Sources and Methods of Equity Financing

Personal Sources

If you want to know what personal funds are available for investment in your business, you must first have a full appreciation of the monthly cash flow required to support your family. You should keep a record, preferably on computer, detailing your monthly revenues and expenses.

This is a prerequisite for those who are operating their business from their homes since a portion of the heating, hydro, mortgage interest, home maintenance and repairs, telephone and home insurance are attributable to the business -- thus serving as a source of cash flow to the household. The percentage of these household expenses that can be written off against the business will depend on the percentage of the total square footage of the house taken up by the business.

You must also do a personal balance sheet, detailing your personal assets and liabilities. An analysis of your assets will give you an idea of how much you could borrow against the assets, and if there are any assets liquid enough (that can be readily and quickly turned into cash) for investment in the business. For instance, a recent appraisal of your house may indicate a value of $200,000.00 with the outstanding mortgage against that being $50,000.00. Most financial institutions would be prepared to finance 75% of the current market value of a property. This means that you could potentially borrow another $100,000.00 for investment in your business, assuming the lender was satisfied that you have adequate means of repaying the loan and assuming that she feels comfortable with the purpose for which the additional funds are being borrowed i.e. that your business will be successful. Your balance sheet might also show that you have $25,000.00 in R.R.S.P.s. You would have to pay tax if you cash them early (and in cashing these in, one assumes you are satisfied that you will be able to make up for "dipping into the future"), but it is indeed another source of funds (albeit a last resort) that can get you started or provide the added impetus to enable you to reach the next level of competitiveness.

Company Sources

You should be fully aware of your company's financial position and you should use the services of a competent professional accountant to advise you on the methods for garnering whatever tax breaks are available to you, depending on your financial position and your legal structure.

If you do not do both, you may be missing an opportunity to obtain additional sources of equity funds and the opportunity of positioning your company to borrow further funds based on the equity in your business. For instance, a knowledgeable accountant will tell you that you are permitted to charge a particular rate for each kilometre driven for business purposes. For purposes of this example, let us assume that the permitted rate for the use of one's personal automobile to perform company business, is 30 cents per kilometre. If you drive, say an average of 1,500 kilometres per month on business, this means that you could charge the company $450.00 per month or $5,400.00 annually. This represents a source of funds to the owner to be withdrawn tax-free if the owner so chooses, or as an investment in the company in the form of a shareholder loan. At the end of the company's/sole proprietorship's fiscal year, $5,400.00 would show up as a loan from the shareholder to the company, if the funds were not withdrawn.

If the owner subsequently decided to borrow funds from a bank, the company's position would be enhanced by the fact that additional funds were invested in the business (by virtue of the fact that the owner did not withdraw the $5,400). (If the bank agreed to lend the money, it would likely ask the owner to "subordinate" his position to the bank's position. In other words, the owner would agree not to withdraw the funds that the company owes him until the bank had been fully repaid). Indeed, subordinated loans are another source of equity funds used by owners to finance themselves. They can be considered as equity so long as there is a subordination agreement in place with the lenders.

Another source of funds used to finance the business are the earnings generated and retained by the business. These earnings are equity funds but they can also enhance your capacity to obtain more debt. The greater the accumulation of the retained earnings, the greater the company's net worth. (Net worth is defined as assets minus liabilities, and an increase in retained earnings is an increase in one or more of the categories of assets - like cash). The greater the net worth of the business, the more you are apt to be able to borrow from a financial institution. Most lenders stick to certain debt/equity ratios, such as 2:1 or 3:1. Thus, if your company's net worth rose from $50,000 to $100,000, your potential borrowings could go from $100,000 to $200,000, or from $150,000 to $300,000, assuming you had the security to support the loans.

If you are a new business, your accountant will also tell you that, depending on the province, you may be eligible for a provincial tax holiday for your first three years in business. This is yet another source of funds -- you are retaining funds that you would otherwise have to pay out. Thus, as an example, if your annual revenue is $100,000, you would generate roughly $13,000 per year for a total source of $39,000 during those first three years of business (based on a 13% tax rate).

These are just a few examples of the type of information you must have if you are to use your company to maximize sources of equity and debt financing. A professional accountant can save you many times more than his fees.

Venture Capital, Private Placements and Initial Public Offerings

If you are a typical SME, you may not be involved in a significant breakthrough in the high-tech area and you probably need less than $100,000, so it is unlikely you would qualify for other forms of equity which involve access to public or institutional funds: venture capital from institutions; private placements; and initial public offerings (for large amounts, typically above $5 or $10 million). Consequently, you would likely have to rely on personal sources and those generated by your business, as the sole source of equity to run your business. However, if you are fortunate enough to have a company or a product with a terrific potential for growth, and the funds required are probably at least $ 250,000, there may be institutional or private funds available to help you grow. For amounts ranging up to one million, the BDC (Business Development Bank of Canada) has two financial products in place that may help provide you with equity funds -- (Venture Capital) and (Venture Loans) .

Venture capital firms will invest in your company if they feel that your business will be profitable and grow substantially. They expect high returns (typically in the 25% range -- either annually or eventually in the form of capital gains when the venture capitalist sells its shares). They also expect a substantial minority position and a seat on the board of directors as well as regular financial and other reporting requirements.

A private placement is analogous to venture capital except that the investors could be individuals as well as institutions and the approach by the owner of the business tends to be made privately to a select number of individuals/firms instead of via an open request from various venture capital firms. In some cases, these individuals, because of their knowledge of the industry or because of their management style, may not have quite the same requirements as an institution in terms of reporting formula and so on, but they will demand a similar return and ownership.

Remember, be it via a venture capital firm or private placement, you will be giving up a portion of your company to others who will have the right to participate in the future success of the business. Don't give it away easily!

Both venture capitalists and private investors invest in firms in anticipation of that firm eventually going public. An initial public offering (IPO) usually occurs when the amounts required are at least $ 5 million and more, generally in the $10 million to $20 million range. The firm will have to have a good track record and substantial growth possibilities for an IPO. There are numerous requirements to be met before and after a firm goes public, including several years of historical audited financial statements, regular formal board of directors meetings (with at least two outside directors), quarterly financial reports, etc.