How to bridge the equity gap
It's tough to gain between £250,000 and £3m – but it can be done. Here's how
Anyone with experience of looking for growth capital will know how difficult it is if the amount you’re searching for comes in between the £250,000 and £3m mark.
While new initiatives from the public and private sectors have looked to bridge the equity gap, it remains a serious obstacle for growing businesses to negotiate.
Why an equity gap?
In many ways the bigger economic picture has compounded the problem. While there’s plenty of money about, uncertainty in the stock market has made those with it much more nervous about where to invest. “It’s no secret there has been a toughening of the market over time,” says Saul Klein, who has just raised over £2m for his online DVD rental business (see box on page 66). “Funding has been tight and even with our business there was no guarantee of success.”
In an uncertain market, it’s the smaller end that’s suffering most, as investors seek out larger deals with more established companies where the risk is lower, and the likelihood of a sizeable and quick return on investment is all the more probable. For VCs, the focus is on visibility and profit sooner rather than later, and it’s the same with venture capital trusts (VCTs). While there’s pressure building up to make investments, they’re reluctant to do so, preferring instead to invest small sums in already established businesses.
There’s also the problem that smaller deals don’t always add up economically. “Put simply, the problem you’ve got is the relatively high transaction costs given the size of investment. A larger investment is just more economical,” explains Mark Wignall, MD of GLE Development Capital. It takes the same number of man hours to research and negotiate a £1m deal as one 10 times the size, so it’s hardly surprising investment houses prefer to lean towards the top end of the market.
And if equity houses do choose to invest, they’re going to take a pessimistic and risk-averse view, which means entrepreneurs may find themselves being asked to give up a bigger slice of the pie than they had anticipated. For some there’s a perception that, what they see as a risk-averse attitude, is a cultural problem. Brian Smith, MD of Newlands Scientific has been trying to find investment to help take his ‘Whispering Windows’ product – a device that allows music to be broadcast from shops or other outlets onto the street and which reacts to outside noise – to market, but has found it a tough task. This, despite an impressive customer list.
“In my opinion the equity gap in this country is a cultural issue,” he claims. “We’ve got licensed companies outside of the UK who are taking our product to their investment market and getting funding for the project. Yet even though we’re the intellectual property owners we can’t do it here. Raising money abroad appears to be so much easier.”
There are plenty of others who look overseas with envy. “It seems to me we’re more risk-averse in the UK. I know if we’d been based in the States we would have been given four times the valuation based on our business,” claims Mat Atkinson, CEO of marketing technology firm Mtivity. Although he managed to secure funds of £445,000 through a combination of private investors and regional funds, he describes the whole process as “horrific”.
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There are signs, however, the frosty early stage market is thawing as private equity activity picks up across all sectors. “It’s always going to be difficult for pre-revenue companies, but now we are seeing more competitive valuations, the market will become more balanced and there will be a willingness to back earlier stage opportunities,” says First Stage Capital’s Jason Purcell. While not always easy to find, there are more solutions to bridging the equity gap than ever.
There also appears to be a strong move on the government’s behalf to solve a problem, which has been threatening to undermine the future of enterprise in this country. Through further private/public funding initiatives such as the Small Business Investment Companies (now Enterprise Capital Funds – see box), announced during last year’s Budget, along with further tax incentives for VCTs. While some, like Hotbed’s Gary Robins, would prefer to see financial rewards directed towards investor networks rather than backing what he sees as a “losing horse”, the general consensus is such schemes will be the key to unlocking capital for tomorrow’s growing businesses.
“Co-investment schemes, where the government works alongside approved funders, such as business angel syndicates, will have some degree of success, at a time when some of the bigger VCs have withdrawn from the market,” says Colin Mason, professor of entrepreneurship at Strathclyde University. “I don’t think the market is any tougher, it’s always been vigorous – that’s life. But if you do your research, there are plenty of openings to be had.”
As ever, you should identify early on who the most likely sources of funding will be, checking out their investment criteria, sector specialisms and average size of deals, otherwise you will just waste a lot of valuable time shooting in the dark. There are an array of specialist equity options available, whether it be by sector (such as biotechnology through Ludgate Investments or media via Genesis) or region, (regional venture capital funds such as East Midlands or London), or other criteria (for example, Bridges Community Ventures invests in companies whose operations benefit the local community). These are an excellent starting point.
However, while there are plenty of VCs who claim to focus on early stage companies, definitions seem to vary on what this actually means. So if you’re pre-profit and without an existing customer base, you may find the door is not always open. There are, however, exceptions to the rule. For example, APAX Partners is launching a sizeable early stage fund covering six sectors in which, it claims, profitability is not a criteria for it to invest.
You may also find it difficult to get around the table with VCTs. Even though they exist to bring together smaller sums for earlier stage companies and fill the gap left by many VCs, dealflow has been extremely sluggish. “The VCT market is difficult to break into if you are pre-profit and, like many small companies, we’ve had a lot of difficulty proving our commercial pedigree,” says Brian Smith. But though they’re unlikely to be a strong option for many businesses at present, if the government’s new initiatives do stimulate their activity, things could change and soon.
Business angels, a sector which has hardly offered a heaven sent solution to the equity gap in recent times, also looks like being a re-emerging sector. While it’s true many networks have struggled to raise funds and lend to operate inefficiently, a new breed has stepped in to fill the gap, and ‘super-angel’ investor syndicates like Hotbed and Pi Capital are doing good business. With further developments likely in this sector of the equity market, it’s also an area to keep an eye on.
As one of the government’s initiatives to bridge the equity gap, the Regional Venture Capital Funds, have established themselves as a strong option for raising finance and demonstrated to investors, there’s money to be made in the equity gap by combining private and public money to stimulate enterprise in their specific regions. Though many fund managers would like to see the maximum threshold increased to further help dealflow, they should definitely be high on your list.
Peter Le Noury is investment director at Catapult, which manages the East Midlands Venture Capital Fund. Though its maximum investment threshold is set by the government at £250,000, its average deal is nearer £350,000, achieved by bringing in private investment. There’s also plenty of opportunity for further funds. “Seven out of 10 businesses need more funding than they think, and we have the structure to offer follow-on investment. Effectively they are taking on a partner and we’ll do all we can to see it through until the end. We’re more likely to put in more money to try and turn things around rather than call in the receivers,” he says.
There are also other options to consider, such as corporate venturing, where larger companies will make an investment in their smaller counterparts, so when you’ve taken all these into account the equity gap doesn’t seem so wide after all.
Once you’ve found your preferred route to funding, it can help to make contact with those with the cash as early as possible, whether or not you need to get your hands on it straightaway. And if you choose carefully, and check they have the right contacts, professional advice can also help if you give a competitive edge in tracking down who to speak to. “The market is imperfect so you need to plan through options carefully,” advises Mark Wignall. “The management team should hire professional advisers because they can refine the proposition. They should also be acting as a conduit into the sector, channelling your energies into the right areas.”
In his pursuit of finance, Julian Hucker, MD of business-to-business text messaging service Esendex, went down the business angel route, but it wasn’t until he sought some professional advice that he finally secured a deal. “We couldn’t understand why the deals didn’t work because we had little feedback. What swung it for us, to get the bulk of the money, was speaking to Tenon. They helped us express our ideas better and made our business plan a clearer proposition of what we were about and what investors would want to hear,” he says.
Once you’ve identified your best sources of funding and made an approach, there are three key areas which your potential investors will be scrutinising: the business plan; your management team, and your knowledge of the market.
“What you have to remember is what’s investment-worthy is often in the eye of the beholder,” says Colin Mason. “You really need a friendly critic and a fresh set of eyes.”
As well as ensuring you have a solid business plan that displays a strong connection between current trading and future forecasts, an impressive management CV is also a winner. So, if you’re part of a management team that’s a bit weak on experience, bringing in a credible non-executive director can help make up for it. Speak to any investor and they would prefer to back an average idea with a great management team, than vice versa.
And if you feel you’ve got those areas covered, you also need to ensure you have an excellent understanding of the market in which you are operating.
“You need to be addressing a problem in the marketplace, demonstrate you’re solving it and offering a competitive advantage,” says Purcell. “It needs to be a significant market to grow and there needs to be a clear understanding of what you are raising money for and why it’s a good investment opportunity.”
What to expect in return
Even though the options for negotiating the equity gap can be a time-consuming and stressful process, that’s no reason to get into bed with just anybody. Getting your hands on the money is important, but it’s vital to also consider the terms of the deal, and the personalities of those behind it. Investors make it clear what they expect from you, so why not the other way around? “It’s the value added stuff that’s harder to pin down, so you need to think carefully about what you’re getting,” says Colin Mason. “It comes down to what both sides can live with and neither should feel backed into a corner.”
Spend the same time checking out the business background of your potential investors as they’ll devote to poring over your credentials. Speak to their previous investments and ask how the relationship worked. “Obviously the key thing is the money, but you need an investor who is a good partner, and has had experience of building an early stage company. Will they get you the right introductions? Will they be a good sounding board? Have they got further capital and will you be able to go back and raise more cash? People don’t do enough referencing,” says Jason Purcell.
The right investor can be extremely beneficial to all aspects of your business as Mat Atkinson has discovered. The funding he eventually raised through the London Regional Venture Capital Fund has brought him more than just money. “They’re a great team and very active, though that wasn’t what I was necessarily looking for. It’s not just about the money, but the business acumen, the contacts and the PR. The dilution has never really been an issue for me, if you create a business designed to be venture backed, it’s going to be part of the plan.”
Atkinson raises what will be a key issue in any deal; ceding part control of your business to an outside party. Make sure the terms are right and you’re not forced into handing over more than you’re comfortable with. Julian Hucker spread the £250,000 he received from a business angel network into three stages, thereby avoiding giving up too much too early. “They were able to tailor the funding to our requirements, which was a big selling point,” he says.
There’s no reason why you have to bring external finance on board, and you may have a strong opinion on where your business should be heading and how that can be achieved without outside influence. Investors will want to see, on average, triple their original investment returned, but the best ones will not want to interfere with the day-to-day running of your enterprise. Of course, some businesses need private equity just to exist, but for many the decision is whether it’s better owning 100% of a £1m business or 75% of one that’s worth £5m. “If you’re raising funding to grow your business and want complete control then you’ve got it wrong,” says Gary Robins, “You need to see your investor as a partner, rather than baggage.”
CASE STUDY 2 PREVX
Nick Ray is one CEO who?s entered the equity gap ? and won Even three years ago, anyone with a smattering of IT knowledge realised computer security was set to be a major growth area. But when Nick Ray started Prevx back in 2001, with a view to developing a market leading intruder prevention product, finding funding was difficult.
?To start off, it was a bit bewildering. We did have corporate finance advice in terms of identifying where to go, but we ended up speaking to around 70 sources of funding. It was a long and laborious process as 2001 was not a great time for new tech firms. It was very difficult for a pre-revenue and pre-product company to get anywhere with VCs. The trouble was we couldn?t possibly get there without their help,? he says.
After getting close to a deal with two investors before being ?jilted at the altar?, Ray was forced to continue developing Prevx?s product with the company?s own financial resources. The breakthrough came when he eventually got sat at the table with the South East Growth Fund, convincing those behind it to invest ?500,000 in the company. ?Their willingness to listen and understand our business was great. They were very supportive and introduced us to other opportunities and really didn?t interfere with the day-to-day running,? he says.
However, as is often the case with a fast growth business, by the time Ray had his hands on the money, he realised it wasn?t enough and another round of funding lay ahead. No longer private equity novices, they gravitated towards Hotbed?s network of private investors.
?The terms of the deal were relatively benign ? unlike with the VCs ? Hotbed were more of a leveraging network which really appealed. Initially they were wary of us, but as they began to promote it to their investors we developed our products. In the end we were three times oversubscribed,? he says.
CASE STUDY 1 VIDEO ISLAND
Saul Klein discovered the benefits of making an early start looking for funding Saul Klein?s online DVD-rental service Video Island is a great example of a business that should light the imaginations of potential investors. In September last year, he picked up ?2.1m from Index Ventures and Benchmark Capital, who had backed other online success stories, such as eBay and Betfair. As the co-founder of The Electronic Telegraph, the world?s first daily newspaper on the internet, and Fantasy Football, his online credentials are impressive, to say the least. But when he started his latest venture he still made a point of putting in the groundwork to make raising funding as smooth a process as possible.
?Starting up a company like this is easy, it?s carrying on that?s hard because you need a lot of growing capital. We talked to individuals in the VC and private equity world right from the off. At an early stage, we let them know what we were doing, even if it was too early for them to come aboard. Then, when the timing was right, we would have a much better idea of who our ideal partners would be.?
But even with all his connections and experience Klein had to make sure he could demonstrate an acute market awareness and show his business would operate differently to US market leader Netflix, rather than cutting-and-pasting its strategy. Instead, he impressed them by going the partnership route, linking Video Island?s service through major players such as MSN ?The clever ones recognised the UK and Euro markets are different and we would have to do something to compete with the large national brands,? he says.
So thorough research, business credentials and market knowledge worked for Klein. ?It was critically important to have investors who shared my vision,? he concludes.