Like any venture capitalist, an RIA owner needs a solid grasp of the financing options available for underwriting growth. However, the advantages and disadvantages of these methods can be difficult to see. To shed light, we'll focus on the financing strategies that most RIA leaders use to align capital with business objectives, life cycle stages and market conditions.
Highlighting the significant capital needs within a growing industry, Association of Investment Advisers found in 2021 that over 60% of RIAs manage more than $1 billion in assets. Meanwhile, Cerulli Associates reports a 14.5% increase in the number of VNRs between 2015 and 2021, reflecting the trend of new firms entering the market in need of financing.
For most independent RIA owners, raising capital involves one of three primary instruments: equity financing, debt financing, and convertible securities. Each carries significant implications for ownership, control and financial health.
- Equity financing
This method involves selling shares of ownership in exchange for equity. Early-stage VNRs often rely on this to drive expansion without the immediate pressure of debt repayment.
- Debt financing
Borrowing funds with a promise to repay over time, along with interest, preserves ownership but imposes regular financial obligations. Established VNRs with stable cash flows may prefer this route to leverage their assets while maintaining control.
- Convertible instruments
These hybrid options can switch from debt to equity under certain conditions, providing flexibility for RIA owners unsure of their long-term capital structure needs. This can be useful for startups looking to raise repayable capital either in terms like bonds or – after conversion – as equity.
As suggested, each of these strategies offers advantages and challenges that can affect the structure and development of firm ownership. By researching the pros and cons of equity financing, debt financing, and convertibles, RIA owners can make decisions that more closely match their business goals.
A deeper dive
On the positive side, equity financing provides capital without the burden of direct repayment, allowing businesses to focus on growth rather than debt service. But it reduces the share of the founder and possible profits. For VNRs, equity financing requires balancing the need for immediate funds against the long-term value of holding a larger share of ownership. Giving capital too early can limit future flexibility, especially when it comes time to recruit top talent.
Debt financing allows owners to retain ownership, but it requires incremental repayments, including interest, on a strict schedule. This can choke cash flow. For mature VNRs with liquidity reserves, it may make sense to use existing assets to finance growth without diluting control or ownership. Be careful, though: Repayments can become difficult when market conditions or business results deteriorate.
Convertible instruments hold the middle ground between equity and debt financing by providing initial debt with the option of converting the liability into equity issued to holders of convertible notes. This can be useful for VNRs that require flexibility in terms of repayment, but these instruments can be complex. As a result, the terms of the conversion must be carefully considered to avoid unfavorable results for the firm.
Strategic alignment with business goals
Aligning financing choices with business goals and market conditions is critical. Early-stage VNRs may prioritize equity financing to accelerate growth without debt, while more established firms may use debt to finance expansion while retaining ownership. The prospect of market volatility, which may require flexibility when it comes to financing structures, may also influence these decisions.
Understanding the motivations of capital providers is equally important. Funding from family or friends can offer softer terms, but can complicate relationships if the business falters or misunderstandings occur. In contrast, private equity firms expect returns within specific time frames—compensated, in theory, by the experience and discipline they bring to the table. Clarity about the objectives—whether market expansion, product distribution, or talent utilization—of “strategic” financiers in the same or closely related industries is essential. This can help ensure that expectations are marked with concrete results and managed effectively over time.
Avoiding common pitfalls
Proper care is paramount. Failure to vet potential investors or lenders leads to unfavorable terms and strained relationships. Asking potential partners about past unsuccessful deals can provide valuable insight into how they handle adversity. This approach reveals more about their character and operational style than success stories alone. In short, rushing to deal without a full understanding of the possible outcomes is never wise.
VNRs should also consider alternative sources of capital such as crowdfunding and grants, and maintain a balanced capital structure with a mix of debt, equity and other instruments to avoid over-reliance on one type of financing.
Building and Maintaining Investor Relations
Investors require regular, transparent communication and mutual respect. If properly maintained, these relationships can provide strategic guidance that can contribute to the long-term success of an RIA.
When it comes to fundraising for independent VNRs, informed decision-making is everything. By understanding the pros and cons of each type of capital, aligning financing strategies with business goals and remaining adaptable to market realities, VNRs can make financing a vehicle for adding depth and growth. Building strong relationships with investors, meanwhile, strengthens the potential for sustainable growth against a backdrop of financial stability.
Shirl Penney is the CEO of Dynasty Financial Partners