Published by Adam Baron
Starting your own business can be daunting. One of the biggest concerns you will probably have is how to fund it all. There are a number of private and public funding ‘ingredients’ that you can combine to create the perfect recipe that works for your business. The five main methods;
- Research and Development tax reliefs
- Venture capital.
A good chef will always get to know their ingredients and think about how to utilise them for the best end result. Likewise, as an entrepreneur, you should understand your funding options and how best to combine them to grow your business.
In this article, I look at each option/ingredient and their pros and cons in turn. This will hopefully give you some food for thought and help you think about which combinations may end up being your recipe for success.
Self-funding/Bootstrapping – DIY or cooking without any help or recipe!
Honestly, fundraising can eat up a lot of your time and energy. Bootstrapping which is the word that is used to describe self-funded businesses, allows you and your management to focus on building the business and developing the product without the distraction of fundraising. By bootstrapping, you can build up steady momentum and strengthen your core competencies.
There’s no such thing as a free lunch. When external investors offer their money, they expect something in return. They’ll often ask you to relinquish a portion of your ownership stake and a share of your profits. They will also have a view and expectation on how you should be achieving growth and profits.
Self-funding your business avoids external influences that can push your company in unexpected directions. There is only ever one cook to work on the broth, you. You can build a sustainable and profitable business without needing to please any investors, other than yourself.
Successfully ‘bootstrapped’ companies are attractive to potential investors because they have a proven track record of managing money responsibly. It can be easier for a self-financed start-up to raise new capital later in its life cycle.
Sounds great, right? But bootstrapping isn’t always a picnic.
When you bootstrap, you have to solve more problems with fewer resources while keeping your business running. You will always have a lot on your plate. It can be demanding and sometimes the outcome is a series of cobbled together solutions. It is not always as effective or efficient as it should be. More an eclectic group of flavours than a well thought out menu.
When potential investors look at your business, the quality and experience of the leadership will be a key factor in their willingness to invest. Bootstrapping often means little or no money for attracting top talent. You can’t afford the best people to help you run the business. You may be able to compensate to some extent by finding people who are passionate about your business and therefore will be willing to sacrifice salary in favour of equity.
Bootstrapping is certainly ‘cheap’ in absolute terms but it can limit the growth potential of your business because of having to accept less than perfect solutions or people. This may ultimately make your business less appealing to future investors or acquirers.
Debt – cooking with a sous-chef
The traditional way for small businesses to access funding was from banks. If you can get one, a loan is an effective source of capital because of the comparative cheapness to equity. The British Business Bank estimates banks reject 100,000 small business loan applications each year - a funding shortfall of £4billion.
Traditional banks do continue to lend huge sums every year even if, in recent years, they have become more risk averse. They will want you to show an immediate ability to service a loan so you have to be profitable, which many fast growth start-ups are not.
A recent influx of ‘quirkier’ debt providers including asset financers and venture debt providers has changed the lending landscape. Asset-based lenders (“ABLs”) will take a view on your assets and their ability to resell those assets to cover their loan if you become unable to service the repayments due.
Venture debt is another relatively new offering from debt providers. Unlike conventional debt financing methods, venture debt does not require any form of collateral, recognising that early stage companies generally do not own substantial assets. The way that lenders mitigate their risk is by more often than not, providing funds to companies that have already successfully completed at least one round of capital equity fundraising. This provides them with enough comfort to lend to pre profit companies.
In addition to contractual interest payments the majority of venture debt instruments involve warrants on the company’s common equity as a part of the compensation for the high default risk. In the future, the warrants can be converted into common shares at the per-share price of the last equity financing round which could be costly, therefore resulting in a loss of some control if payments are not made.
The warrants often provide the biggest returns to the borrowers relative to the appreciation potential of the company’s common shares. It’s a bit like being leant the use of a kitchen but because the owner has taken bit of a gamble they will want to retain the ability to acquire part of your restaurant in the future for a pre-defined price.
In essence, the banks and other lenders just want to know that you can handle the heat in the kitchen and have the ability to fulfil your repayment obligations. They won’t tell you how to do things. This is great if you can afford the cost of the debt, i.e. you are profitable, but not very useful if you aren’t there yet.
Grants – Sticking to a carefully crafted recipe
Government agencies, and their grants, are a recognised source of funding for start-ups. They provide a sum of money for a specific project or purpose that a business doesn't need to pay back (unless it breaks the conditions of receiving it).
Many of these grants are earmarked for a specific purpose such as feasibility, development of new products, process or prototyping. They usually subsidise projects that will bring a lot of value add to the community through the creation of jobs, social inclusion and/or economic growth. They can provide critical funding to build significant traction and hit major technology and product milestones before seeking the next round of venture capital money.
There are more than 6,000 schemes on offer to UK companies and schemes will have their specific criteria and application process which adds to the complexity. It's no surprise many business owners feel overwhelmed navigating the world of grants.
Crudely, the main benefit of a grant is that you don't have to give up any equity or compromise your plans with shareholders. You get a non-repayable sum of anything from several hundred pounds to hundreds of thousands to help with a specific project or an aspect of growth.
A grant can also give future investors and banks confidence. A large organisation will have thoroughly examined your project and ideas and decided they are sound enough to warrant much-coveted funding.
The main disadvantage of a business grant is that it has to be used for a specific project rather than spread around different parts of your business. The funding is not flexible; you will have to stick to and deliver your original plan/application regardless of the wider business context. So grants are good if you have a specified financial need for a self-contained project. They are not nearly as useful if your priority is being able to react to the market and changing circumstances. If you don’t stick to the recipe, it will all fall apart! Grants might be compared to getting help to create a specific dish rather than how to run your kitchen?
R&D – Using the same ingredients to make two dishes
Research and development (R&D) tax credits are a government incentive designed to reward UK companies for investing in innovation. Unlike grants, these tax credits aren’t restricted to specific future project but reward you for investing in an activity which is resolving ‘scientific or technological uncertainties’. You are being incentivised to come up with something new or just better.
R&D tax credits can be a valuable source of cash to invest in accelerating your R&D, hiring new staff and ultimately growing your business. Many businesses don’t claim for R&D costs because they don’t think the scheme applies to them and/or they are reluctant to approach HMRC who administer the scheme. It is always worth speaking to a R&D tax credits specialist to see if you qualify as you could be missing out on recovering up to 33% of your development expenditure.
You can benefit from R&D tax credits whether your business is making a profit or a loss. Loss-making businesses can claim a R&D tax credit payable (cash) amount from HMRC, while profit making business can significantly reduce their corporation tax bill.
As the process is one of self-assessment, it is important to be well advised ensure that the company complies with a specific set of guidelines and document their working, in case of an HMRC enquiry.
A bit like being able to reuse ingredients that you had already to create another dish which will complement your meal. There is no downside to R&D tax credits but this option alone is unlikely to be whole answer to your funding need.
Venture Capital - sharing the kitchen with an experienced chef to get a piece of a bigger cake
Venture capital is a form of investment in early-stage companies with high growth potential. Investors provide funds to realise that high growth potential in exchange for a partial ownership of the company. Venture Capitalists (VCs) generally look to make a return on their investment within three to four years.
While you may want to avoid giving up a piece of the cake to an outside investor, VCs can bring several benefits. There is the obvious injection of cash to invest in growing the business. However, entrepreneurs don’t always understand the other key benefit; VC investors can become a real partner in growing the business. They provide invaluable business guidance, practical support and advice across financial and human resource management.
Having an experienced chef at your side will help you understand where things can and have gone wrong. They will help you make bigger and better cakes with less risk of the cakes collapsing before they are fully baked.
What’s the right mix for you?
In the end, it’s a case of each to their own. There is no single funding recipe that is right for every business. Each start-up is unique and the right funding recipe will be different. Some businesses simply need a cash investment at an early stage, others you can bootstrap with very little resource. Some businesses prefer to take on an equity investor despite having to give away a part of their business (equity) because it means having a partner on board to help them grow.
In a nutshell, there’s no right or wrong way to do it, growing a business is never a picnic and it’s rare to have your cake and eat it. Nonetheless, with a balance of public and private funding it is possible to find ingredients that work for you and maximise the benefit to your company.
About Adam Baron
Adam has been advising growth stage companies for a number of years, with a strong focus on client relationships and satisfaction.
His background in law adds a different dimension to the way he is able to analyse, interpret and present information.