HOW CAN A PRIVATE COMPANY RAISE CAPITAL THROUGH EQUITY?

Considering the provisions of the Companies and Allied Matters Act (the Act), defining a private company may be quite impossible without considering its features. CAMA defines a private company as one which is stated in its memorandum to be a private company. (Section 22(1) of the Act). This definition leaves one wondering what makes a company deem itself qualified to be a private company. This is perhaps resolved by the features highlighted in the Act.

According to Section 22 of the Companies and Allied Matters Act, a private company by its articles, restrict the transfer of its shares, have its total numbers not exceeding fifty and shall not invite the public to subscribe for any shares or debentures of the company or deposit money for fixed periods or payable at call.

The above are some of the features of a private company, and anyother company not a private company is a public company.

Because it does not offer its shares to the public, a private company operates under less stringent legal requirements than for a public company. However, one may also wonder how funds are raised.

A private company may raise capital by way of debt financing or equity financing. Sometimes, raising capital may involve a combination of both ways.

Debt financing occurs when a company borrows money in exchange for a promise of repayment with, in many cases, a collateral. However, a company also has other options if it is reluctant to go the way of debt financing. This article mainly discusses the ways in which a private company may raise capital through equity.

1. Raising capital by asking friends and family

This is a workable plan for many. Many private companies raise funds by having people they know invest in their company. It is usually advisable that you have a sound business plan and are certain of how much you are trying to raise. Also, it is advisable to raise capital from people who understand your plans and are clear about the risks.

2.     Raising capital by crowdfunding

Not many would want to raise capital through crowdfunding, but it is still a viable option. There are crowdfunding success stories. Asides raising capital for business, crowdfunding gives a businessman the opportunity to receive feedback about products and assess the popularity or otherwise, as well as take note of points for progress. He also has the opportunity to connect with people that he would not ordinarily connect with. Success with this approach depends on the ability to communicate to a mass of strangers and social networks in a concise manner.

3.     Raising capital by reinvesting profits

When firms make a profit, the profit made can be reinvested into the business. For many established businesses, this is a major way by which capital is generated. Dependence on this method of raising capital is however not encouraged as the company might not be able to float in tough times. Businesses are often advised to find other sources of financial capital other than profits.

4.     Raising capital through a venture capitalist

Venture capital firms financially invest in relatively new companies that have the potential for substantial growth. A venture capitalist usually invests in a startup business in exchange for an active role in the company. The venture capitalist may offer money to the business in exchange for equity in the form of shares. This is in contrast to bank loans, for which the company would be indebted. They may also go beyond only investing money in startups to providing guidance, giving advice on key employees, customers, potential products, access to networks, and other developmental opportunities. This option is available for small startups and pre-revenue companies and a great alternative to bank loans. It has been opined that the value gotten from venture capitalists far outweighs the advantage of only having a low-interest rate. Usually, venture capitalists amass funds from a variety of sources and invest such funds in startups. Depending on the performance of the funds, the investors receive returns.

5.     Angel investors

This is another funding option for a private company. Like venture capitalists, angel investors also finance startups in exchange for equity. Unlike venture capitalists, however, angel investors are rich individuals who fund startups with their personal finances. They primarily provide financial support and are not obliged to be further involved.

Depending on risk appetites and other considerations, angel investors have different expectations on the Return on Investment (ROI). This may make them a better fit for slow growth start-ups when compared to Venture Capitalists.

Because of their relatively limited financial capacity, angel investors typically invest a lesser amount of money than venture capitalists. Angel investors will also more readily invest in early-stage companies than venture capitalists. On the other hand, a venture capital firm will be more eager to invest in a business with a track record that reveals a lot of growth potential.

MEZZANINE FUNDING

This type of financing combines both debt and equity. This mode of financing grants a lender the right to convert security into equity in case of a default in the loan obligation. Among other reasons, companies consider Mezzanine financing when they seek to reserve senior debt capacity to a time in the future; or when they have maximized their senior debt borrowing capacity. Companies also consider mezzanine finance when they desire to pursue long-term opportunities which may not be feasible with traditional loans.

Mezzanine loans are less senior than traditional loans in that they have a lower priority than traditional loans in a case of bankruptcy. In multi-tiered financing, for instance, the funds sources will be ranked senior debt, senior subordinated debt, subordinated debt, mezzanine debt, and the owner's equity. A mezzanine lender is close to being the least-ranked in priority in the case of an unfortunate event. Thus, they are riskier and for this reason, interest rates are also higher than in traditional loans. The terms of repayment are flexible and may involve a blend of interest and equity or even equity convertibility.

Lenders in the world of mezzanine financing are rather patient and are long-term investors and include insurance companies, mutual funds, banks and private investors. The lender gives a loan and in turn, obtains an authorization to convert the loan or portions of the loan to stock at either partial or complete default. Mezzanine loans typically don’t require repayment during the term of debt but at the end of the term which presents an opportunity for the company to improve its cash flow.

Like in other equity funding options, the risk of forfeiting a part of the company exists if the borrower is unable to pay back the loan. Also, the interest rates for mezzanine financing is much higher when compared to other funding options.

Nevertheless, a private company may consider mezzanine financing in instances where it wants to avoid the equity dilution that comes with regular equity finance. Mezzanine finance often appears as equity on the company’s balance sheet, projecting a lower debt level for the company and making the companies easily eligible for more financing. Also, mezzanine lenders are often willing to provide more funds than traditional banks, allowing the company access to a wider pool of funds.

WHY CHOOSE EQUITY FINANCE

Equity financing has many advantages, especially for small startups. Unlike debt finance, the burden of having to pay back debt is avoided. Some investors are in fact, often willing to provide additional funding as the business grows. Equity financing as well retains the cash flow in the company and typically offers the business more than funds, as investors often bring valuable experience, contact, technical skills, and credibility along.

DOWNSIDES TO EQUITY FUNDING

Financing a business through equity is more overwhelming - approaching and convincing investors consumes more time, energy and even money. Furthermore, the relationship with family members and friends who have contributed to the financing of the company may be injured if the business fails. A major disadvantage is that equity financing brings with it shared ownership of the company and while this may have some benefits, businessmen must exercise caution in the equity dilution especially if they still want to retain the ownership of the business.

CONCLUSION

In increasing capital, companies have the task of deciding whether to go the way of debt financing or of equity financing. A good corporate finance practice involves an intelligent mix of both ways in the most cost-effective manner.