Running out of funding and personal money is one of the main reasons why start-ups fail, which is why tech start-ups often seek external investment. However, with the current economic challenges, obtaining external investment has become more difficult, leading start-ups to adapt their investment strategies. Zickie Lim, Partner and Head of Venture Capital Investments at Mills & Reeve, offers practical advice to help tech start-ups and scale-ups navigate this new landscape.
From supercharging growth to investing in product development, there are many reasons why tech start-ups choose to seek external investment.
But in 2023, we’ve seen a significant cooling in this area. In a frostier economic climate, companies are raising less and investors are insisting on more conservative valuations to ensure they can recover the multiples they’re ultimately looking for. Investors are also seeking management teams that can demonstrate disciplined capital efficiency, focusing on long-term value creation and, increasingly, reliable annual recurring revenues.
Against this backdrop, more than ever, founders should ensure they’re familiar with all possible start-up financing options, including any legal bear traps.
As easy as A, B, C: equity investment
Equity investment is still the most popular way to raise funding for early-stage and growing businesses in the UK. Founders often choose this option because traditional bank lending isn’t available to early-stage businesses with few tangible assets and limited-to-no revenues.
To go down the equity fundraising route, founders must feel comfortable relinquishing a level of control over their business as shareholdings are diluted. Founders need to work with investors to develop a joint vision for the business. This means dealing with increased scrutiny around how you’re using funds, whether you’re following your business plan and how you’re progressing against pre-agreed objectives.
Generally, businesses that go down the equity investment route raise more than one round of funding during their lifetime. Most start by raising a modest amount of seed investment to move their business to its next phase, by which time founders can negotiate a better valuation for a more significant funding round. Alphabet share classes (A shares, B shares, C shares etc.) are the most common structure for subsequent funding rounds. The shares for each successive round typically include a right for that class of shareholder to receive their money back ahead of the holders of the earlier share classes. This is also known as ‘preference stacking’.
This approach to start-up financing encourages management teams to use funds invested in their company to increase the value of the business ahead of an exit event. The idea is to create sufficient value to ensure all investors get their money back by the time an exit happens – as well as give management and founders (who usually only hold ordinary shares) a chance to share in the proceeds of the sale or exit return of capital.
Quasi-equity: convertible loan notes and ASAs
While equity investment remains popular, in the current economic climate, we’ve also seen increased interest in investment instruments that enable investors to provide bridge financing while deferring the all-important valuation question.
Convertible loan notes are just one example of this. These are loans granted to start-ups that, in certain circumstances, convert into equity, often at a discounted price and often during the business’ next equity funding round. Discounts are up for negotiation but tend to be between 15% and 30%.
Advance subscription agreements (ASAs) work similarly. Investors advance money to a business, which applies the funds to subscribe for shares once a pre-agreed trigger event happens, such as its next funding round. Some ASAs also build in a discount on the subscription price for shares at a similar level to those which apply in convertible loan notes. ASAs can, if structured and drafted appropriately, also enable investors to secure tax relief via the SEIS or EIS scheme. However, it’s worth noting that investors in convertible loan notes aren’t eligible – more on this below.
For more mature businesses: venture debt funding
Venture debt funding is favoured by later-stage businesses that have raised (or are raising) a significant amount of equity funding from venture capital or corporate venture capital investors. Founders often use it to supplement their equity fundraising. It’s used less often in the UK than the US, and its popularity has waned slightly since the collapse of Silicon Valley Bank – a major provider of primary venture debt for tech businesses.
Venture debt funding is worth considering if you’re a slightly more mature fast-growth tech business that has raised or is raising a Series A or later funding round. Typically, venture debt providers will lend up to 20% to 30% of the total equity funding raised by a business.
What makes venture debt funding attractive to many founders is that it’s non-diluting. Having said this, it often involves an ‘equity kicker’, where businesses grant a warrant to lenders, enabling them to acquire shares at a low price. Venture debt can also be expensive, with high interest rates and short maturity dates between one and three years.
Crucial for early-stage investors: tax-advantaged investment schemes
Securing tax relief is a top priority for many UK investors in start-ups and early-stage businesses. If you want to access this group of investors, it’s vital to understand the country’s tax-advantaged investment schemes and position your business accordingly.
The UK Government’s Seed Enterprise Investment Scheme (SEIS) has successfully encouraged investors to finance early-stage, high-risk ventures, enabling fledgling businesses to raise their pre-seed or seed rounds. Let’s look at the latest figures from HMRC. The number of businesses raising investment under SEIS appears to be growing – 2,270 raising £205 million in 2022, compared to 2,105 raising £176 million the previous year. Interestingly, the scheme has recently been extended and expanded to allow start-ups to raise money over a longer period, making it even more attractive!
SEIS sits alongside other UK tax-advantaged investment schemes, such as the Enterprise Investment Scheme (EIS) – a sister scheme to SEIS for later-stage investment opportunities. The Venture Capital Trusts Scheme (VCT) is also available.
Meeting the criteria and conditions necessary to secure relief through these schemes can be tricky. It’s crucial to consult an experienced advisor, as each regime has numerous bear traps. It’s very easy to fall into one, resulting in tax relief not being available to investors on any of their current or future investments in your business – a surefire way to alienate them before your relationship has even gotten off the ground! In the case of VCT, the stakes are even higher, resulting in the potential loss of tax relief for the VCT fund manager over their whole VCT portfolio – a disastrous and costly mistake.
The outlook for start-up financing
While investment activity in the UK declined in H1 2023 and valuation discussions remain challenging, funding for early-stage businesses is holding up reasonably well. There’s a lot of ‘dry powder’ in the system in the form of money raised by investment funds in the last one or two years. In most cases, they are obliged to invest this within a certain timeframe (typically five to 10 years). So, opportunities are out there for UK DeepTech, GreenTech and life science businesses with strong management teams focused on capital efficiency and long-term value creation.