The funding escalator: How to raise finance and keep control
All you need to understand the key funding rounds, likely ways to exit your business, investor timelines, and how equity dilution works as you grow
Many businesses – probably a sizeable majority – come to the market and trade perfectly happily without any recourse to equity investment.
For others, raising cash from investors is a one-off event – perhaps funding the development of prototype technology at the pre-revenue stage or providing the wherewithal to move into new markets as the business grows.
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But for some, it’s an ongoing process, beginning with a seed capital investment and moving on through growth finance and several rounds of venture capital funding. And if progressive funding rounds are not exactly a way of life, they are very often an essential means to support rapid growth.
And along the way, the business that began with one or two founders owning 100% of the shares picks up individual or institutional investors, each with their own requirements and timelines.
In the process, founders and early investors see their ownership diluted as new backers come on board. To some extent – and depending on how hands-on the investors seek to be – control is also diluted with the founders answerable to a broadening group of owners whenever major decisions are taken.
So what does a progression through a number of funding rounds mean for a rapid growth company and what can be done to align the interests and ambitions of the founders and owners?
What are the key funding rounds?
1. Seed capital
Right at the bottom of the funding escalator we have ‘seed capital’. The traditional role of seed finance is to provide the resources to bring a product or service to the point where it can be sold commercially.
Typically it will enable a pre-revenue business to prove the concept and develop the product – for instance, through a prototype or beta stage.
Again, not everyone will require equity funding at this stage and for many businesses the preferred options are self-finance (if you happen to have sufficient resources) or an injection of cash from the much-touted ‘friends and family’, either in the form of a loan or in return for an equity stake.
But in some cases you have to go beyond your own resources and immediate circle. For instance, if the product is a new piece of technology, the process of development and proof of concept can eat cash. Hence the need for seed capital.
Aside from friends and family the traditional sources of finance have been grants (for example, those offered by the Technology Strategy Board and Regional Growth Funds), equity investors such as high net worth business angels (working individually or in syndicates) or the very few venture capital (VC) institutions that operate at the very ambitious end of the seed capital space.
But there is been a hugely important development in the market with the arrival of an ever-expanding band of equity crowdfunding websites, such as Crowdcube and Seedrs. These companies are not in themselves investors.
The sites – and others like them – enable young businesses to pitch to communities of backers. The investors themselves range from armchair dragons committing anything from £10 upwards through to professionals putting up a lot more and taking advantage of tax breaks.
If we take Crowdcube, the longest established equity crowdfunding site, as an example, the average investment by an individual in a single business is £2,500. The upshot is, if you raise, say, £50,000 through a crowdfunding site, you will have sourced the cash from dozens of investors. Each will have put in different amounts. Some will be business angels by any other name, others will be ‘amateurs’ taking a punt.
Professional investors may baulk at a company funded by dozens of individuals, particularly where every investor becomes a shareholder. Crowdcube’s Luke Lang, which operates in this way, doesn’t believe this is an issue. “Crowdfunding platforms can support businesses through several funding rounds,” he says.
For the record, Seedrs operates a nominee structure meaning the crowd’s investment remains under one named shareholder, which Seedrs argues makes follow-on rounds less complicated and more attractive to growth investors such as venture capital firms. In the case of Crowdcube, only the larger investors have voting rights although all have shares.
2. Early stage finance
Once a company has moved beyond the seed capital stage and begins the process of taking the product or service to customers we enter the realms of early stage or start-up finance. In terms of investors we’re looking at a similar group of players, namely angel investors, venture capital funds, and crowdfunding platforms.
Another player in the crowdfunding space, SyndicateRoom, enters here as it specialises in bringing together sophisticated investors, following a company gaining a level of backing it effectively recommends the proposition.
3. Growth finance
This stage could be followed by more funding rounds, linked to specific goals or milestones. For instance, growth finance could be required to fund acquisitions or move into new markets or prepare for a stock market flotation. These are often referred to as A, B & C Rounds.
No two companies follow exactly the same route. At one end of the spectrum, a technology company with stellar growth potential could find itself funded through the seed, early and growth stages by the same venture capital institutions (or group of institutions).