We understand that getting the right funding in place is critical to the success of a small or medium sized business and that navigating the funding cycle and being aware of the issues that you will need to address can be a challenging and time-consuming process. At each stage of the funding cycle, there are many different options available. There are also a number of common issues that will need to be addressed in order to persuade investors to finance your business, no matter where you are in the funding cycle.
In this article we’ll take you through the stages of the funding cycle.
Nearly all newly formed businesses require some form of funding. Depending upon the business, it may need longer term investment in plant and machinery, or shorter term investment to acquire inventory or to cover operating losses such as advertising and promotional costs until sufficient sales are made for the business to fund itself. At the very outset, funding may come from the founder’s savings or from friends and family. Alternatively a business can approach more professional sources of venture funding, for example from business angels, crowdfunding platforms or specialist venture capital firms either directly or via tax efficient schemes, such as the Enterprise Investment Scheme (EIS).
Once a business is established and its business model proven, it may find it needs finance to grow. Depending upon the size and maturity of the business there is a greater number of sources of finance. For smaller companies, venture capital and private equity firms are possible sources of private equity finance, as are high net worth individuals or their family offices. For businesses that are already profitable and can demonstrate a sustainable level of operating cash flow or earnings before interest, tax, depreciation and amortisation (EBITDA), lenders such as banks, leasing companies or specialist providers of mezzanine or high yield debt will be interested in providing debt finance. For business that have an established track record, it may also be possible to raise public equity finance by obtaining a listing on a recognised stock exchange such as the Alternative Investment Market (AIM) section of the London Stock Exchange (LSE).
Once a business gains a certain size or scale, its owners may decide that they no longer wish to fund the growth of a business because the amounts required are too great, or the owners are willing to cede control of the business. In these circumstances, the owners may wish to consider an exit from the business. This could take the form of a sale of part or all of the business to a strategic investor, such as a competitor. Alternatively, a private equity firm may be interested in acquiring the business should it be able to support leverage or have the high growth characteristics that are attractive to this type of investor. Equally, the business may have a solid track record of financial performance suitable for public market investors and be able to list on a recognised stock exchange to provide liquidity for the owners rather than only the new capital necessary to grow the business.
There are a also a number of issues to address when seeking funding. These include:
Risk and Return
Investors, or providers of equity and debt finance, will all be seeking a return on their investment. The rate of return required will depend upon the perceived risk being taken by the investor: the higher the risk, the higher the required rate of return. To persuade any investor to fund a business the owners or management of the business must persuade the investor that he or she is reasonably likely to be able to meet the required rate of return threshold.
To obtain almost any type of funding, a business will need to be able to communicate as clearly as possible the reasons why an investor should invest in its business. Ideally, this should be capable of being expressed in a few sentences of plain English which make it clear why there is an unmet customer need for the product or service being offered and how satisfying this need makes, or will make, money for the business. This is sometimes referred to as an “elevator pitch” or “investment teaser” and is the starting point for any investment proposal. It is essential because every investor needs to be persuaded that there is compelling reason for the business to succeed and hence to invest. As the amount of funding sought becomes larger and the level of sophistication and specialisation of the investor becomes greater, the quantity of supporting detail accompanying any high level “elevator pitch” increases.
Investors will wish to understand the track record of a business in order to assess the prospects of success of any investment proposal. If the business can demonstrate that is has an experienced management team and a successful track record then the perceived risk and cost of finance will be lower. In addition, the number of interested investors and the pool of available finance will be larger. Conversely start-ups and newly formed businesses with young and inexperienced management teams will normally have to pay more for finance from a tighter group of prospective investors.
Once a business has identified a compelling investment proposal and the reasons why it has the experience to succeed with such a proposal, it will need to create a business plan. This will typically take the form of a presentation document or investment memorandum that describes the reasons for and the amount of funding required as well as the operational steps to be taken by the company to implement its investment proposal. In addition, it will include the business’s financial track record and the expected financial projections that result from the implementation of the investment proposal. Ideally, the plan will show the return on investment that could be made by investors assuming the plan is successful. In addition, the plan may also show how the returns change if some of the assumptions turn out to be different than those assumed (sometimes known as a sensitivity analysis). Most investors will conduct a thorough due diligence process on the business plan to assure themselves that the assumptions in the plan are reasonable and that the management team is capable of executing the proposed plan. This process may be led by an investor, either for itself or on behalf of a group of investors. The process may also involve a number of financial and legal advisers to the investor or investor group. This can be a long and intensive process which places considerable strain on a management team while it continues to manage the day-to day operations of the business.
The structure of an investment varies greatly and will depend upon the particular circumstances of the investee company and the proposed investor or group of investors. At one end of the spectrum, there is an investment in the equity capital of the company. Typically, this is the most expensive form of investment in terms of the rate of return required. It also carries the most risk from the investor’s perspective. An investor will seek to mitigate this risk by maximising its level of influence or even control over the business. It will do this through board representation or in some situations via an agreement amongst shareholders regulating how the business is governed in certain circumstances. At the other end of the spectrum, there is an investment in the form of a loan to the company. Typically, this is the least expensive form of finance for a company. As a result the investor seeks to protect itself through the terms of the loan agreement which may include restrictions on certain activities, the achievement of financial performance covenants and the provision of security over the assets of the business in the event of a failure to repay the loan or other event of default by the company. Between these straight equity and debt structures, there are a range of alternative structures including, for example, convertible loan notes or loans with equity warrants attached, which may be used by more sophisticated investors to combine the benefits of the more basic straight equity and debt structures. These hybrid structures can be beneficial to investee companies if they reduce the cost of finance. There are many considerations to be taken into account in arriving at the most appropriate type of investment structure. As a result, companies often seek input from advisers to ensure that the optimum capital structure is achieved and implemented.
When seeking to raise finance many companies will retain a financial adviser and a legal adviser to assist in the process of fundraising. The financial adviser will typically help the business to develop and present its investment proposal and business plan to a range of potentially interested prospective investors. The legal adviser will typically assist in documenting the funding transaction. Given the broad universe of investors, the financial adviser should be selected based on its ability to locate the right type of investor and to persuade the investor of the merits of the business seeking funding. In addition, the financial and legal advisers should be able to assist the company in preparing an investment memorandum, if required, and addressing the due diligence concerns of the prospective investor. The advisers should also be able to assist in negotiating the optimum funding offer from amongst a number of possible investors. This normally comprises the lowest cost and least intrusive form of finance which is also appropriate to the circumstances of the business. In most situations, with the possible exception of a newly formed startup which may not have the resources to pay advisory fees, it is usual to involve advisers at an early stage in the fundraising process.
If you’d like to talk through any aspects of this article, please get in touch with us.