That Lightbulb Moment: Equity Finance or Debt Finance?
In previous articles, we have looked at fundraising and what founders need to do ‘to get investment ready’, but what do we mean by ‘investment’ and what types of investment are appropriate for start-ups?
It is important to understand that no one-size-fits-all. To raise funds to launch and scale a business founders need a firm grasp of the types of investment that are available, and what will work best for their business.
A start-up’s initial source of funds typically comes from both founders’ savings and minor investments from close friends and family. The terms on which these funds are raised are very light, and typically (although not always helpfully) undocumented. F&F rounds, therefore, provide quick and easy money, but it is unusual for this to sustain business costs and expenses for any substantial period.
With that in mind, from the inception of the business founders are well advised to investigate what funding options are available and the types of investment that are appropriate depending on the nature of their business and their strategy for short term and long term growth and development.
Start-ups need to access funds quickly to:
- Validate and develop a minimum viable product to take to market
- Employ staff to develop and build the product
- Cover marketing expenses and attend events
- Build and maintain a website
- Generate a sustainable working capital cycle so that it can purchase and maintain sufficient levels of stock and pay suppliers on time
- Rent new office premises for staff to work from or manufacture its products
- Acquire appropriate IT hardware and software
- Achieve legal compliance and pay professional fees, such as lawyers and accountants
- Purchase appropriate insurance policies, such as Employers’ liability or product liability insurance
Having quick access to the right level and the right type of funds can mean the difference between beating a competitor to market with a better product and the business stalling and failing. A comprehensive business plan should be prepared early to intricately document (i) what funds are needed to get the business to specific milestones and (ii) the businesses’ cash flow requirements.
Key funding options for start-ups include:
- Business grants, which might be sector or region-specific;
- Government finance e.g. the Government-backed Start Up Loans scheme (up to £25,000);
- Alternative finance, such as factoring;
- Debt finance (bank loans or bonds, debt-based crowdfunding, credit cards or other lines of credit); and
- Equity finance (angel investors, Venture Capitalists, equity crowdfunding).
When considering what type of investment is appropriate, a founder should consider:
- What is the business structure?
- How much capital does the business have?
- What are lenders’ interest rates
- How fast is the company growing and what size will it become?
- Is the business idea ground-breaking or disruptive?
- How much is being raised?
- How quickly does the business need the cash?
- Will the business need to raise more and when?
- Does the business have any material trading history?
- Does the business have good cash flow?
- Does the business have a credit rating?
- Does the business have any assets or property to use as collateral?
- What is the level of risk in the success or failure of the business?
- What level of interest is there in the business?
- Do the founders need additional support and mentoring?
Understanding that a business is not suited to debt finance or equity finance will soon become apparent. Founders should avoid a blanket approach to raising investment, and instead use the preparation of a business plan, growth forecast, management accounts and any investment pitch document to focus their minds about the type of investment that is going to work for their business. Raising private equity from investors can be a complex and time-consuming exercise, and founders will want to avoid expending energy on pursuing other investment options, which might not complement equity finance. Founders should try to develop a clear investment strategy from the outset and stick to that.
Now we will look briefly at the two main types of finance – equity finance and debt finance.
Venture Capital / Equity Finance
The UK boasts a substantial number of active venture capital firms (VCs), which are based predominantly in the City. VCs provide different levels of funding to support the growth and development of start-ups and early-stage businesses that have the potential to become industry leaders and disrupt markets. Start-ups raise venture capital, which is a form of private equity investment, from VCs in exchange for issuing equity in their companies to the VC.
Equity finance investors come in all different shapes and sizes, and start-ups may receive investment from any one or more of these types of investors:
- Family and friends
- Individual high net worth or angel investors
- Angel Investor Networks
- Family Offices
- Venture Capitalists
The terms on which investment is provided by each of these types of investors may vary significantly. VCs and other experienced investors will understand the minimum level of protection that they need with regards to their investment, and how they expect the investment to generate a return for their investors. Start-ups may have more flexibility on the terms of the investment when dealing with high net worth individuals and angel investors during the earlier stages of the start-up’s journey.
We will consider in future articles how VCs work, and the headline terms start-ups must consider when raising equity finance from experienced investors, and how those investments are ultimately documented.
It is well recognised that the cost of equity finance is typically more expensive than the cost of debt finance, and this is because of the equity risk premium it demands given investors higher exposure to risk and financial loss. Of course, unlike a bank, an investor has no guarantee of any income in the form of dividends, which is linked to the business profitability, and there is also no guarantee of any increase in the value of its shares. Some early-stage businesses may seek to mitigate this cost by using a carefully balanced hybrid of equity and debt finance.
Founders may be reluctant to give up equity to investors, particularly if they believe that their business is going to enjoy quick growth and become highly profitable in the short term. Those founders will likely turn to borrow money from online lenders and use agile funding options such as invoice discounting and peer-to-peer lending.
Aside from retention of ownership, key advantages of raising debt finance over equity finance are:
- it builds up a credit rating, improving the chances of success for future funding applications;
- it is easy to understand the cost of servicing the debt;
- all the funds are available once the application is approved; and
- it can be less time-consuming and uncertain than equity fundraising;
However, an early-stage company may have difficulties in securing debt finance because:
- it has already raised debt finance and is heavily geared;
- it is not well placed to complete long, detailed applications designed for larger corporate entities with detailed trading histories;
- it does not have the time to attend physical meetings and wait weeks or months for approval, or worse, rejection;
- it has no material assets to use as collateral;
- it has unproven business models and forecasting abilities;
- it has no or minimal revenue and poor cash flow;
- it has bad credit history;
- it has no or low profitability; and
- it has no, or a lack of sales history, with no fancy revenue figures to impress the bank manager.
Many start-ups seek to raise debt finance from online lenders, which typically have less detailed application processes and can transfer funds quicker than traditional high street lenders. Credit brokers might be used to introduce the start-up to their panels of lenders, helping the start-up to achieve the best possible loan terms.
Although some lenders are prepared to loan to start-ups without securing the debt, they will typically ask founders to provide Personal Guarantees. Of course, this then shifts a lot of risk onto the individual founders in their personal capacity, putting their family homes and other personal assets on the line.
In conclusion, founders must take care to understand at a very early stage the nature of their business and understand its short-term and long-term goals. Will the business be more successful with backing from a bank that wants regular fixed repayments of capital and interest or support from a VC which will take a stake in the business and want involvement at the board level? To understand how a VC might impact the business you may want to read our previous article “How to get investment ready”.
If you need any advice or guidance in relation to raising investment, please get in touch with Ollie Flowers.
This update is for general purposes and guidance only and does not constitute legal or professional advice. You should seek legal advice before relying on its content. This update relates to the prevailing circumstances at the date of its original publication and may not have been updated to reflect subsequent developments. If you have general queries about our updates, please email: firstname.lastname@example.org