Raising capital to support the growth plans of your Internet or technology business is a critical decision. Your choice of financial partner can fundamentally alter your business activity, so it’s important to understand the strengths and weaknesses of each source of capital.
Debt finance
Debt finance is obviously preferable to equity finance, if it is available, as there is no dilution to existing shareholders. However, young technology firms rarely have the three years profitable trading history or the positive cash flow required by banks to get this type of financing. ‘Soft loans’ from friends and family are the most common type of debt finance for startups. It seems an easy solution but familiarity between you and your lender can be problematic. Any changes in your ability to repay could lead to strained personal relationships.
Equity finance
Equity funding – such as angel investors, venture capital (VC) and private equity (PE) – works on the basis of investing varying degrees of capital in your firm and, in exchange, receiving an equity stake in your business. Equity funders usually require special rights, either to protect themselves if they become a minority shareholder, or to ensure control if they end up a majority shareholder. If you are successful, you must ensure you’re comfortable with a smaller share in a larger, more profitable company. Also, these investors have their own and their backer’s expectations to meet. Failure to perform as required could result in a lot of pressure to deliver results.
Angels
Angel investors are individuals putting a few thousand to a few hundred thousand Euro into early stage businesses. They have more flexibility than larger investors and typically, specialize in one industry or sector. This expertise can be extremely relevant; bringing an entrepreneurial perspective that is less available with other sources of finance. It can be limited in terms of its geographic reach however. What helps your business grow in the UK, isn’t necessarily what works in Germany, or Spain.
Venture capital
As my main area of expertise, mainly in Denmark, Spain and the UK, I know VC can be a great way to develop your business but it’s not right for every company. VC funds range from around €2.5 to €10 million and raise investment through ‘limited partners’, for a set period of say, five to ten years. Through investments in a number of firms, like your own perhaps, they ideally grow them to a large enough stage to exit, pay back their limited partners with good returns, and gain financial benefits for themselves and the original business owners.
VC firms are very experienced and sophisticated investors, bringing strategic ideas to your board table, as well as a healthy contacts book. On the lookout for dramatic growth opportunities, VC funds are big investors in early-stage emerging technology firms. Their funding can open doors to growth and development that wouldn’t otherwise be possible.
Venture debt mirrors the benefits of traditional debt but normally requires an equity partner, so you will need one of these.
Private equity
PE benefits and disadvantages are very similar to VC but differ in the huge amounts of capital provided. Funding of millions or even billions of dollars means PE funds usually require a majority stake in your firm, meaning you could lose control of your company. It’s unlikely you’ll be considering PE at this stage however, as their focus is mainly on established firms needing access to capital to drive growth or offset financial difficulties. VC firms can offer similar results in a ‘so called’ recapitalization transaction, where a new shareholder buys out the existing shareholders to facilitate the next stage of development.
IPO
All equity finance investors plan to exit your firm, profitably, after a few years of development. An initial public offering (IPO), where your business offers shares to the public, is the preferred route to public markets.
Somewhere like AIM – the London Stock Exchange’s global market for smaller developing businesses – is ideal for Internet and technology companies looking for this type of growth capital. Going public means your firm operates under public scrutiny, but can facilitate sales if potential customers trust a public company more than a private one.
Remember to ensure your management and corporate governance style, as well as your business expectations match those of investors influencing the direction your company takes. Redemption rights can be part of VC and PE contracts, giving shareholders the right to force the sale of your company, perhaps before you are ready, financially, or otherwise.
Alternatives
Some countries have government grants in place supporting enterprise development. Healthy levels of research and development (R&D) and innovation are vital in cultivating growth. The UK’s R&D tax credit reduces company tax bills or, for some small businesses, provides a cash sum based on R&D expenditure.
Crowdfunding is a fairly new source of financing, raising funds online from a number of supporters – ‘the crowd’. It works better for consumer-focused products, where it’s easier for the crowd to understand what a business does. It’s useful for firms unable to gain funding elsewhere but has drawbacks, as if your target isn’t reached, you don’t get any finance at all.
Seed funding covers very early stage investments, supporting your firm until it generates its own cash flow, or is ready for further investment. It’s usually provided through crowdfunding, angels or friends and family. Some funds, like German-based High-Tech Gründerfonds specialise in seed investment, supporting high-potential technology startups in their very early days, and beyond.
What next?
Regardless of whichever source of finance you choose, remember the main financial objectives and methods of working of external capital providers may not match yours – banks can be ‘hands off’, while VC firms may call everyday. It’s advisable to establish any potential backer’s preferences and governance style by building a relationship, before you enter into an agreement.
Through co-investing with many of the different types of investors discussed across Europe, I know it’s important to raise capital to support growth when your business is performing well. It’s virtually impossible to do when the business isn’t growing.
Your aim should be identifying the most helpful type of investment for the stage your company is at now. And, more importantly, finding good chemistry with investors who support your vision and will work with you collectively to reach a point where you can all benefit, profitably.
At Vie Carratt we help companies communicate the reasons why they are valuable to potential investors and buyers. Please get in touch if you would like to discuss more.
By David Carratt, Founder and Director, Vie Carratt