Background to equity financial instruments
A market perspective
Equity support for ‘high growth’ SMEs in the real economy
SMEs represent over
of the total number of businesses in the EU.
They account for more than half of Europe’s GDP and play a key role in adding value in every sector of the economy.
They are essential to EU’s competitiveness and prosperity, as well as economic and technological sovereignty.
Equity financing plays an important role in the SME market, especially for high-risk start-ups and high growth companies. This class of ‘entrepreneurial’ businesses can be distinguished from others by their aspirations and potential for growth, rather than by their current size.
Equity funds only support a sub-group of SMEs. Many small companies which are profitable and provide a good standard of living and stable employment for their owners and employees cannot be considered as ‘high-growth or innovation oriented’ businesses attractive to equity investors.
Equity investments vs debt/loan financing
An equity investment is different from senior debt or a loan from a lender, such as a commercial bank. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the success or failure of the underlying investment. In contrast, an equity investor receives a stake in the company and, as a shareholder, their return is dependent on the growth and profitability of the business.
Equity investment
Medium to long-term finance.
Investor takes a share of ownership in the company.
Committed until ‘exit’, subject to investor participation on the company’s Board.
No interest is paid, return on investment through a capital gain on sale of shares.
Provides a flexible capital base to meet a company’s future growth plans.
Good for cash flow, as it requires no capital or interest payments.
The returns to the private equity investor depend on the business’ growth and success: the more successful the company, the better the returns of investors.
No security is given to investors. If the business fails, equity investors will rank alongside other shareholders, after the banks and other lenders, and stand to lose their investment.
As business partner sharing business risks and rewards, the investor can provide hands-on advice and managerial expertise to assist business growth and sustainability.
Senior Debt
Short to long-term.
Investors takes a creditor position in the issuing company with no link with ownership.
Commitment subject to compliance with loan terms e.g. loan facilities may be repayable if covenants are not met.
Interest payable regardless of results.
Provides a source of finance to meet short or longer term needs of the company.
Requires stable good cash flow to service interest and capital repayments.
Depends on the company continuing to service its interest costs and to maintain the value of the assets on which the debt is secured.
Security is usually required up to the value of the loan. If the business fails, the lender has first call on the company’s assets through enforcing its security/collateral.
The assistance available varies considerably across debt products and providers. Typically a senior debt provider would not provide hands-on advice and managerial expertise.
Figure 3: Overview of the differences between equity investment and senior debt
In addition to the direct benefits of equity finance, companies often seek equity to secure:
- Knowledge benefits: many equity investors with broad experience and knowledge assist in company management decisions as an advisor or a mentor.
- Network benefits: equity investors can provide their portfolio businesses with access to a strong business network in terms of supply chain, vendors, suppliers, customers, service providers or any other supporting entity.
- Financial benefits: the equity investment may improve the cost of capital for companies and offer an easier way to raise a large amount of capital faster, in particular if the company does not have extensive credit history established with debt providers.
- Certificate benefit: before investing, equity investors will undertake a detailed and professional due diligence process. Following the investment, the company will be required to adopt high quality accounting and reporting practices. A successful fundraising is an indication of the health of the company.
Sustainable food from insects
Bulgarian start-up, Nasekomo is the first insect-based sustainable food production company in South-East Europe.
Nasekomo is an innovative company with a very active R&D department which works independently or in collaboration with leading academic institutions and business partners to develop processes and technologies that will propel forward the insect industry.
Supported by a EUR 1.5 million equity investment from two ERDF equity financial instruments, the growing biotechnology company used the investment to finance their R&D and the industrialisation of their production.
The company is currently closing a much larger financing round (EUR 40 million in total), with the participation of international investors.
This additional investment values the company at EUR 50 to 100 million and will allow the building a 4 000-ton factory in central Bulgaria.
The early commitment by the equity investors backed by the ERDF in the first funding round has been key to enabling the company to attract the initial private sector co-investment in their business.
The Fund Manager of Financial Instruments in Bulgaria (FMFIB) is a Holding Fund that manages EU shared management resources through 13 different financial instruments on behalf of five Bulgarian managing authorities. A robust organisational structure has been set up which has allowed specialist expertise to be recruited and retained.
This has allowed standardised procedures to be developed, for example in connection with selection, monitoring and audit, securing economies of scale and ensuring experience gained with one financial instrument to benefit future operations.
This case study highlights the steps taken to set up the Holding Fund and features the financial instruments set up under the ERDF ‘Innovation and Competitiveness’ and ‘Regions in Growth’ operational programmes.
A Equity market analysis – market conditions in EU macro regionswonderful title
As the equity market is generally more volatile than the debt market, quantifying equity financing gaps as stable over a short period of years proves challenging. The equity financing gaps identified in a recent fi-compass report provide an indication of equity market conditions in each country or group of countries.
Here are the results for the different EU macro-regions: