Small businesses are often faced with problems that larger businesses do not face, the largest of which is typically maintaining cash flow to run operations as well as to expand. Cash flow can be generated from many different sources including cash from operations, debt financing, and equity financing. While all three make for reasonable ways to raise capital, cash from operations is often insufficient to fund growth to truly expand the business, while debt financing can restrictive covenants that can limit an organization’s ability to expand. Debt financing often has punitive interest rates for small startups which can limit their ability to succeed during the critical initial period of the business when cash flow is tight.
Equity financing is commonly used as a way to attractive capital for small startup companies. Equity financing can either be obtained on public markets (regulated market exchanges) or through private equity financing. Many organizations, particularly small start-ups, do not feel as if they have sufficient critical mass to effectively tap public markets due to the regulatory costs associated with public filings. As such, this leaves private equity as the most effective way for these organizations to obtain financing to run their business.
Private equity can be attracted from many different sources. Individual investors make up a source of private equity raises, but can be difficult to attract. In addition, blue sky laws which fluctuate from state to state may limit this as a source of equity for some companies who are attracting a large number of investors (typically over 500). Startups often turn to institutional investors as a way of raising equity that can be significantly higher in amount and therefore not subject to these possibly punitive blue sky laws.
The way in which private equity transactions can be structured may be varied and fluctuate in terms. Common stock shares are sometimes issued, but increasingly preferred shares are issued by small startups to investors that afford them the ability to convert these shares to common shares if the startup entity is successful, but provides them with the ability to maintain a higher liquidation preference if the organization is later liquidated. As a result, convertible preferred stock is often used in private equity deals with startup organizations, although many varieties exist.
Raising private equity can be challenging for small startups as they often do not have the earnings history of larger organizations. However, they provide the opportunity to grow significantly faster than more established businesses and offer a higher rate of return to reward shareholders.
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This video gives the training for finance on how private equity works.