According to a survey commissioned by specialist lender Shawbrook, one in ten small and medium sized businesses (SMEs) that struggled to access funding have eventually folded, 72% of SMEs have had difficulty accessing financing, and 29% have delayed major investments due to insufficient funding.
High interest rates and tightening lending criteria have severely limited affordable financing. There is no denying that the current investment market is sticky, paralysed, cautious and/or just plain slow.
Investors are battening down the hatches on their current portfolios, recognising that they will need all of their financial resources to keep existing investments afloat. They have little appetite for new risk. Aside from the EIS investor syndicates, there appears to be very little new money for SMEs.
What is Series A funding?
Series A funding is the next round of funding for startups after the initial seed funding. Series A funding typically takes 10–30% of the business and lasts around 12–18 months before further capital is required.
Time to secure funding
In the current economic climate, chasing a Series A can be a far more protracted process than management initially intended. It swallows up management time as founders attend endless pitch meetings and management update business plans, focusing on fundraising rather than building the business. Employees become disgruntled as the company tries to operate on a shoestring and is unable to grow with a small workforce. Management tire of chasing their tails; without funding there can be no growth, but investors want to see viable growth and realistic projections before they invest.
Intermediaries promise help with introductions, drafting projections, and using their networks but their services often cost a monthly fee and are not purely contingent on closing the financing. Engagement letters should be reviewed thoroughly before engaging any third party to assist. However, they won’t necessarily speed up the process and can be costly. Management and their current shareholders also have a vast network of their own contacts (including those of their lawyers) in the first instance and a new strategic investor or hire can bring in their own leads.
Securing investors, assisting due diligence, negotiations and instructing legal documentation all take time. It is essential for the board to factor in a realistic timescale to close a fundraising round in the current climate in order to manage cashflow and be fully aware of solvency issues.
Finding the lead
In the wake of Theranos and FTX, investors are especially cautious about investing in sectors requiring specialist knowledge and often require a lead who:
- has sector expertise;
- understands the science;
- has the resources to complete extensive commercial due diligence; and
- is willing to take the risk of a substantial proportion of the investment available.
There are some investors and angel syndicates who specialise in biochemistry or AI due diligence; however, they do not always have the deepest pockets, whereas corporate venture often has the sector expertise and resources, together with substantial funds.
Once the lead has committed, co-investors tend to fall in line and confidence grows.
Getting the house in order
Before opening any data room up to investors, management should ensure that their house is in order. NDAs should be secured and any skeletons aired with advisers before documents are shared. Whilst a Series A is no exit, it is still a sale of sorts and the cleaner and more ordered the house, the more compelling the management team. If this process begins at Series A, then it is easier to update for Series B and C, requiring only a little sprucing up for the final exit and a higher multiple for an orderly house.
Structure the investment
Funding desperation can blinker a company into accepting any money from any investor on any terms. Founders might argue that some immediate investment is better than no investment at all and cannot consider anything more complicated than a stop gap, short raise to take them into next year. It is more efficient to try to secure the investors at Series A for the follow-on Series B by tranche investments, subject to milestones and an uplift on the pre-money value on second close to reflect the hurdles. Milestones should be drafted carefully to avoid future disputes but this structure avoids management re-engaging with investors and opening up the documentation. It can save on legal costs and management time whilst securing committed investors who are contractually bound to follow their money.
Many companies factor in a follow-up investment at the same pre-money within a few months of completion. This can help those investors unwilling or unable to commit at first close. Follow-on investors sign up to the subscription and shareholders agreement by a deed of adherence and shareholder authorities are secured at first close, simplifying the company securing additional investment and not locking out those who are late to the party.
Finally, and all too frequently, companies operate a sticking-plaster approach of a convertible bridge loan from existing investors, until the next equity round closes. The loan notes may be secured (although this sends a worrying signal to third-party investors that shareholders are worried about the viability of the business) and convert automatically at a 20–25% discount to the next full equity round. Companies should limit the possibilities of repayment of the loan notes to hard insolvency triggers (given the delicate nature of the balance sheet) and automatic conversion on an exit and next equity financing. Before issuing the loan notes, the board might consider carving out any existing anti-dilution protection in the articles from conversion of the loan notes into equity, or current investors as loan note holders could secure a double benefit of discounted and bonus shares.
Companies should remember that desperation does not attract the investor community. After an investor withdraws their interest, management should always ask for constructive criticism. Before re-engaging, management might consider restructuring the business, spinning out those parts of the business which are problematic or even winding up the original company in a pre-pack administration and starting over.
The boom of Silicon Valley Bank has gone but innovative venture debt is still available and sometimes where you least expect it. Some providers are exploring loans against R&D tax credits and government grants (Innovate UK) but how long this will be available remains to be seen, given government warnings about availability of R&D tax credit. Suppliers could be issued with share warrants in lieu of the company shouldering price increases. Creativity is the key to survival, and it is worth exploring solutions with your lawyers and stakeholders in addition to the wider investor community.
If you have questions or are seeking Series A funding, please contact Catherine Williams.
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.