It is the perennial question: you need funding to grow but what will it cost you? Debt funding, if you can get it, is cheap, though has a cash flow implication. Equity funding has no cash flow implications, but is expensive as it will cost you part of your company. So what do you do?
For most early stage companies money is the big issue. You need cash to grow, so where can you get it from? There are the following sources of cash for early stage businesses:
- bank debt, personal debt and private lenders
- angel and third party investors
- other ‘friendly’ investors (e.g. suppliers, customers, business partners, friends and family)
- invoice discounting
- asset finance
What is the best source of funding?
The first thing to bear in mind is whether you really need funding? All early stage companies should be spending as little as possible and be concentrating on sales. Sales bring revenue and allow organic growth; they also validate your business. For most businesses this is the best way to grow, but it may well be slow.
Grants are great; they are free money – the holy grail. The problem is they take ages to secure and they are generally hard to find. All grants are governed by different criteria so it is hard to provide any specific advice. One general word of advice that does apply to all grants is “do your homework”. The body giving the grant will tell you what it is looking for, but consider speaking to companies who recently received a grant; how was it for them? What did they do to stand out from the crowd? What is the funding body really looking for? Also consider the time and effort required to apply for the grant in question.
Equity investment and business angels
Equity can be expensive. It means you have to “give away” part of your company. It would be likely that, in the early stages, your company will have a low turnover and not yet be profitable. As a result the investor will attach a very low value to it, meaning you may well get very little cash for the equity you are offering. You will no doubt attribute value to future sale, but this is very hard to quantify and investors and companies rarely agree on valuations. As the investor can always choose to walk away, typically it is the investor dictates company valuations. They will take anything you say as opinion and not fact and, as a rule of thumb wont value any pre-revenue business over £500,000.
There are lots of angel networks out there (Angels Den, Cambridge Business Angels, London Business Angels, Advantage Business Angels, Thames Valley Investment Network, Angel Investment.
Network, Beer and Partners etc), but they mainly have one thing in common, they are managed by network managers whose job it is to match investors and companies. The fees charged by the networks normally include a joining fee and a commission based on the amount raised. You should make a point of finding out the fee levels and when you have to pay them as early as possible. You should also watch out for a situation where you raise funding independently from the angel network, but still owe them a commission on the amount you raise. This is especially important if you approach more than one angel network. Again, if you do use an angel network, do speak to others who have been there already; find out what it was like; find out what the angels are looking for – are they after a business like yours?
Where other sources of funding are not available (they usually are not) then do try the angel networks; but go in with your eyes open. Where possible try to find angels that know something about the market you are in, do not go alone if you have a business partner and do not be afraid of admitting risks to your business – the investor is investing in you, not just your product, and will want to know how you cope with adversity and that you have a balanced view of the market. But, do not be disheartened; angel deals are closing every day successful companies will always attract funding at acceptable valuations.
Angel investors typically want EIS treatment. If you don’t know what this is then you need to! A further Keynotes publication looks at this important issue. In short, EIS is a government funded tax break and guarantee for investors to de-risk their investment in you, ay little or no cost to you.
Venture Capital Houses
There is much talk of Venture Capital Houses. VCs are usually only looking for scalable businesses and rarely invest in early stage companies. The price of their money is can be very high; they will require a significant degree of control of your company and typically only invest over £2 million. VCs probably are not for you… yet.
VC money and angel money are chalk and cheese. Angels are investing their own money and happy with risk, providing they understand it and trust the founders. VCs on the other hand are the custodians of the money of their own funders. They are looking for a return on that capital for their investors and the ability to pay their fees. As it’s not their own money they won’t be making up their mind as to whether to invest in early meetings with you, instead they will be engaging in long and detailed due diligence. Often taking many companies through the process and investing only in one.
Before contacting a VC find out about the nature of the fund, what it invests in and when. Also find out who you know there, either directly or indirectly. VCs get 30 or so business plans every day. This means you would stand a better chance if you can get to a named person there and further that your initial ask of the VCs time is just 2 minutes to read a summary or email. Consider this request and then consider the standard request of please read my business plan. VCs have day jobs too!
Arm’s length investors are hard to come by; you can improve your chances of securing equity investment by looking for the right investor. In short it is best to choose someone who wants you to succeed. This might mean they are your friend or a member of your family, or it might mean that they are or will be connected to your business in some way, e.g. customer, supplier distributor or a funder of very similar or complementary businesses. Equally, the investor could be your true business partner. Generally, it is very hard to launch a successful business single-handedly. Skill sets tend to fall into groups, such as admin and deliverability, sales and accounting. Where you need to make use of further skills (you cannot be an expert in everything); then consider finding a partner with whom you can work. If such a partner has both cash and complementary skills then, taking investment from him/her, might be just the ticket.
Asking friends or family for investment if often easier and more successful. However, often the money they are investing is money they cannot afford to lose. Do consider that at the very early stages (i.e. the realm of friends and family investment) there is no objective valuation and founders will not have tested the value of their business with third party investors. The result means in most cases that friends and family pay far too high a price for their shares and when a later investor comes along it will be at a lower valuation. This can be difficult to explain to your friends and family investors.
The use of convertible debt might be a solution to this and a separate Keynotes publication looks at this investment medium. Straight debt seldom works as the business is rarely able to repay the loan and in most cases the terms of any future raise might be that the creditor who has provided a loan converts it to equity or waives the debt.
The terms of any deal are vital. Most investors will require you to sign a term sheet and then a shareholders agreement (even if they do not, it may well be in your interests to anyway), so you need to know how to avoid the investor imposing unacceptable terms. For some guidance in this respect please see the article set out below, “Angel investment in your company”.
If you need cash to grow and you can get a loan, then do seriously consider this; loans are cheaper than equity. The type of loan will be determined by the identity of the lender.
Who will lend to me?
You and your directors -most businesses are funded, initially at least, by their directors/shareholders. These sorts of ‘friendly’ loans typically do not require a loan agreement, although it is a good idea to document how much has been advanced. If you are a director and you loan your company cash, you can use this to your advantage. First, any interest the company pays you can be deducted from the taxable profit, meaning that your company should pay less tax when it moves into profit (if the loan was interest free and you received a corresponding dividend instead then this deduction would not apply, despite the fact that you would receive the identical return). Watch out though that you choose a normal rate of interest and a simple loan. If the interest rate is excessive, if the interest is linked to profits or has certain equity rights (such as conversion rights), then it will not be deductable. If in doubt, you should ask your lawyer or accountant. Second, when your company becomes profitable you can have your loans repaid. This is a simple procedure, whereas if you invest through shares in your company then it is more complicated and expensive to turn those shares into cash later.
Friends and Family -if your business borrows from any non-commercial lender you should consider entering into a simple legal agreement with that person, regardless of their relationship with you. It can be as short as you like, but should at least deal with the amount advanced, repayment date(s) and interest. Unless you stipulate otherwise, any loan to the business will be repayable on demand (i.e. repayable at any time). You might also like to address whether you can overpay in part or full at any time. Agreeing the basics may be useful to preserve good relations with the lender! Also, do note the comments made earlier about the extreme difficulty companies will have in repaying very early stage debt.
Banks -banks are currently imposing very tough lending criteria, making it hard for early stage companies to secure a bank loan. Bank lending is a subject in itself. A future Keynotes publication and event will look at this issue and the government’s loan guarantee scheme.
Social lending – the poor supply of bank debt, coupled with the high demand for it has lead to the phenomenon of ‘social lending’. There is no magic to it; it is borrowing from people, not banks. The same tests typically apply, but the hurdles may be set slightly lower. Accordingly the lender may take some small element of risk, but will expect a higher rate of interest to compensate. You might like to have a look at www.fundingcircle.com, www.zopa.com and www.firstfunding.org.
Invoice discounting is just a way of accelerating the receipt of cash from your customers. Where you have a trading business and you have a regular income through invoices to customers, who pay in accordance with your normal terms, then you can approach a bank or an invoice discounting house, who will essentially lend you money against your customers’ debts to you. The bank will advance about 80% to 90% (depending on the provider and their assessment of your risk) of the outstanding value of your sales invoices, with cash usually being advanced within 24 hours of the invoice being raised. The invoice discounting company will secure its lending by taking a charge over your book debts and will charge a monthly fee in addition to interest on the sums advanced. Discounting is often seen as an alternative to bank overdraft funding but it may be expensive and may also tie you in to a long-term contract. It is also commonly available only to businesses with an annual turnover in excess of £500,000.
All the big banks offer invoice discounting, but it is expensive and you often have to pay for the facility whether you use it or not. A new breed of invoice discounting is slowly coming to the fore. One example of this is Market Invoice (http://www.marketinvoice.com) . Instead of paying for a facility Market Invoice will allow you to trade individual invoices through their platform. It’s piecemeal, but can be an attractive alternative for early stage companies dealing with well established customers.
This does exactly what it says on the tin and it is no different from buying a car on finance. Asset finance can be arranged with the seller of the goods (almost invariably capital assets such as photocopiers, IT hardware and plant and machinery) or from a dedicated finance house/bank.
Think very carefully whether you need someone else’s cash and don’t underestimate the cost of capital. In a very real way you will cease to work for yourself and start to work for your investors. This is commonly forgotten. If you do go out for investment, then do so as late as you can. The later you seek investment the less risk you will present to investors, the better the valuation you will receive and the easier it will be. Consider friends and family first, but be upfront about valuations. Then consider finding a third party within your industry. If both fail, then try banks and angel networks, but do not expect it to be easy or quick! It might take 9 months so make sure you are raising cash for at least 18 months otherwise you’ll forever be fund raising and never at your desk.
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.