An equity injection is the introduction of new equity into a company. The purpose of an equity injection is to increase the value of the company and improve its financial position. There are various types of equity injections, including share issues, rights issues, and private placement. Share issues involve the sale of new shares to investors. Rights issues allow existing shareholders to buy new shares at a discounted price. Private placement involves the sale of shares to a small number of investors.
Equity injections can be used to finance a variety of corporate activities, including expansion, acquisitions, and research and development. Equity injections can also be used to reduce debt levels and improve the company’s financial ratios. Equity injections are typically dilutive to existing shareholders. However, they can be accretive if they are used to finance growth or reduce debt levels.
What is an Equity Injection?
An equity injection occurs when a shareholder or investors increase their ownership stake in a company by investing additional funds. The term “equity injection” is most often used in the context of private companies, where owners or shareholders inject additional capital in order to fund growth or expansion.
Injections can also be used to shore up finances in times of distress, such as during an economic downturn. Equity injections can take the form of debt or equity financing, with the former being more common. Debt financing involves borrowing funds from financial institutions, while equity financing comes from the sale of new shares.
Equity injections can be a risky proposition for shareholders, as they may end up owning a smaller percentage of the company if the injection does not lead to successful growth. However, injections can also lead to tremendous rewards if the company is able to use the additional capital to generate new growth.
How to calculate the equity injection
A common misconception among business owners is that the equity injection calculated by the lender is based on the loan amount. However, this is not the case. The equity injection is actually based on the total transaction cost, which includes the purchase price, closing costs, and any additional funds that may be needed to complete the sale.
As a result, buyers should be prepared to provide a down payment that is significantly higher than the loan amount. Only by understanding the true nature of the equity injection can buyers accurately assess their financial needs and obtain the best possible loan terms.
The total transaction cost includes:
- Cost of the business
- Additional capital expenditures
- Extra cash flow for operations
- Personal guarantee
- Other transaction costs
You can calculate the total transaction cost by adding all the costs of buying the business. Equity injection is usually a percentage of that amount.
Example illustrate the point. Here are two hypothetical transactions each with a total cost of £1,000,000 each. These are referred to as opportunities A and B.
- Opportunity A: The buyer gets £400,000 of seller financing and needs to finance the remaining £600,000.
- Opportunity B: The buyer fails to get any seller financing and needs to raise finance of £1,000,000.
Both of these opportunities have the same cost of total transaction. Both buyer A & B need an equity injection of £100,000, which is 10% of £1,000,000. The amount of seller financing they negotiate and the size of the loan they request are not used in the calculation.
Why is an equity injection required?
An equity injection is required by a lender as it lowers their risk. This benefits the buyers and also protects them because it enables lenders to charge lower rates. The three main reasons why lenders require an injection are:
1. Protects against value drops
The injection provides the lender with a financial cushion that protects them against drops in the company’s value. This cushion allows the acquisition to absorb a modest drop in value without affecting the lender’s principal. The idea is that if the company’s value does drop, the lender still has their original investment, plus the injection, to cover the losses.
This type of financial protection is known as a “cushion.” Lenders typically require a cushion when they are making an acquisition loan because it gives them some peace of mind that their investment is safe. In addition, lenders often require borrowers to provide a personal guarantee, which means that the borrower is personally responsible for repaying the loan if the company cannot. The cushion protects the lender from loss in case of default and provides some security in case the company’s value drops.
2. Shows buyer commitment to the transaction
The injection of funds into a business purchase is an important signal to the lender that the buyer is committed to the transaction. Experience shows that buyers who have not committed their own funds to the purchase are less likely to stay on if things become challenging. This is especially important in troubled businesses, where the lender may be forced to take over the business if the buyer walks away.
By requiring a buyer to invest their own funds, lenders can be more confident that they will stay on and try to turn the business around. Injections of buyer funds are thus an important part of any business purchase, and help to ensure that the transaction is successful.
3. Covers valuation differences
In a situation where there is a discrepancy between the seller’s asking price and the lender’s appraised value, an equity injection can help to make up the difference. This is beneficial for both the buyer and the seller, as it allows the buyer to purchase the business at the seller’s asking price while still getting financing from the lender.
An equity injection can also help to close the gap in situations where the buyer and lender have different appraisals of the business. In this way, it can provide much-needed flexibility in business transactions.
The transaction could be structured as follows:
- Lender valuation: £800,000
- Seller price: £1,000,000
- Loan: £720,000 (90% of £800,000)
- Equity injection: £280,000 (£80,000 + £200,000)
Can I finance the equity injection?
If you’re thinking about starting a business, one of the first things you’ll need to do is find a way to finance your venture. One option is to inject equity into the business. This means that you’ll use your own personal funds to finance the business. However, there are some important things to keep in mind if you’re thinking about injecting equity into your business. Buyers cannot finance the equity injection. The funds must come from either the seller or from loans.
Allowing buyers to finance their equity injections would defeat one of the primary purposes of having them in the first place. Buyers would not have any of their own personal funds committed to the business, and as a result, they would have no financial incentive to stay on if the business ran into problems. Consequently, it’s important to make sure that you have the necessary funds in place before you inject equity into your business. Otherwise, you may find yourself in a difficult situation down the road.
Equity injection sources
Equity injection sources come from personal sources. The most common equity injection sources include:
1. Personal savings
Personal savings is probably the best and safest way to get the funds for buying a business. By diligently saving a portion of their salary every month and putting it in a savings account, buyers can accumulate the money they need over time. This method can take several years to reach the objective, but it offers peace of mind knowing that the money has been saved without any risk. Additionally, personal savings offers the benefit of being able to purchase the business outright, without having to take out a loan or bringing on any partners. For these reasons, many buyers start saving for their acquisition years in advance.
2. Personal investments
Personal investments are often seen as a lucrative way to make some extra money. However, personal investments can also be used to cover the cost of an equity injection. When using this method, buyers can liquidate their existing stocks and mutual funds in order to raise the necessary funds. This option does come with some risk, as investments can fluctuate and lose value. However, for buyers who are diligent in building up their investment account, this option can be a viable way to cover the cost of an equity injection.
3. Working with partners
One option for buyers who don’t have the necessary funds to buy a business outright is to bring on partners. Working with partners can provide the buyer with the extra capital they need to complete the purchase, while also giving the partners a stake in the business. Keep in mind, however, that partners are also owners in the business and must meet all of the financing requirements. This means that buyers should carefully consider their choice of partners and make sure that they are aligned with the buyer’s goals for the business. Done correctly, partnering can be a great way to finance a business purchase. However, it is important to choose partners wisely and ensure that everyone is on the same page regarding the business’s future.
4. Retirement funds
Retirement funds are vital to many people’s financial security, and tapping into them should generally be a last resort. Retirement savings have usually been built up over many years, and depleting them could leave an individual without the resources they need later in life. Additionally, using retirement funds to finance an acquisition is essentially gambling with one’s future; if the business deal goes south, the buyer could find themselves in a very precarious position. For these reasons, we typically advise buyers against using their retirement savings to fund an acquisition. However, we understand that each situation is unique, so we always encourage buyers to speak with a financial advisor to explore all of their options.
5. Home equity
Home equity is the portion of a homeowner’s property that is worth more than the outstanding balance on their mortgage. Homeowners can often borrow against their home equity to get extra cash, using it for anything from home improvements to investing in a small business. However, this strategy is very risky, as the borrower is essentially betting their home that the venture will be successful. If the business fails and the borrower is unable to make their loan payments, they could lose their home.
For this reason, most experts advise against using home equity to fund a small business. However, in some cases, it may be the only option available to the buyer. Before taking this step, be sure to consult with a financial advisor to ensure that you are making the best decision for your situation.
Need more information
Business buyers who have a short fall and in need of an equity injection to cover the short fall, we have a number of financial products that can help. Simply complete the online enquiry form and one of our equity injection experts can help.
How does an equity injection work?
A equity injection works is an investment of funds borrowers contribute into their business before being granted a government guaranteed loan. It essentially functions as a down payment for the loan and demonstrates that the borrower has some skin in the game.
Why is investment called an injection?
An investment is called an injection into the economy because it is used to create new capital or replace existing capital in the economy. These capital additions work as assets and so inject income into the economy.
Seasoned professional with a strong passion for the world of business finance. With over twenty years of dedicated experience in the field, my journey into the world of business finance began with a relentless curiosity for understanding the intricate workings of financial systems.