Funding choices and the consequences

By Matthew Cushen

You’ve some inspirational market insight and created the killer idea for a business. You can see where the revenue will come from, and with a healthy margin. But what about the investment you’ll need to get it up and running?

Can you afford the time that it could take to grow the business organically – limiting the upfront cash and reinvesting revenue? Or do you need to develop the product/service quickly, chuck cash at marketing, get the brand in front of people, grow quickly and grab market share before others?

Do you have some personal cash to keep you going or are you going to need to pay yourself a salary before the business is generating enough cash to cover it? Are you going to recruit and pay others? Probably the most stressful aspect of building a team is ensuring you can meet payroll each month.

To answer these questions you need a cash flow forecast, and ideally some comparisons across some different scenarios. The high investment/fast growth scenario, the slow burn scenario, the optimistic scenario and the worst-case scenario where you don’t manage to generate any of the expected revenue and cash is flowing one way. A cash flow needn’t be complicated, just adding up the revenue coming into a business each month and subtracting the cash flowing out of the business (salaries, rent, R&D, marketing etc.). But it should be comprehensive. And it’s called a cash flow for a reason. Forecast when payments are made, which can be vastly different to when a sale or contract is made, and VAT timings make a big difference to. If you aren’t a natural spreadsheet warrior then find someone who is that can help – to both think in that structured, comprehensive way and make sure the maths adds up.

From the cash flow (and adding a bit of contingency for unforeseen events) it will be clear how much investment you will need.

Maybe you can ‘bootstrap’. Cobbling together some personal cash to grow the business, either just sufficiently to get some confidence that the idea has legs, or possibly even to the point that the business is generating enough free cash to reinvest. My business partners funded their first business, in 1992, with a £2,000 loan from one of their mothers. She drove a hard deal. If she wasn’t paid back within six months she’d take 50% of their business. It focused them both and after 182 days they paid the loan back, with interest.

But many of us haven’t got spare cash or family in a position to lend money. Or the business idea may be capital intensive – i.e. need lots of up-front investment (maybe in R&D, product development, manufacturing and/or marketing) before it generates revenue.

To fund a business there are broadly two options:

Debt: taking on a loan. Sometimes available for businesses generating cash or buying assets that can be easily converted back to cash, such as commonly used equipment (like that used in a commercial kitchen) or stock, therefore providing some security to the lender.

Equity: selling a slice of the business. Useful for start-ups that need time to get to their first revenue, who are spending on intangibles like marketing or product development or who are going to forgo early profits to grab market share fast.

Then there are various different sources:

‘Family, friends & fools’: a traditional route for either a short-term loan or long-term equity. Often the easiest and quickest option but not open to many and can strain even the most unconditional love if the business runs into difficulty.

Start-up loans: the government backed scheme that lends up to £25,000, at 6% interest with no arrangement fee. Critically there is no personal guarantee, so if the business cannot afford to pay back the loan, the scheme will not come after the founder’s personal assets.

Banks: a loan option for businesses generating cash. Banks are under a lot of pressure to demonstrate their support and funding for growth businesses. But they limit their risk, which generally means, at least in the first couple of years, business owners are likely to have to provide a personal guarantee. So, as they say, your home could be at risk if you don’t keep up repayments.

Peer to peer marketplaces: such as Funding Circle, that assess risk, liquidity and value of a businesses’ assets and facilitate private individuals lending cash, in return for higher interest than they could get from stashing their cash in a bank.

Founder’s cash: if you believe in your business, need to invest before building revenue, want to avoid giving away equity and have some savings, then you can avoid giving away equity at a low early valuation by using your own cash. Or by finding a business partner who’s able to put in some cash as well as expertise to become a co-founder. If the business subsequently raises equity funding, investors value the commitment and confidence founders show by risking their own cash.

Angel investors: typically, angels invest in exchange for equity, but occasionally as a loan. Amounts are likely to be between £5,000 and £100,000. Often angels invest as a syndicate, where they may know each other or have come together specifically for one investment. Some may be ‘smart money’ – investors that have and are willing to share expertise and contacts within your sector.

Angels can be found independently, using LinkedIn for example, but this can take a lot of time & energy – diverted from operating the business. So, although networks charge 5% to 8% of the funds raised, it can make sense to use networks for making introductions. Regardless of how you find them, you’ll been to spend a lot of time meeting angels and pitching your story.

Equity crowdfunding: over the last eight years, the likes of Seedrs and Crowdcube have become a useful source of start-up equity funding. Investors generally invest between £100 and £50,000 through crowdfunding (with a long tail at the bottom end and very few at the top). A business raising £100,000 could easily end up with hundreds of shareholders. Potentially useful advocates for a consumer business. But many small shareholders can be a burden later down the line and there is a significant up-front time investment required to create a compelling campaign. Crowdfunding is not as democratic as we’d like to believe. For a campaign to be successful, 30% to 40% of the funding needs to be committed before kick-off (the crowd follows the crowd), so it doesn’t remove the burden of having to land some other investors up front.

Investment funds: the government offers generous tax reliefs for investing in start-ups, but few investors have the time to consider their own deals or would back their own judgement in this specialised space. So there are funds that do the leg-work and give them a diversified portfolio of investments. If a start-up can attract investment from a fund, it’s a very efficient option. Fees are similar to those charged by angel networks or crowdfunding platforms, but for one conversation and one set of paperwork for the entire funding and subsequent shareholding. Generally the funds are backed by sophisticated investors and well placed to provide follow on funding as the business grows.

On this last one, I could be a little biased as my small venture capital business, Worth Capital, has a start-up investment fund. In exchange for equity we invest in the winners of the Start-Up Series – a competition that will be open on smallbusines.co.uk from 01 September.

There is one more option beyond debt & equity for businesses with an innovative and tangible product that can get shipped around the world. Product crowdfunding through sites such as Kickstarter or Indigogo helps you get your story straight, gather insight, build brand awareness and can finance initial manufacturing as customers pay up front. Production only starts if a minimum number of ‘backers’ is reached.

Plenty of options, from which to find the right funding route for your business and ambition. Good luck!

Are you interested in equity investment? The Startup Series, hosted by smallbusiness.co.uk, gives company the chance to secure equity investment of £150,000 to £250,000 every month. To enter visit startupseries.uk.

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