Equity Financing

Private Equity Financing

What is it?

Private equity financing simply means that the company, usually at the earlier stages of development, obtains funds from private sources in exchange for giving up an ownership stake of the company. These investors are closely engaged with the management and governance of the company, with the sole purpose of financial returns either through dividends or capital appreciation. These private sources can come in many forms, more commonly from wealthy individuals, investment funds, or institutions.

Venture Capital (VC) is a special class of private equity financing. It focuses on young start up companies and in addition to providing financial support, also renders management guidance, industry expertise and even networking channels. Typically, the VC would be closely involved in the governance and monitoring of the firm, until it finally cashes out by selling its stake (or part of its stake).

Who qualifies for it?

There are no formally established criteria, which regulate the private equity market. Hence, in that respect, any company is qualified. However, one must bear in mind that the private investor (in any form) is taking on a huge amount of risk by investing in an unquoted company with no market valuation, and more often than not, with uncharted financial records. Hence, it only makes sense that these investors would also demand higher levels of returns to commensurate the higher risks assumed. After all, most of these funds and investment houses are themselves under market scrutiny.

Companies that seek funding from private equity investors are usually start-ups with a sound business model or innovative break-through, or companies that have just established a respectably sized operation and require funds for expansion. In short, these are SMEs with either great potential (for e.g. one with a patented technology) or a solid foundation (for e.g. network of suppliers and customers). Such companies are likely to appreciate quickly in value (net worth), and are thus lucrative targets for private investors such as VCs.

What are the advantages and disadvantages?

Before obtaining private equity financing, SMEs need to weigh the advantages and disadvantages. They are detailed as follows.

Advantages

• Private investors such as VCs usually have significant business and industry experience, contacts and networks (supply-chain, marketing, clientele), which will be useful to the company, especially at the Start-Up and Growth stages.
• The backing of a reputable private investor will lend considerable credibility to a company, and open access to other forms of financing such as credit lines from banks.
• A privately negotiated deal between the private equity investor and the company usually means a high degree of flexibility in structuring, to meet the needs of both parties.
• Compliance and regulatory requirements are considerably lower, compared to debt and public equity financing. Reporting and communication can be negotiated and tailored to meet the needs of both parties.

Disadvantages

• To a certain extent, there is a loss of autonomy in decision making by having private equity investors that are heavily 'entrenched' in the decision making process of the company.
• Private equity financing often comes with a whole host of terms and conditions, including clearly spelled out expectations such as annualized returns, performance benchmarks, and other caveats which aim to protect the interests of the private investor often at the expense of other minority shareholders.
• Powerful private equity financiers such as VCs may seek to protect their larger investment interests in other firms (or markets) by enforcing restrictive non-competition clauses on the Management or shareholders, or forcing them to engage in business practices, which are unfair to the firm.

What are the risks?

Obtaining private equity financing is not without risks. Some of the risks include:

• The private equity investor may replicate the business idea that he was presented with and pass it on to another established company where he holds ownership stakes.
• Private equity investors may use the company to further the cause of other companies where they have larger investments. For example, he may force or influence the company into supplying materials to another company at below-market prices.
• Performance-oriented private equity investors may withdraw their funds if the company does not perform in accordance with the required returns.
• Since there is no market valuation for the stake in the company's shares, the company may be 'under-valued' by private investors with strong bargaining power. This is especially so if the Management of the company has comparatively less information.

Public Equity Financing

The alternative to obtaining financing from private equity sources would be to obtain funds from the investing public by listing the company on the stock exchange. The chart below shows the progress in the growth of the Singapore Stock Exchange.

What is it?

Briefly, an IPO process involves the following key steps:

Simply put, the company seeking financing 'lists' a majority share of the company for sale. In effect, it is not very different from the sale of goods and services, as it involves a similar process of branding, marketing, distribution and accounting. The main difference is that market forces will largely determine the 'price' (the demand and supply, or trade, of the company's shares on the stock exchange).

Who qualifies for it?

Unlike private equity financing, SMEs that plan to get listed have to satisfy a host of listing requirements set by MAS as well as the Singapore Stock Exchange. These criteria can be separated into quantitative and qualitative, as shown below.

What are the advantages and disadvantages?

Unlike private equity financing, SMEs that plan to get listed have to satisfy a host of listing requirements set by MAS as well as the Singapore Stock Exchange. These criteria can be separated into quantitative and qualitative, as shown below.

It is important that companies considering IPO as an avenue for obtaining financing evaluate both the advantages and disadvantages of doing so, so that their objectives can be met while avoiding common pitfalls. These are detailed below and summarized below.

Advantages

• Public listed companies may find it easier to raise funds for expansions, diversification and working capital needs.
• Directors and certain large shareholders will be able to reduce personal funding and guarantees.
• A company that is listed on the stock exchange is able to realize value-add for the shareholders beyond that of the book value. For example, a share in the private entity may be worth only $5. Traded on the equity market, the shareholder's share may be worth $7, thus realizing a $2 tax-free capital gain.
• Listed shares can be used as 'currency' to facilitate mergers and acquisitions, which may expand the scale and scope of the company's business and operations, and reap greater value enhancement.
• Listed companies usually enjoy more prestige and credibility, making it easier to obtain other sources of financing such as bank loans with better terms. The goods and services of a listed company often command more brand equity and awareness.
• In addition, a prestigious listed company also attracts better talent and human resources, thus ensuring succession in the management team. Another way in which a listed company can retain talent is through Executive Share Options (ESO) schemes.

Disadvantages

• Listed companies have to comply with a huge list of rules and regulations from MAS, the Singapore Stock Exchange, as well as other regulatory authorities. Compliance with these rules often involves expenses such as auditors' fees, legal fees etc. More resources (money and manpower) have to be committed to meet stringent financial reporting requirements such as the recently imposed 45-day reporting rule.
• Listed companies have to disclose information on their annual reports (and other periodic announcements). Hence, companies have to constantly balance between keeping shareholders informed (an expensive activity commonly known as 'Investor Relations', which has impact on share prices) with the risk of disclosing too much information to the benefit of competitors.
• Much of management's time has to be dedicated to meeting statutory demands such as holding meetings, financial reporting, and investor relations activities.
• Listed companies are under more scrutiny from the public (investing and non-investing) and authorities. Financial information needs to be disclosed in the annual report in a timely manner, and listed companies need to spend the necessary resources to ensure that.

What are the risks?

Despite the highly publicized glamour of IPOs, getting listed (both pre and post listing) is a risky activity. Some of these risks include:

• Not meeting the application submission deadline set by MAS.
• Over-valuation of IPO price, resulting in under-subscription (subject, of course, to the scope of the underwriting agreement).
• Flouting of financial reporting and other statutory rules and regulations, resulting in costly fines, bad publicity or even suspension of operations, and personal liabilities of directors or shareholders.
• Not meeting market forecasts of earnings and operating performance, resulting in plummeting share prices and unhappy shareholders. A related risk is that management who are assessed and compensated based on share prices will be tempted to manipulate earnings (and engage in other fraudulent activities) to meet forecasts.
• Risk of hostile takeovers. Listed companies are easier targets for 'corporate raiders' and other aggressive companies that expand via M&A strategies.