The money that your business can raise as debt will generally be limited by the assets available to give as security. Any money that your business needs in order to trade or invest for the long term into the business, which cannot be raised as debt or grants, will have to be invested into it by either introducing capital (which is to say money) from outside (in shares in a company) or later by leaving profits in the business. It is this owner’s cash that is referred to as equity.

A provider of equity is putting money into the business normally in return for a share in both its ownership and its profits and future value. An equity provider is therefore in a fundamentally different position from a normal lender when it comes to risk and return:

As a result, if you seek other equity investors for your business (such as backing from a VC firm), you will be selling part of the ownership of your business to these investors, and as a result reducing (diluting) your own percentage holding in the business and, in the process, your control over it as well as your share of its present and future value.

Other than in respect of capital raised by you from your own resources to put into your own business as a sole trader or partner in a partnership, this type of funding is really only applicable to limited liability companies through the issue of shares. This chapter therefore covers:

• how shares work;
• the sources of external equity investment; and
• the process of raising these types of funds together with the issues that any business will face in doing so.

SHARES AND DIVIDENDS

Shares

For most small businesses in their earliest days of trading, shares simply reflect the ownership of the company and have nothing to do with raising finance as they tend not to be tied to any particular sum or investment.

The number and value of the shares that your company is allowed to have (known as its authorised capital) and how this is to be divided up into individual shares will be set out in the company’s memorandum of association, which is a key part of the company’s constitution. Most off-the-shelf companies will, for example, be incorporated with 100 £1 ordinary shares giving a total authorised capital of £100.

However, not all of the shares need to be issued at once. At the founding of the company the organisers will arrange for some of these shares to be issued to the initial shareholders (who are known as subscribers for the shares) and who therefore become shareholders or members of the company. Again typically in an off-the-shelf company this will be two £1 shares, giving the company an issued share capital of £2.

The company should in turn have received payment of £2 from the shareholders for their shares so that the shares are paid up. If cash has not been paid for shares that have been issued then, in the event that the company fails, those shareholders who have not paid up the value of their shares can be called on to do so.

Should you then wish to buy this off-the-shelf company, the subscribing members will complete stock transfer forms signing their shares, and therefore the ownership of the company, over to you. Since you will now own both of the only shares issued, you will own 100% of the company (as you own 100% of its issued share capital), despite the fact that 98% of its authorised share capital has yet to be issued.

So long as they are authorised to do so by either the company’s constitution or by resolution passed by the shareholders, the directors of the company can then go on later to issue (allot) the remaining shares subject to the rules set out in the company’s articles of association, which is the other key document of its constitution. The shares might be issued for the payment of their nominal face value of £1 each (at par) or the company might set a price which includes a premium so that, for example, a new investor might be required to pay the company say £500 for each share they received, which would mean that the company received £1 for the share and a £499 share premium into its reserves.

Requirements for PLCs

There are additional requirements in respect of Public Limited Companies (PLCs), which must have a minimum of £50,000 of issued share capital of which at least 25% (together with any share premium) must be fully paid up before the company is allowed to trade.

Alternatively the existing shareholders may sell part or all of their shareholding to a new investor, in which case the price of the shares is paid to the old shareholder and liabilities may arise for stamp duty or capital gains tax on which the seller should take the appropriate tax advice.

The company will need to report the details of new shares issued and transfers of shares to Companies House using the appropriate forms, most of which can now be downloaded from the Companies House website (www.companieshouse.gov.uk).

Dividends

Dividends are a payment made by the company to its shareholders out of its profits. The decision to pay a dividend is a matter for the board of directors and dividends can only be paid when the company has made sufficient profits to do so (and therefore has what are known as ‘distributable reserves’). In some cases companies can be found to have paid unlawful dividends, where it is later apparent that they did not have sufficient reserves, in which case the company can request that these are repaid.

Since dividends are paid per share, the more shares that an investor has, the higher the dividend payment they will receive.

Other types of shares

So far we have only talked about ordinary shares. They might be regarded as a standard form of share, giving a full share in the business with regards to both ownership and value, but no particular rights over other shareholders.

However, the company’s constitution can allow (or be amended to allow) for the creation of a variety of other types of share which will generally be given rights in advance of the ordinary shareholders. These types of share usually arise later in a business’s life, where it is negotiating some form of formal investment in its equity from an outside party when that investor wants to try to safeguard their likely return on the investment.

These types of shares include:

• Preferred ordinary shares, which have voting rights like ordinary shares, but are agreed to have priority in the order and value of dividends paid, and the return of capital over the ordinary shareholders.
• Preference shares, which give the holder the right to a specified dividend to be met before any dividends are paid to ordinary shareholders. This means that should the company become short of cash the preferential shareholders have a better chance of being paid a dividend than the ordinary shareholders. Preference shares do not, however, normally carry a right to vote.

Preference shares can be the following.

• Cumulative, which also carry the right that even if a dividend is not paid in a particular year, this liability of the company to pay the shareholder carries over into following years so that it is not lost. This means that cumulative preference shareholders have an even stronger chance of being paid than preference shares as they are not reliant on the cash in any one particular year.
• Convertible, which have a right to be converted into ordinary voting shares.
• Redeemable, which carry an agreement that the company can buy them back at either a set date or the company’s discretion, sometimes at an agreed level of premium, and which therefore provide a mechanism for returning the capital invested to shareholders.

Changes to share capital

Whatever arrangements are written into the company’s constitution at the outset, the company’s directors have the ability to amend these arrangements by putting suggested changes to a vote at a meeting of the shareholders.

These changes can involve:

• increasing the level of authorised share capital;
• decreasing the levels of authorised share capital by cancelling unissued shares;
• consolidating shares into larger nominal values where, for example, a million lp shares might be consolidated into 10,000 £1 shares; or more commonly;
• subdividing shares into smaller amounts where, for example, an authorised share capital of 100 £1 shares might be subdivided into 1,000 10p shares.

As should be clear by now, the ownership of shares determines the ownership of the company which therefore determines two important aspects: control of it and entitlement to its profits and value. There may be circumstances, however, where you want to treat these in different ways and this can be done by creating different classes of shares.

For example, if a company wished to incentivise its staff by setting up an employee share scheme so that staff could share in rewards, whilst the original owners wanted to keep clear control of the direction of the business, they could achieve this by setting up two classes of shares:

• Class A shares, which would be voting shares the old owners would retain and which determined the control of the business.
• Class B shares, which would be non-voting shares which could be sold to the employees and which would entitle them to receive dividends.

Again, all such changes to the nature of the share capital will need to be reported to Companies House using the appropriate forms.

FINANCIAL PROMOTIONS

Before considering raising any sort of equity from any third party you do need to be aware of the onerous levels of regulation that surround this, as failing to comply can lead you into considerable problems.

The starting point is to look at raising equity funding you are going to need to approach investors. But as soon as you send out a business plan, or contact people to discuss the possibility of investing in your business, this is defined as a ‘financial promotion’ under the Financial Services and Markets Act (FSMA). The rules under the FSMA are essentially designed to protect investors from being enticed into investing their cash in fraudulent or excessively risky schemes. So unless your approach falls under one of a number of exemptions set out in the Financial Promotions Order (FPO), it will need to be issued by an authorised person, which is generally someone regulated by the Financial Services Authority (FSA). If you fail to do so, not only might you be committing a criminal offence in issuing a financial promotion, but the other party may be able to walk away from any agreement entered into.

The FPO therefore specifies a number of exemptions to the overall prohibition in the FSMA on sending out proposals, the most important of which are as follows.

• Investment professionals (Section 19), such as employees of venture capital firms whose business is in considering and making investments and who are therefore considered sufficiently sophisticated to understand the risks involved in an investment put to them.
• High net worth investors (Section 48), who have obtained a certificate from either their employers or accountant certifying that they have income of over £100,000 a year, or net assets of over £250,000, were able to receive some classes of communication. However, in a Catch 22 clause they have to have provided you with a copy of this certificate before you can communicate with them. Under new rules introduced in 2005, individuals can now certify themselves and some types of proposal can be sent to people you reasonably believe are certified (although in practice this probably still means that you need to have a copy of their certificate).
• High net worth companies (Section 49), and those of their employees who are directly involved in investment, where high net worth means assets or issued share capital of over £5m (or £500,000 for a company with more than 20 shareholders).
• Sophisticated investors (Section 50), if they could find an authorised firm willing to take the risk of issuing them with a certificate stating they were sophisticated enough to understand the risks involved, can also be sent some types of proposal (although these have to carry heavy caveats). Given the obvious potential legal risk to a firm issuing such a certificate, it was rare for people to be able to obtain this type of certificate and again Catch 22 applied in that they needed to have provided you with their certificate before you could approach them in the first place. Under the new rules individuals can now self-certify themselves on a variety of grounds, which range from being a member of a business angel group to having been a director of a £lm turnover company within the past two years.
• Associations of high net worth or sophisticated investors (Section 51) such as business angel networks (so long as the investor will have no liability over and above the level of the investment) can receive proposals.
• Sale of a body corporate (Section 62), where essentially either the whole of the company or a controlling interest of over 50% of the shares is offered for sale.

Even if the potential investor that you wish to approach falls within one of these categories you will still need to be careful as the FPO specifies differing:

• notices that have to be given to each group, such as clear health warnings on any communication relying on the sophisticated investor exemption; and
• types of communication that you can send each group as the FPO distinguishes between communications that are:
  • real time or non-real time;
  • those which are parts of a marketing campaign or one-off approaches to a single investor or limited group that might be expected to act together; and
  • solicited or unsolicited.

The FSMA also prohibits the making of any misleading statements in any papers provided to potential investors that are involved in persuading or inducing investors to invest, which will obviously include your business plan. But your business plan, for example, will inevitably include a number of assumptions, some of which, in the absence of a 100% reliable crystal ball, may turn out to be completely wrong. So how can you tell what a court might subsequently hold to be a misleading, deceptive, or false statement made sufficiently recklessly for you to deserve sentencing for up to seven years? You may wish to remember at this stage that you are not a bank robber, but simply someone trying to raise finance for your business.

As a result of this regulatory minefield, you should therefore generally seek professional advice before speaking to any party about raising equity finance for your business.

WHAT ISSUES DO YOU NEED TO CONSIDER?

In all cases where you are bringing in outside investors you will need to consider the following.

• How much control you are handing over, what percentage of your business you will be selling and how actively involved the investor will then want to be in the business.
• The need for a business adviser to help you in the process of deciding what are the right sources of investment for your business, finding suitable investors, preparing the necessary documentation and then negotiating an investment through to completion on acceptable terms.
• How long it will take to raise the money, as all investors will have to go through some form of process to decide whether to invest, before which you will have had to go through some form of process in drawing up a business plan or proposal to interest them in investing.
• How certain you are of getting the cash, as you are ultimately reliant upon an investor deciding to risk their money.
• The costs involved in attempting to raise cash which can be substantial, as a proportion of the cash raised (and to what degree your advisers will require an upfront payment or will work on success only fees).

Some of the particular characteristics of the different potential sources of investment in relation to these points are discussed in the next chapter.

HOW MUCH IS YOUR BUSINESS WORTH?

If you are looking for an investor to buy part of your company to provide it with cash, an obvious issue that you are going to have to think about at an early stage is: how much is your company worth? After all, this will determine the size of stake you are going to have to sell your investor in return for their cash, since if I am investing Elm to buy 50% of the business this implies that the business as a whole is worth £2m. It is therefore important to know how the size of the investment sought relates to the business’s value overall, so that you know whether the £lm you are seeking really represents 25%, 50% or 100% (or more) of the company’s value.

There are six broad bases of business valuation, many of which are interlinked. These are:

The first thing to appreciate is that the valuation techniques most commonly used are based on estimates of future net cashflows or earnings, as the investor is really buying a share of the future cashflows and profits of the company.

It may come as a surprise in looking at these items that both the investor and your professional advisers will almost always make significant adjustments to both past and projected earnings information to establish an estimated sustainable level of earnings. This will involve the stripping out of any excess charges you are putting through the company for tax reasons and the insertion of market rates for costs such as rent and directors’ earnings. This is a normal part of the process and nothing to be particularly concerned about in principle, although it can lead to some major changes in the level of sustainable earnings shown for your business, which can in turn lead to a major change in the estimated value of the business.

The most commonly used basis of valuation in dealing with small owner managed businesses is the multiple of earnings approach.

This is calculated simply on the basis of:

• earnings/profits (before interest and tax, known as EBIT or PBIT)
• times the appropriate multiple.

The level of multiple to be applied is then obviously a matter of judgement, given the strength of the business and the current economic circumstances. If, for example, you had an established manufacturing business with a good market position and established management team you might expect this to achieve a multiple of say five to seven times current earnings.

Obviously, the worse the competitive position or reliance on strong management, the lower the multiple that should be expected. The clearer the competitive advantage and steadiness of the earnings stream, the higher the multiple that can be sought.

Most corporate investors, including venture capitalists, will also use discounted cashflow or net present value techniques to value a business. These are based on the assumption that £1 today is worth more than £1 in a year’s time because:

• an expectation of receiving £1 in a year’s time is by definition more uncertain than an actual receipt of £1 now and therefore there needs to be some reward for taking this risk; and
• £1 in a year’s time is actually worth less than £1 now as over the year, a £1 receipt now could be invested to earn interest.

Discounted cashflows are therefore used as a way of estimating what an investor is prepared to pay now, for the future stream of cash that is going to be generated by having bought a particular asset, business or project.

The advantage for you in a business that is expected to grow swiftly is that these are explicitly based on the future expected cashflows of the business, whereas multiple figures tend to start from a multiple of existing trading figures and so tend to take much less direct account of growth potential.

The key issue for this type of exercise is therefore not only the nominal value of the cashflow forecast, but the discount rate used. This comes from either of the following.

• A financial theory, called the capital asset pricing model based on:
  • the risk free rate of interest that an investor requires for investing their money in shares rather than in a safe investment such as government stocks;
  • times a risk factor for investing in a particular sector, known as beta, which is generated by looking at returns generated by quoted companies.
• Or a weighted average of the investor’s cost of the capital (WACC) where at its simplest, if it costs the investor 10% a year to raise cash and they can expect a return from your investment of say 20% a year, they are going to expect to make money by investing in your business.

If you would like more details on the basis of business valuations, two chapters are devoted to this issue in each of my books Buying a Business and Making It Work and Selling Your Business for All It’s Worth, also published by How To Books.