Equity investment is financing provided by an investor in exchange for shares in the company. She therefore becomes a shareholder of the company, meaning that the investor acquires partial or full ownership of the enterprise. This allows the investor to vote on certain company matters and, in some cases, benefit from dividend disbursements or a board seat. Equity financing can be an interesting mode of financing particularly for businesses in their initial startup phase with a model that bears potential for scaling.
Compared to debt financing, early-stage enterprises can access equity investments without showing a solid track record of success, in case the enterprise meets the investor criteria. As enterprises mature, the risk investors take and the share they receive for their investment go down.
Equity investors realize gains either selling their shares to another investor, selling them back to the entrepreneur, or by getting dividends on their investment once enterprises are matured and generate significant profits. Yet, equity investments are associated with high risk: the investor is last in line to receive any compensation in case of default or bankruptcy. Given the risky nature of equity financing, investors typically expect potential for higher return as a compensation for the high-risk investment.
If you seek equity investments, you consequently have to make a very strong case for the return on investment (RoI) you can generate for the investor. With traditional equity investors that seeks financial returns, the market potential and your business model are sector-specific key components to build an investment case. When it comes to investors who equally consider impact as a form of RoI, the specific sub-sector, customer segments and type of service or product you offer play another important role.
When is Equity a suitable financing option?
There is a broad range of equity investors. Different equity investors have different preferences when it comes to the maturity of enterprises, but generally, equity can be a financing option for enterprises from a fairly early stage onwards all the way to public listed companies.
Typical sources of funding for young enterprises are equity investors such as angel investors who invest their own money, and venture capital firms which invest in risky companies with high growth potential. These rather risk tolerant early-stage equity investors often want to resell the shares after a few years and generate a return from this ‘exit’ by selling their shares for a higher price. Hence, equity investments mostly make sense, if you plan to raise sub-sequent investment rounds and you have some sort of an investment trajectory outlined already.
At later stages, when enterprises have matured enough to generate a steady flow of revenues or reached profitability, private-equity investors follow after venture capital investors. Based on the same equity investment model they also buy shares in a company in return for the capital provided.
This factsheet focusses on earlier stage equity investments.
The following (non-comprehensive) characteristics and implications provide you with an overview to analyse the pros and cons for this investment instruments:
Depending on enterprise stage and investment round
Pay-back period (Maturity)
Usually 3-7 years
Use of funds
The following table summarises some key characteristics of Equity and implications you should consider:
What does this mean for your enterprise
The higher your company’s financial valuation, the smaller the portion of shares you give to the investor in exchange for his/her capital
To this background you should duly consider, if your company is at a good point to yield a high valuation. Several factors influence your company valuation. Visit the factsheet on company valuation to understand company valuation methods and factors that influence the valuation result.
Investors do not get repaid but potentially generate return following the resale of shares (based on the differences in share prices)
The envisaged enterprise trajectory should be aligned with the exit strategy of the investor. You should also be aware that the conditions for resale of shares can limit your influence on future investors that will have a direct say in the management of your enterprise.
The exchange of company shares for capital usually comes hand in hand with a seat on your board.
With an equity investment, you also give away your freedom to run your company on your own terms. This can be to the better or worse depending on the alignment of your vision with the vision of the equity investor as well as on his/her level of involvement in your company. When handing over some control to an investor, conflicts might arise in case you and the investor don’t see eye to eye when it comes to the mission of the business, the management style or ways of operating the business. Overly engaged investors might also absorb a lot of your resources for reporting and responding, taking away time you need to manage the business.
Getting an equity investor on board is often compared to marriage – be wary about this and evaluate thoroughly whether you, your enterprise, and the investor are a good fit.
Equity investments come hand in hand with an expectation for return on investment
Equity financing might cause the business to lose sight of its initial mission due to the influence of the investors on the direction of the business. This may lead to an increased focus on generating returns over generating water-related impact (Mission drift risk).
|Since investors own part of your company, you will have to share part of your (future) profits with the shareholders.||This has implications that you may initially neglect, but especially if you are embarking on the equity investment train, you should be aware that your shares will be diluted with each new investment round. It is therefore recommendable to project how your shares in the company will likely be reduced in subsequent investment rounds and establish clarity what amount of shares you want to maintain over time to maintain motivation and the right mindset to drive the enterprise to success in the long run.|
|The above are just very few implications of equity investments that can come with very different conditions.||To manage an equity investment round, it is therefore highly recommended to involve an experienced financial advisor, who can help translating the investment world and clarifying the implications of a wide range of important details. Tip: many financial advisors work on a success fee basis (2% – 3% is reasonable) , which is only paid if you close a successful round.|
The following key features and considerations related to Equity are important to understand (partly based on (UBA et al. 2020)):
- Dividends: As a shareholder of the enterprise, the investor will benefit from dividends from those shares. They are usually paid out only with large and established companies, mostly listed in the public market, meaning for investment in private companies, the return is mostly realized through the resale of shares.
- Exit: Investors can realize potential return through the resale of their shares (=exit). Financial markets in developing countries often have low liquidity and depth, making it difficult for the investors to exit their equity investments. The entrepreneur can also have an exit strategy whereby company founders plan to transition the ownership to another company.
- IPO: Businesses that have profitable operations, management stability and strong demand for their products or services might want to carry out an IPO (Initial Public Offering). Meaning that a private company goes public by selling its shares to the general public.
- Common stock: If an investor has common stock, they have a claim on the enterprise’s earnings (or dividends) and have voting rights. An enterprise can also issue different classes of common stock to shareholders. For instance, shareholders with A-class shares might have voting rights and dividends, but those with B-class shares have no voting rights and no dividend.
- Preferred stock: Preferred stocks, on the other hand, have dividends but no voting rights. Preferred shareholders have a higher claim on the enterprise’s assets than regular shareholders with common stock. This means that, in the event of liquidation, preferred shareholders are paid off before other shareholders.
- Performance: While the provider may have return expectations based on ex ante assumptions, actual performance may turn out very different. Returns associated with equity investments are often non-uniform due to the finance recipient’s fluctuating performance.
Preferred stock / equity as a relevant variant of equity
Preferred equity or preferred stock is essentially company equity that acts as a safer, yet less lucrative version of a common stock. As with common stocks, investors receive dividends for the shares owned in the company. Unlike common stocks though, this amount is fixed, which provides a downside protection, but also limits participating in the upside.
Since preferred stocks are typically cumulative, common stock owners will not receive dividend payments until preferred stock owners have received theirs. Although their liquidation priority ranking is junior to debt, it is senior to common stock, meaning that if your company were to go bankrupt, preferred stock owners would be repaid before common stock owners. This makes preferred stock a less risky investment instrument for investors.
A last important feature to mention is that preferred stockholders have no voting rights, limiting their participation in the company decision-making. This makes preferred stocks a good option when you want to raise money through the sale of equity shares, but don’t want to give out voting rights since that would mean less control over your company trajectory.
As with all investments, this specific variation of equity investments has a range of other characteristics you should duly consider. We have compiled more detailed information on this instrument that we are happy to share if you contact us.
Tips to build your investment case as a young water-related enterprise
The water sector is very big and provides lots of investment opportunities for commercial investors. Estimates put the global market for products and services along the human interface with the water cycle (sourcing, treatment and distribution and wastewater treatment and disposal) at over 1 trillion USD per year (Summit Water Capital Advisors, 2017). More still, the sector is not strictly defined and lots of adjacent industries have direct and indirect links, including agriculture (irrigation, fertilizer or soil conditioners that are recovered from faecal sludge and organic waste, etc.) or hygiene (with products ranging from household appliances to hygiene services and products for health care providers).
It is therefore not surprising that equity investments play a key role in the global water industry, which is among others reflected in approx. 400 publicly traded water (or hydrocommerce) companies (ibid). Moreover, many fund managers now see the water space as an investment opportunity for the long-term on an essential commodity that is scarce in many regions (Brightstar Capital Partners, ny).
But equity investments also play a key role in the development of enterprises at earlier stages. To build your case for equity investments the following three scenarios (among others) can leverage sector specific aspects and considerations for a compelling equity-based investment strategy: 1) building an enterprise where investments have already proven profitable, 2) developing and rolling out disruptive business models to overcome key sector challenges and 3) business models that leverage significant development impact and build a strong case for impact-oriented equity investors.
- If you consider equity investments to scale your enterprise, it is key to understand in which areas proven business models exist that attract investments. In the water sector for example, these include among others high-end consumer solutions, data and sensor-based business models to enhance water resources and distribution network management, water purification technologies, quality testing and monitoring solutions, desalination and other water sourcing solutions or wastewater treatment products and solutions. In adjacent areas like agriculture, business models around irrigation systems and sensor or data-based solutions to enhance water use efficiency have managed to attract equity investments. In such areas you need to be highly competitive and build a strong investment case in comparison to similar businesses in the market.
- Beyond such highly profitable business area, the broader water sector faces significant challenges and gaps, where viable solutions are still lacking. Especially solutions for off-grid and decentralized or low-income communities have struggled to become viable. Also other aspects, including cost intensive aspects of network operation and maintenance or logistics remain challenging in different contexts. Around such prevalent challenges, disruptive business models may stand a chance to attract risk conscious investors and venture capital. For this, you need to proof that you stand a chance to convert unresolved challenges into profitable business and hence investment opportunities. Over the past decade business models and solutions to extract or harvest water from air, different types of off-grid water supply (including e.g., pre-paid water kiosk solutions) or container-based sanitation solutions are examples of areas where equity investments have been made into rather innovative businesses.
- Last but by no means least, entrepreneurial solutions in and around the water sector hold significant potential to achieve meaningful developmental impacts, which are a key currency in the emerging impact investing community. With significant challenges related to SDG 6 (clean water and sanitation) and adjacent development goals, including SDG 2 (zero hunger), SDG 3 (good health and well-being), SDG 11 (sustainable cities and communities), SDG 12 (responsible consumption and production), SDG 13 (Climate Action) or SDG 14 (Life below water), environmental and social business models stand to build strong cases for equity investments that recognize impact as a form of return. Sanergy is one of several impact-oriented sanitation businesses that have managed to leverage equity investments. With two early-stage investors recently concluding a successful exit, a strong case for the power of impact investing in the broader water sector has been made (BUSINESS AFRICA ONLINE, 2021).
These scenarios are not mutually exclusive but are often overlapping. With the ambition of contributing towards enhancing impact-oriented entrepreneurship in the water sector (scenario 2 and 3 above), we want to provide a few examples that range from impact-oriented equity funds all the way to impact-focussed foundations, that are meant to make it slightly more tangible how this could be relevant for you as an entrepreneur.
Sub-commercial and impact-oriented equity investments:
- An increasing number of foundations and private investors have started to conduct equity investments with strong expectations on impact returns that often outweigh expectations of financial return. Some of them have an explicit focus on water, sanitation and adjacent industries. Some of the foundations that have such a focus share relevant and helpful information on their strategies and investment approaches. Examples include e.g., the Stone Family Foundation, which highlights the need to develop innovative new business models, rather than new technologies, while at the same time recognizing the need to provide high risk, patient and flexible capital. (SFF 2014) WaterSpark is a global initiative that focusses on accelerating and scaling technological solutions to water challenges in access to safe drinking water, sanitation and hygiene, water scarcity and water quality. With a mission to catalyze innovation and investments in related technology and business models this platform brings together a number of investors and partners to support water-related impact startups and facilitate investments.
Equity investors that engage across a broader return continuum, based on impact considerations:
- Water Equity invests in financial institutions and enterprises that support the achievement of Sustainable Development Goal (SDG) 6 and are committed to sustainable and equitable environmental, social, and governance (ESG) practices. In this endeavour, the fund focusses on enterprises that can significantly expand access to safe water and sanitation among low-income families, while at the same time bearing potential to scale. This includes investing in microfinance institutions, micro-utilities, toilet manufacturers, and water purification and sales kiosks. The Fund states that they manage their portfolio’s impact with the same rigor as our financial performance. Aqua-Spark is another impact-oriented investment fund, that focusses on an adjacent industry fostering sustainable aquaculture SMEs across the value chain, such as sustainable feed alternatives, antibiotic-free farming, innovative technologies, disease battling and market access. (Impact Assets, ny)
Market rate return expectations (with focus on investing in enterprises):
- AXA Impact Fund – Climate and Biodiversity is an example of an impact-oriented investments fund that will invest into impact-oriented businesses. The success of the Fund will be measured according to two criteria, financial and impact. The investments are expected to generate market-rate financial returns. In addition, the fund identified key performance indicators and expects investments to contribute at significant scale to CO2 emissions reduction, healthier ecosystems, habitat conservation, and empowerment of vulnerable people and communities. (AXA INVESTMENT MANAGERS, 2019) Under the umbrella of this impact investing strategy, AXA IM has co-invested into Sanergy. Sanergy collects organic and sanitation waste, then processes these waste streams into insect-based proteins derived from black soldier flies for animal feed, soil-restorative organic fertilizer for sustainable agriculture, and biomass fuel replacing unsustainable firewood and heavy fuel oil in industrial boilers. (BUSINESS AFRICA ONLINE, 2021).
- The Sustainable Water Impact Fund is the result of a partnership between Renewable Resource Group and The Nature Conservancy. This institutional scale framework is focussing on investing in land and water assets. This makes the fund less relevant for early-stage enterprises but we decided to still include it as it reflects an emerging trend to move mainstream financial markets towards impact-oriented investments in water-related areas. The fund aims to improve the management of surface water, groundwater and farms to more sustainably manage water resources, the environment and the agricultural economy, while at the same time fulfilling its fiduciary responsibilities to investors. According to TNC this includes e.g., investing into and operating agricultural assets that sustain the economic livelihoods of farmers and the communities who depend on a vibrant agricultural sector, while at the same time protecting farmland, and achieving very real conservation benefits like building seasonal wetlands, and making water available in streams at critical times for wildlife. (HALLSTEIN, 2020)