For any business, the art of raising capital is an extremely important aspect task to stay afloat, at many different times of the business. One of the most common ways that you will see business do this is with an equity raise.
What exactly does equity raise even mean? Equity raise, or equity financing, is defined by Investopedia as:
“the process of raising capital through the sale of shares. Companies raise money because they might have a short-term need to pay bills or they might have a long-term goal and require funds to invest in their growth.”
If you have seen the show Shark Tank, then you know exactly what this looks like. Investors will come into The Tank and pitch their ideas to a group of five potential investors, The Sharks. They will always end their presentation of their company by saying something along the lines of, “So Sharks, I am seeking a $100,000 investment for 10% of my company.”
At that point, the onslaught will begin as the Sharks will pepper the entrepreneur with questions about their business. They’re trying to better understand the company to determine if it’s a viable investment where they not only can make their money back, but hopefully make tenfold what they put into it.
Of course, the entrepreneurs are wanting to sell part of their company for the expertise that The Sharks bring to the table, but they’re also looking for something else – money! They are seeking money, or capital, for some aspect of their business.
They’re essentially trading away a part of their company for some capital, and that’s what an equity raise is.
Now, companies will do this for a variety of reasons. Early on in a company’s life, you might see them sell part of their company for the following reasons:
- Fulfill purchase orders/increase inventory
- Hire more staff/provide salary to the entrepreneur
- Open up a new location
- Expand Research & Development to launch a new product
- Increase your marketing spend
Any of these reasons are great options for a company to sell some shares of their company. In addition to the pure monetary benefits, there is a major benefit to selling shares of your company over simply raising debt – if the company fails, you’re not on the hook to those investors.
Now, of course, you’re going to feel awful that you lost other people’s money, but when you sell shares, you are now bringing on a partner. If you sell 20% of your company to someone and then that person does absolutely nothing, then I think they deserve a lot of the blame as well! You can’t have 20% of your company not helping – no wonder you failed!
I always talk about the importance of viewing buying stocks as that you’re truly taking a part ownership in the company – the thing here is that when you buy or sell shares from a small company, you actually are truly becoming partners.
When I buy 5 shares of Apple, I’m not truly a partner, but by having that mindset it will make me a much better investor.
Now, on the downside of choosing to equity raise over debt raise, if your business then takes off, you own less of the company. If your company is worth $500K and you sell 20%, therefore generating $100K in cash, instead of taking a 9% loan on $100K, was that the right or the wrong choice? Well, it depends!
If the company is worth $5 million then you now have $4 million because you sold 20%. If you had just decided to raise debt instead then you’d pay $9K since your loan was 9% on $100K.
But what if the company failed and is now worth nothing? You now own 100% of nothing, which is still nothing, and you also have $9K in interest that you owe to the bank.
It’s all just a game of balance. And of course, by choosing the equity raise, that might be the reason why you went from $500K to $5 million. But it also might be the reason you went from $500K to $0.
It’s all about understanding your own business and making the call that is the most important for you.
Tying it back to Shark Tank, you will sometimes hear the Sharks say that they’re not going to invest because they think that the entrepreneur doesn’t need an investor. Or, they might offer up a loan to the entrepreneur and take a much smaller portion of equity than the entrepreneur initially offered.
The reason they’re doing this is because they think the entrepreneur is on a great path and might need the cash more than they need the partnership. In general, my thoughts are that if you only need the cash to solve a short-term issue, you’re likely going to be better off with debt capital raising.
If you need a partnership and don’t want to be on the hook for the debt, then it might make sense for an equity raise.
Again, all depends on your situation, as does literally everything in life!
But it’s not only small companies that raise equity. In fact, many companies will take their company to the stock market if they reach a certain threshold where they want to make their shares available to the public in what is called an Initial Public Offering, or IPO.
The IPO market has been absolutely bananas lately as we have seen some major companies IPO in the last. People have this infatuation with getting companies super early on, but the market has just become so over-inflated with IPO’s that it seems like the hype is falsely driving up the price for them.
In the last few years we have seen companies like Beyond Meat, Uber, Lyft, Pinterest, DocuSign, Spotify, Lemonade, and Palantir. In fact, we’re just saw some huge IPOs for 2020 with Airbnb and DoorDash.
There’s just this insane frenzy around IPO’s right now, and while I understand the desire to get into some of these companies, it’s just mindboggling.
I don’t want to go too far down the rabbit hole but let’s talk about one company that I absolutely adored, Snowflake (SNOW). Snowflake had its IPO in mid-2020. Snowflake raised their IPO price TWICE in the same day, going from $75 to $120.
At $120, I told myself that there was just no way that I could buy into the company. I already was viewing it as a purely speculative addition to my portfolio, solely based off its insane revenue growth, but at $120 it was just too rich.
Then, as soon as shares were available to the public, the price was up to $245! It doubled from a price that had already been increased TWICE by Snowflake.
Am I going to invest? Heck. No. Way overvalued.
Want to guess what the share price is today?
The question is – did I make the right choice or the wrong choice to stay away? My process says that I made the correct choice. The math says that I made the wrong choice.
Personally, I am a bit nervous on these IPO’s because the companies are so new, and I got wrapped up into a bad decision with Beyond Meat when it first IPO’d. That company was absolutely nuts as you could initially buy in the $60’s and then a few months later it was $235.
Personally, I caught FOMO and bought around $180 just to panic sell it around $150. Not a monstrous loss, but it showed to me that I was just being an idiot and investing for legitimately no sound reason. From that point on, I told myself that it’s ok to invest in these IPO’s, but only if you really love the company, are ok with literally losing 100% of your investment (like you should be on all speculative investments), and have a certain price that you will not go above, no matter what.
Truthfully, it’s easy to see why these companies want to continue to raise equity in the public markets with the IPO process.
Their companies get A TON of hype and publicity and the demand that their stock creates is just absurd, especially if they already have a strong brand following.
For instance, let’s talk about the companies that I mentioned that just IPO’d, Airbnb & DoorDash. Both of those companies filed their IPO while we’re still in the heart of COVID, which normally might seem like a bad thing, right?
But what do these two companies do?
Airbnb provides homes that people can rent when they go on vacation. Personally, I have used Airbnb quite a bit on bachelor parties, long weekends at the lake, and then just big getaways with other couples. It’s amazing and much more useful than a hotel, and I think that people are finding it as a much safer alternative during COVID as well.
They can isolate near only their family and still do fun things such as go to the beach, try new restaurants, and continue to be safe with Airbnb.
DoorDash is a company that delivers food to you. You place your order through an app and then they will pick it up from that restaurant and deliver it straight to your house. While most people think of “ordering delivery” to mean pizza (and that’s by far my #1), DoorDash is one of the first companies that have opened the door to many other delivery options.
As you might imagine, there has been a ton of hype around these two companies because they are both being used more than ever due to COVID, so what better time to raise equity?
They might be able to pull a Snowflake and raise their IPO price twice in the same day because the amount of demand is just so out of control. If you’re either one of these companies, it honestly is probably the perfect time for them to IPO, and that’s really the point, right?
You’re selling the shares of your company in a effort to maximize your equity raise. If you can IPO at a massive price, it just means there’s going to be that much more in the company’s pockets.
At the end of the day, raising equity is a natural piece that businesses will continue to endure. You’ll have it occur when you’re a brand new company that is simply looking to fund purchase orders; you’ll have it when you’re a pretty-well established company that is looking to IPO; and you might have it when the company is hitting some hard times and they need to issue more shares to generate even more cash.
We have frequently seen Tesla issue more and more shares to increase their equity raise when the opportunity seems ripe. Some companies just burn through cash at such a rapid rate that they’re going to have to continuously keep raising equity.
The most important thing that you need to consider as a business owner is if it makes since for you to increase your debt or sell ownership of the company, and as I mentioned before, that’s something that truly only you will be able to know.
My recommendation is for you to seek advice from those that you trust if you ever find yourself in this type of situation to make the right decision. You really will need to take a good, hard look at what the need is for raising cash and then that will lead you down the right path.
Until you can answer that question, you’re not going to be able to properly make the right decision. Most of us will never have to deal with any sort of dilemma like this, which is both good and bad.
Instead I will just get to sit here and constantly refresh the SNOW price and regret my decision for choosing not to invest in them. Except, honestly, I obviously regret the decision, but knowing that I have a defined process in place has really helped me out quite a bit.