September 30, 2022
As your business develops, you may need to raise money from external sources to expand your product, grow your business or simply provide working capital. In this blog, we outline the main sources of finance for start-ups, from equity financing to convertible loan notes, to crowdfunding. Let's dive right in.
A very common form of early-stage funding is to offer shares in your company to investors in return for investment, known as equity financing. This is a solution for start-ups that cannot obtain a loan.
Equity investment is not repayable like a loan. Instead, an equity investor invests hoping to make a profit when the company is eventually sold or listed on a stock exchange, but there is a risk that they may not make a profit, or they may even lose their money altogether if the company is not successful.
The downside for a business owner is that by offering shares to investors, you give away part of the ownership of your business, which in turn reduces your entitlement to any increase in its value or profits. Equity investors will usually have voting rights so that they can influence major business decisions and, depending on the type of investor and the stage at which they invest, they may require additional protections such as:
An equity investment round involves several steps. Firstly, you are going to need a business plan and most investors will want to carry out due diligence on your business before committing to invest. You will also need to agree on the company’s value with the investors, as this will determine how much they will pay per share. Once investors are satisfied that they wish to proceed, legal documentation will need to be prepared and signed to ensure that the shares are issued properly in accordance with company law.
The most common type of early-stage equity investors are angel investors and venture capital firms.
An angel investor is a high net worth individual who invests in start-up companies. Angel investors are often keen to ensure that their shares will qualify for the Seed Investment and Enterprise Investment Schemes, which offer tax relief to individuals who invest in early stage companies. You can apply for advance assurance from HMRC that an investment in your company will qualify for SEIS or EIS relief. There are networks of angel investors that entrepreneurs can approach for investment, such as Oxford Capital and the Startup Funding Club.
A venture capital firm manages a fund pooled from different sources (such as individuals and institutional investors e.g. pension funds and insurance companies) and provides capital to early stage companies. Venture capital firms often specialise in targeted sectors, so they can offer industry-specific advice and expertise to your business in addition to funding. However, venture capital firms tend to have a lower appetite for risk than angel investors due to internal requirements and will want to see high growth potential. It is also a highly competitive market.
As outlined above, equity investment involves a process and there can be a significant amount of legal documentation, which takes time to negotiate and can be costly.
A short-term solution is for a company to issue convertible loan notes to investors. A convertible loan note is a loan from an investor to the company which bears interest and converts into shares on certain events occurring, such as a future fundraise or a sale of the company. Convertible loan notes involve less documentation and defer negotiation of the company’s valuation until a subsequent fundraise, so they can be set up quickly and more cost effectively than a share issue.
Convertible loan notes are repayable as a debt if they fail to convert into shares, so they are considered to be less risky than a straight equity investment. However, convertible loan notes are not eligible for SEIS or EIS tax relief which can be a sticking point for investors.
An alternative to equity investment is to explore whether you can obtain a loan. A loan is repayable, usually with interest over a set period of time. The advantage with a loan is that you do not give away any ownership of your business and you retain control of day-to-day business decisions.
There are various sources for obtaining a loan. Many high-street banks offer commercial business loans but they usually require security over a company’s assets to secure repayment of the loan and evidence of trading history and revenue. A start-up business often won’t have any assets to offer as security and may not have started making any money, so a commercial bank loan may not be a viable option.
In recent years, several alternative lenders have emerged that offer loans to small businesses on more flexible terms than high street banks, such as Funding Circle, a peer-to-peer lending platform. However, alternative lenders still charge interest and require regular repayments.
Venture capital firms also provide loans to start-ups, but they tend to require a higher rate of return and there will be lengthy legal documentation involved.
Another option is a government-backed start-up loan through the Start-Up Loans Company, which comes with business support and mentoring services. However, you can generally only borrow up to £25,000 for up to five years and your business must be based in the UK. There are also restrictions on the type of business that can apply and the purpose for which the loan will be used.
Depending on the type of investor and the nature of your communications with them, inviting an investor to purchase shares or make a loan can be subject to regulatory restrictions under financial services and company legislation. These restrictions, together with the fact that you would typically only get an opportunity to pitch to a small number of angel or VC investors at a time, mean that it is difficult to get exposure to a bigger pool, or ‘crowd’, of potential investors.
Crowdfunding is an alternative form of raising finance which has developed significantly in recent years and provides a solution to these issues. Crowdfunding typically involves pitching your business to an online platform which then invites its online community to invest in your business. The crowdfunding platform charges a fee for using its platform which tends to be a percentage of the amount you raise. There are different types of crowdfunding:
Crowdfunding platforms which offer equity or loan-based investment require authorisation by the Financial Conduct Authority and should take steps to check that investors understand the risks involved.
In addition to reaching a broader range of investors quickly, crowdfunding increases awareness of your business and helps to grow your client base.
You may also be eligible for grants, depending on your business type and location. The benefit to obtaining a grant is that you do not give away ownership of your business or accrue a debt, but you will still need to invest time in making the application and preparing supporting documentation, such as a business plan. Examples of grant providers include:
Finally, this may seem an obvious option but many start-up owners rely on support from friends and family during the early stages of their business. The nature of the relationship may mean that you do not need to undergo the formalities you would with a traditional investor and hopefully you can agree more favourable terms, which can save significant costs in the long run!