Startups have always mostly been financed by risk capital, i.e. equity investment where the risk is shared with the entrepreneur(s). Although it has always been possible to get a small loan from a bank (to the extent the lender thinks you can repay it), for any significant financing debt has never usually been possible because the startup will commonly not have assets that the bank can register security against and there is no trading record to give the lender comfort.
a) VC firms
Venture capital firms have been the traditional way of providing equity funding. When new business creation was more unusual and much more capital was needed to start and scale a business these firms were able to provide sufficient funding, while because of the larger sums at risk venture capital firms could manage the added cost of legal work, valuations and other administrative expenses that went into the process. Venture capital firms remain relevant for startups raising larger rounds of funding, but it must be remembered that they are formal organisations with high overheads that will need to extract sufficient pounds of flesh even if they rely on the presumption that only a few in their portfolio will deliver a significant return and the elusive ‘home run’.
b) Angel investors
As startups proliferate and the capital that they require to scale and generate revenue reduces, angel investors (commonly successful entrepreneurs who have a knowledge of business and technology) have increased in number and prominence. Angels have always been around but are becoming more common as the capital needed for a startup becomes less and less, startup entrepreneurs proliferate and it becomes easier to put together the legal paperwork required to conclude a deal. Also, in recent years the UK government has offered angel investors significant tax incentives in the form of the Enterprise Investment Scheme (“EIS”) and the Seed Enterprise Investment Scheme (“SEIS”) (more about these two later on).
As a result of the EIS and the SEIS several funds focused on startups (such as Ascension Ventures) have developed that seek out opportunities and invest on behalf of their individual investor clients. Such funds act as a nominee to hold the shares in the investee company, but for legal and tax purposes the individuals are the beneficial owners of their shareholdings. Also there are now many online networks and resources that make it easy to find angel investors and pitch your business opportunity to them. Two examples that spring to mind are the Angel Investment Network and Angel List.
c) Convertible loan notes
Particularly in the US, many startups receive investment via convertible loan notes which are evidence of a loan which is then convertible into equity at a later date, at specific rates or in response to particular events. They allow investors to achieve a healthy yield and obtain the benefits of a call option over shares in the issuer at a fixed price, which is usually exercised when a VC comes in at a certain valuation. Accrued interest is factored into the conversion, up till then the startup doesn’t usually service the debt.
d) Revenue participation notes
Another slightly more unusual form of finance is a revenue participation note. These are described as ‘quasi equity’, in that they combine the note (a typical loan plus coupon) plus a revenue participation structure (percentage of sales for a defined period of time) that gets capital to the enterprise without affecting its ownership, goals or mission. As a result, if the startup is seen as a good prospect the lender/investor believes he/she will be adequately compensated for the risks involved. The only time I have put something together like this before was for a web developer who worked on a project for a friend in his spare time. The web developer investor then received a share of the revenue and interest once the site went live.
In the US rewards based crowdfunding sites like Kickstarter have already proved hugely popular. These sites work by letting the investee company receive donations in return for which they reward their investors with perks, pre-sales and other things of value, thus not falling foul of the US’s securities regulations.
However, in the last couple of years the UK has been leading the world in the development of equity based crowdfunding, principally through Crowdcube and Seedrs which effectively allow startups to do their own mini-IPO and raise money from an army of ‘armchair dragons’ who can invest anything from £10 upwards in return for shares in the company that allow them to benefit from the potential upside of future dividends and capital gains. Such crowdfunding means startups can leverage the knowledge and influence of the ‘crowd’ and makes raising finance much easier through such features as transparent due diligence, standardised procedures and online payments.
With Crowdcube investors commonly receive B shares which only entitle them to income and capital, whereas more significant investors can receive ordinary A shares that also allow them to vote on certain issues. Like Crowdcube, Seedrs also screen startups to try and have a degree of control regarding the quality of startups on their platform, but instead of different classes of shares they have a nominee structure where Seedrs hold the legal title to the shares and monitor and enforce shareholder rights for the investors who receive the benefit of the investment. This gets rid of the administrative hassle of dealing with so many voting shareholders that puts off future investors, but also encourages the companies to be much more respectful of their backers.