The funding escalator: How to raise finance and keep control

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.

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).

This path continues right up to the point where everyone exits through the sale or re-financing of the business, the point at which a more senior private equity firm comes in.

Alternatively early investors may be bought out by those coming in later. Or the early investors may simply stay put as new investors come in.

For instance, new media company Branient raised €50,000 in seed finance from Seedcamp to develop its cross-platform interactive video product for advertisers. To take that product to market it required €800,000, raised from Arts Alliance.

The next step was a $3m injection to fund international expansion from VCs including Credo and Atlas Capital with the original investors staying on board. As founder Emi Gal explains: “Each round was linked to milestones in the company development.”

What investors are looking for

So what’s the common factor? Well the majority of – although not all – investors will be seeking an exit or liquidity event at which they can sell their shares at a profit. This may occur in a number of ways:

1. Selling the business in its entirety

That can mean the sale of the entire company with the founder selling his or her shares along with the investor but that certainly doesn’t have to be the case.

2. Investors selling their stake

“It doesn’t have to be the last roll of the dice for the founder,” says Simon Ramery of corporate finance consultancy Innovation Capital Advisors. “It could be that the shareholders are bought out by new investors, with the founder staying on.”

The buy-out may involve the creation of a new company (or Newco) and with new investors coming on board, the founder has an opportunity to take some cash out by selling some of their shareholding and then rolling over a large part of their shareholding into the Newco.

“It’s an opportunity for the entrepreneur to take some money off the table,” adds Ramery. “This can be done several times, with the founder staying with the company and benefiting from the continued growth in size and valuation of the business they have created.”

3. Buying out the investors

A third alternative is for early investors to be bought out by the founders – a management buy-out (MBO) – something that can be financed by bank debt once the company is profitable.

4. A public market listing or IPO (initial public offering)

Most growth companies will look to the London Stock Exchange’s AIM market if going public represents their best option to provide an exit and raise further funds.

Standing for Alternative Investment Market, AIM has a long-established track record of attracting small and mid-sized businesses, such as online retailer ASOS and WANdisco, during their formative years.

Ramery makes the distinction between a one-off funding round leading to an exit event for investors and interim fund raising rounds. “As the business grows more cash may be needed, which can be raised from existing investors through rights issues or from new investors,” he says.

5. Patient investors seeking healthy dividends

Not all investors are focused on the exit. Ramery cites the example of ‘Family Offices’ – aka the investment arms of wealthy families and ultra high net worth individuals.. “They may be looking for a good dividend business, rather than a capital appreciation and near term exit event in three to five years like most VCs. This is becoming more the case given we are living in an ultra-low interest rate environment,” he says.

6. Corporate venturing seeking innovations

Another alternative would be a corporate investor who is willing to provide cash support in return for access to an innovative technology or product that they don’t have in-house.

What are the timelines for investor exits?

1. Presenting an exit plan

When exit is the endgame one of the key issues for an entrepreneur is to ensure that his or her plans for the business are aligned with the expectations of the investors.

As Luke Lang, co-founder of Crowdcube explains, a company pitching for investment has to provide investors with some kind of a route map towards the point when they can cash in.

It’s a principle that applies not only when negotiating with business angels or VCs but also when pitching to the broader group of potential backers on a crowdfunding platform. “One of the things that we require our pitching business to do is provide a plan that gives people an idea of when and how an exit will happen. That could be a share buyback or an MBO,” he says.

It’s not an exact science, not least because the exit will be dependent on key milestones, such as the business hitting certain levels of profitability and growth targets, but it does provide a template. As Lang sees it, crowdfunding investors are expecting an exit within four to six years.

2. Understanding the timelines

According to Branient’s Emi Gal this is broadly in line with the expectations of high net worth angel investors. “They tend to invest on five to seven year timeframe although sometimes three to four years,” he says.

Very few investors will expect a business plan to run to a strict timetable. However, key shareholders will normally have the right to take action if they feel things are running too slowly.

For example, they will typically have ‘drag rights’ built into shareholder agreements, enabling them to call in advisers with a view to putting the business up for sale after a certain number of years, if they feel managers are in some way dragging their heels ahead of an exit.

3. Raising more cash

There are some potentially tricky questions here, particularly for businesses that have taken investment once but need more cash.

The simplest course of action is that existing investors see the potential of the company and put up more cash. Unless everybody (including the founder) scales up their investment in proportion, this will involve a recalibration of the ownership structure.

A second scenario is that the existing investors exit, selling out to new investors. “This happens quite a lot,” says Emi Gal. “For instance, you might get VC investors selling out to a private equity company.” Equally, it might be a case of original family and friends investors selling out or an angel investor cashing in when a VC comes in.

To some extent this can be facilitated through pre-agreed drag rights. For instance, there may be a clause in the shareholder agreement requiring angel investors to sell out when the shares reach a certain value.

According to Mark Winthorpe, a company law solicitor at legal firm Pannone, the sticking point is often valuation. “Usually the valuation is provided by an auditor but if the parties don’t agree, you can find yourself in a mediation process,” he says.

Should I worry about equity dilution?  

What is equity dilution? The upside of equity investment is that it provides the finance you need to grow while in many cases also putting you in touch with investors – angels and VCs – who can bring to bear their own experience, expertise and contacts to help you achieve your aim.

The downside is that every investment will dilute your shareholding – your stake in the business will get smaller and smaller.

But if we return to the upside, if things go well, over time the business gets more and more valuable and your stake is worth more. So how does this work in practice?

1. Taking on a founding partner

Let’s rewind to the earliest stage. You have a great idea, you start a company and you own 100%. At that stage, the company has no revenues, no product and no assets. So effectively you have 100% of nothing.

Let’s say for a moment that you’re talents lie in coming up with ideas and selling them, but you don’t have the technical and operational skills to develop the product and take it to the market. So you find a partner who has. Two choices here: You can either pay a wage or fee or offer a share in the business. Let’s say 50%.

Now you own 50% of the business but that half share is potentially a lot more valuable because you now have the ‘human capital’ or ‘sweat equity’ to turn an idea into reality.

The same applies when commercial investors come in. Your share dilutes but the potential value of the business rises. And when money changes hands you can put a figure to that value.

2. Receiving friends and family investment

So let’s go down the road a little bit and see what happens. You and your partner need £10,000 to prove the concept and create a prototype or operational website, app or technology, so you look around for investors.

You don’t want to give away too much so you approach some members of your family who agree to provide the cash for 10% of the company. This leaves you and your partner with 90%, so effectively you now own 45% each. Each of your stakes is now 5% smaller, but you have the cash you urgently need.

3.Enter the professional investor

To take the company to the next stage you estimate that you need £50,000. You believe you have growth potential so you successfully approach a business angel.

The key question here is how much equity your angel will take in return for his or her hard-earned £50,000? That will in turn depend on your investor’s valuation. So let’s say your sophisticated investor puts a value of £200,000 on the business as it stands. That would make the £50,000 worth 25% of the total.

But… and this is a big but… that £200,000  is the so-called ‘pre-money’ valuation. When the additional investment is added the company is worth £250,000. So when this post-money valuation is taken into account the £50,000 represents 20% of the total value. That’s what your angel investor gets and everyone else’s shareholding is reduced accordingly by 20%.

So let’s look at that in value terms. On the pre-money valuation your 45% stake was worth £90,000.  After the deal, your 45% is reduced by 20% to the stake is now 36%. On that calculation the value of the stake remains the same. You haven’t lost anything but you do have £50,000 to grow the business.

The figures move, depending on the valuation of the company. Had the angel decided the company was worth £300,000 pre and thus £350,000 post money, the £50,000 investment would have given him a stake of 14.2%.

Run the figures again and your 45% stake would fall to 38.6% and would be worth £135,100, considerably more than the pre-money figure (although ultimately only worth the whatever a buyer is willing to pay when you do realise the value and sell).

4. Through the institutional funding rounds

This process of dilution continues through the rounds. At each funding event, you have a pre and post-money valuation. So let’s say that at the next stage you’re bringing in a VC fund which agrees to invest £2m, because frankly you have amazing global growth potential. Once again that figure will be based on an assessment of what the company is worth and how the investment can be utilised to rapidly increase the value.

So let’s say the post-money valuation is £2m and the VC takes 30%. Your 38.6% is reduced to 27.02%. However, given that the company is now worth £2m that stake has a value of more than half a million pounds. So if and when the company grows significantly, the maths of dilution begin to work in your favour.

And so it goes on until the exit event, which could be an IPO or a trade sale. At that point the nominal value becomes real (or not, as the case may be).

How to choose investors with dilution in mind

One way to select an investor is to choose the angel or VC offering the largest amount of money for the smallest equity stake but that could be a mistake.

The purpose of investment is to grow the company and you might do that more successfully with an investor who takes a bigger stake while adding value through the skills or contacts he or she brings to the table. An investor who genuinely adds value – say by providing you with contacts in a target market – may be instrumental in doubling or tripling the value of the company.

He or she may ask for a larger stake than someone less well connected. Thus, your holding is reduced but with the potential of a large increase in its value.

That’s the theory, which only holds up if the company becomes more valuable. In some cases, the funding will be required because the company is – if only temporarily struggling – and owners and incumbent investors see stakes falling with no increase in value. “This is a ‘down round’ investment that most people want to avoid,” says Simon Ramery.

How founders can keep control of the business

Then there is the issue of control and influence that comes with a smaller percentage. This affects not only the founders but also early investors, perhaps with small stakes bought at the seed or start-up stage.

Karen Darby, founder of equity-based crowdfunding site for social and environmental ventures CrowdMission, has extensive experience of taking investment for her Simply Switch and Cool Britannia ventures. “There is a danger that original shareholders can be diluted into extinction when larger shareholders come in,” says the serial entrepreneur. “But you can take steps to protect them.”

To some extent this can be done through pre-emption rights in the shareholder agreement, under which the existing shareholders have first call on new share issues.

But arguably this is more strategic issue. So-called sophisticated investors – otherwise known as high net worth individuals or angels – assess the prospects for growth not just in terms of company performance but also the milestones such as acquisitions or moves into new markets.

These milestones could trigger a further round of investments. From there they can assess whether accepting dilution makes financial sense. Founders should be making the same kind of assessment “Everyone should understand why they are taking equity investment,” says Simon Ramery.

Entrepreneurs also need to consider the impact of investment on their ability to make decisions. Investors range from the totally passive, through angels who will provide help and contacts without requiring a seat on the board, to those who take a more hands-on role. VCs will certainly place at least one person on the board.

How to use shareholders’ agreements in your favour

The extent to which investors have a veto on decisions is defined in the shareholders’ agreement and articles of association of the company.

There is room for negotiation here, according to company law solicitor Mark Winthorpe. Investors will want to be part of the decision making process on major events such as taking on new debt or selling shares. “But on operational matters there is room for negotiation and you should ensure you can set the control thresholds at levels where you are comfortable,” he says.

Control is not necessarily absolutely linked to the size of the investors’ stakes. “We chose one investor over another who asked for a smaller stake for the same amount of money simply because the first investor made it clear that we could retain more control,” says Emi Gal.

And the truth is that decisions on control and dilution can’t be separated from the softer issue of whether or not the entrepreneur can work effectively with sympathetic investors. The key is to establish good relationships with investors, while working with timelines, shareholder agreements and levels of dilution that you’re comfortable with.