What you need to know about equity as an alternative investment asset

When it comes to making alternative investments in equity, it’s helpful to think about it in terms of the stage of the company you’re investing in and the type of equity capital you will hold. Equity can be defined as investing in private companies that are not listed on an exchange or investing in a public company to take it off an exchange and make it private.

Private companies have lower disclosure requirements and are typically harder to value and often require thinking and metrics outside the traditional valuation multiples and DCF (discounted cash flow) methodology.  It’s often a strategy about backing management and management teams and their visions more so than financial metrics.  Let’s start by looking at the various stages of equity capital sourcing, which can be thought of as angel, seed, growth capital, pre-IPO and traditional private equity.

Angel stage

Angel investing could be the result of a wish and a dream. The business doesn’t exist (yet), but it’s a nice idea. What matters for an investor at this stage is everyone’s background. If you are going to believe in their dream, ideally, it will be in a sector in which they have some experience. Have they started businesses before? Were they successful or close to successful?

Seed stage

Seed investing is the next part of the journey. At this stage, you have invested time and effort and there are a few dedicated people involved, probably a couple of full-time staff or founders who aren’t earning much money because they’re trying to live out their dream. You’re trying to raise some money to take your rough design to the point where it’s potentially commercial.

Growth capital

Growth capital is sort of an interim step. It’s where businesses have spent a lot of their capital, have likely invested significant sweat capital and simply need more to grow. They may have spent their initial round of capital from the angle and seed stages and only be halfway through building a commercially viable product.

Pre-IPO (initial public offering)

This is the nearly grown-up phase. Business is chugging along, and the founders think there could be an exit coming; however, but the business needs some capital to accelerate into an IPO. Growth capital and pre-IPO are quite attractive investment opportunities because you can see a more predictable path and distribution of potential outcomes and exits.

Private equity stage

Taken literally, this could be defined as any equity in a private company. Although the term ‘private equity’ typically refers to a stage of the investing cycle, it tends to be quite a strategic stage where a reasonable sized investment is made by the private equity firm. The investment usually comes with some control from both an equity ownership percentage and seats on the board.

Next, we will look at the many types of equity capital you can invest in from straight equity to preferred and deferred equity.

Straight equity

Straight equity is the simplest of trades. It’s when you buy equity in a private company (you own part of the company). Angel, seed and even a lot of growth capital investments are straight equity as it’s the only form of capital available to the company at this stage. Straight equity is calculated on a predetermined valuation of the company’s worth at the time you make the investment. There is no maturity, and your investment exists in perpetuity until the company doesn’t exist, is sold, or there is a liquidity event and you can sell your shares.

Preferred equity

Preferred equity is when you invest in a company without owning any of the company directly in return. Why would anyone do this? Because it has a more defined return (if things go well) than straight equity. Preferred equity has equity-like downsides, meaning if the company bombs and the straight equity investors lose money, typically the preferred equity investors will also lose some money.

Deferred equity

Deferred equity is not a typical investment instrument. It tends to be used with staff or advisers to pay them for their services. For example, a company may offer to pay you less than you are worth as it is not yet making money but offers to give you five per cent of the business after two years. That five per cent is deferred equity.

And finally, there are equity options. An option is a contract between two parties that gives the buyer the right to buy or sell an asset at a predetermined price at a specified time in the future. One example is staff incentive equity options, which are often issued for free or at a low strike price, creating alignment of interest between the company and the staff. This is very similar to deferred equity, but with deferred equity, staff get the equity, whereas an option gives staff the right (but not the obligation) to buy equity.

Sourcing equity capital can be a critical step in your growth and success. Although there are many sources of equity capital available, each comes with benefits and drawbacks. Do you really know what you are investing in? Does the business exist or is it still a dream? For your investment to be successful, be sure there a track record of success (or attempted success) from those you are investing in.

Edited extract from Grow Your Wealth Faster with Alternative Assets (Wiley $34.95) by Travis Miller.

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