the answer is yes, you’ve ticked the growth-funding box. If you’re not sure, relook your financials and forecasting. If the answer is no, you’re trying to solve a cash flow problem that will not be fixed by taking on more debt funding.
“As a funder, we care about what entrepreneurs want the money for,” says Kumaran. “We look at business models and strategy. We take a view of the entire picture, which gives us insight into whether the funding will be used in a growth context, or to plug a gap created by a strategy, cash flow, sales, marketing, management or an access-to-market problem.”
The real insight is that it shouldn’t only be up to funders to determine the answers to these questions, but business owners themselves. If you understand why you need funding, one of two things will happen: You’ll realise there’s a problem in the business that funding won’t solve, and you can begin working on it; or you’ll be prepared when you apply for funding, increasing your chances of securing the finance you need.
The reality is that too many business owners apply for funding because their working capital is under strain, customers owe them money or their margins are too low.
2. Understand the funding landscape
Different sectors, industries and funders have their own rules and mandates. To understand the funding you’re trying to access, you need to first understand the sector you’re in, and the funding rules that apply.
For example, property is a long-term investment and funders in this space require a commitment of at least five to 15 years. TUHF, which is a specialised residential property finance company, also requires an equity contribution, as it does not offer 100% financing.
“Funding is usually made up of two components: Financing (loans) and equity (owner’s contribution),” says TUHF’s CEO, Paul Jackson. “The purchase price of the property, the costs of refurbishment and the amount of money the client can contribute of his own money are the three main contributing factors that determine how much financing the client will need to apply for.”
More importantly, entrepreneurs approaching TUHF are dealing with industry experts operating within a niche space. This is true of most funders, and should be carefully considered by business owners.
When you’re considering your growth options, focus on what you absolutely need to push the needle, and make do with what you can as you build up your pipeline.
“In every case ask the question: Do the costs involved in accessing the finance make sense? Will this help drive growth? How? Once you’ve ticked those boxes, consider all your funding options. There are a lot of solutions available to you, from bank funding, which is the cheapest to access but requires a lot of collateral, to private equity funding, which involves giving away equity in the business,” says Kumaran.
“Alternative funders like us play in the middle of these two traditional options. Alternative funders tend to be niche and specific, focusing on specific sectors or industries. They carry more risk and don’t require collateral, which is why they’re more expensive than banks, but they bring industry and sector-specific insights as well — and it’s debt funding, which means you aren’t giving away equity in your business. Their processes tend to be efficient as well, largely due to the niche nature of the funder. When you’re ready to grow, find a funder that matches your needs and understands your business.”
3. Start early
“Raising capital patiently is key, because acquiring funding quickly but unwisely could lead to repayment issues,” says Quinton. “Some funding can only be accessed later and you need to be patient, or you may find yourself struggling to pay it off before your business has grown big enough to do so. You need to focus on preparing a business plan and understanding the cash flow impact of the decision you make. Look for an advisor or banker to work with you on the business plan.”
4. Know what funders look for
All funders are looking for specific business and personal traits in the business owners they back. Quinton values integrity and honesty, a good understanding of the business they are in, and personal commitment. “Funding a new business is always tough because the entrepreneur may not have experienced all the sides of the economy and may not be accustomed, mature and ready enough to go to the next level. This is where a steady track record is advantageous,” he adds.
Paul agrees. For TUHF, the entrepreneurial character and competence of the borrower is of paramount importance. “We follow a character-based lending approach,” he says.
“A client that displays certain characteristics is considered a better investment option. These include entrepreneurial qualities; an open-minded attitude that is willing to take advice; someone who is self-disciplined and manages the cash flows of the property to the benefit of the property, and not for personal use. Other sought-after characteristics include someone who keeps their tenants happy by keeping the property clean and well maintained, providing all-round good customer service; is committed to doing everything in their power to ensure the success of the deal; is up-to-date on utilities; and directly involved in the property management, even if there is an external service provider.”
5. Avoid red flags
Every funder has red flags they watch out for and they will walk away from a deal if they find them. “A bad past business track record indicates the business owner’s legal, financial, and HR values,” says Quinton. “These are important to us. Without some ethos and standards, you end up not being on the same page as your investor. I usually ask about the entrepreneur’s previous partnership — how they handled it and why it ended. Desperation is also a deterrent, as is a poor business case.”
Paul agrees. The driving factor in TUHF’s business is the borrower’s aptitude in property. “Real estate competency is therefore a key characteristic of TUHF borrowers. It’s important that the building is properly matched to the skill and entrepreneurial competence of the borrower. Some of the conditions we evaluate include a credit record, ensuring the borrower is not under debt review, or blacklisted; returned debit orders on a client’s bank statement; track record and state of repair of the client’s other properties; having the right risk attitude, which in our case is considered, cautious and patient; taking the time to do due diligence; and property fit — does the size and nature of the project match the client’s talents and experience. It’s a red flag for us if one of these is mismatched.”
6. Don’t give up
The most important step in funding is perseverance. Many business owners knock on multiple doors and make numerous applications before finding a funder that fits. This could be because red flags need to be addressed and financial management accounts followed, but each time you approach a funder you learn something new that you can implement in your business.
“Don’t view failure as a disaster,” says Quinton. “Figure out which stage of the lifecycle your business is in and align that to your commitments.”