Introduction

Whether you are a new company looking to get your business off the ground, or a more established business looking to scale-up, raising money is likely to be key to success. The source of capital which is most appropriate for your business will depend on several factors including the amount of funding required, the purpose of funding (i.e., whether there is a need for expertise and mentorship as well as capital) and the timeframe within which funds are needed. You will also need to assess the cash flow management of your business and whether taking on liability (through debt) or giving away part of the business (through equity) is a viable option.  

This article will set out different options available to start-up and scale-up businesses when fundraising. There are three main categories: non-dilutive non-debt fundraising, debt fundraising and equity fundraising.

NON-DILUTIVE NON-DEBT FUNDRAISING

As an alternative to equity (which is dilutive) and debt funding, ‘non-dilutive non-debt’ funding (NDNDF) allows businesses to receive funding without giving up any part of ownership of the business and without incurring liabilities associated with capital repayments and interest charges.   

Key considerations of non-dilutive non-debt fundraising

NDNDF is an attractive option as it allows a business to maintain control and ownership and to manage cash flow. It means that businesses can access capital quickly to invest in things like inventory, employees and equipment in the early stages without having to worry about reserving funds for repayments.  However, such funding can be challenging to obtain due to strict eligibility requirements and the competitive nature of many of the schemes and programmes. Applications can also take up a lot of time and resources (often with a low rate of success) that a business could otherwise be using to develop the company. Furthermore, NDNDF often provides a one-off payment which may help short term cash flow but may not be suitable for those businesses looking for long-term investment.

Options for non-dilutive non-debt fundraising

• Government funding: SME R&D Tax Credit scheme – a Government tax incentive scheme designed to ‘reward’ UK small and medium-sized enterprises (SMEs) for their work on cutting-edge projects. Businesses that qualify are reimbursed up to 33% of their development costs which can include employee salaries, subcontractor expenses and software and infrastructure costs. Eligible companies must:
  • have less than £100M revenue;
  • have fewer than 500 employees;
  • be registered in the UK and be liable for corporation tax; and
  • have conducted research and development work that satisfies HMRC’s definition of ‘eligible R&D’.
• Innovate UK grants – Innovate UK (a government body part of the UK Research Institute (UKRI)) offers several grants, the most popular one being SMART. Businesses from any industry can apply for a share of the £25m investment for projects lasting between 6 and 36 months that are for “game-changing and commercially viable R&D innovation that can significantly impact the UK economy”. The SMART funding programme is very competitive and runs once a year with only 6% of applicants being successful. Small Business Research Initiative (SBRI) (part of Innovate UK) also offer various innovation grants (by running competitions) across a range of industries including manufacturing and digital security. Successful applicants can receive up to £100,000 to test an idea, and up to £1 million to develop a prototype. For businesses in Scotland, Scottish Enterprise also offer SMART grants under the "SMART: SCOTLAND" banner.
• Accelerators and Incubators: Both incubator and accelerator programmes provide advice, mentoring and training to early-stage businesses. Incubators (such as Level39 and Seedcamp) are usually non-profit organisations that focus on early stage start-ups who may not necessarily require capital but need assistance with the foundations of their business. Accelerators (such as SETsquared, Farm491 and The University of Edinburgh AI Accelerator) work with more established companies to help them grow and scale up within a set timeframe.  The added benefit of accelerators is that they are more likely to offer capital alongside training and mentorship. However, as the goal is rapid growth, accelerator programmes can be very competitive and any funding provided may require businesses to give up a portion of ownership.

DEBT FUNDRAISING 

Debt funding essentially involves taking out a loan (either from an individual or a lending institution), which means a company will incur liability - both in terms of paying back the capital, as well as interest. 

Key considerations of debt fundraising 

The available options for a company to fundraise through debt are usually determined by the company's stage in the growth lifecycle. Start-ups will have more limited options when compared to more mature businesses as they are unlikely to be profitable or perhaps even revenue generating, and will have limited assets against which security can be taken. Obtaining a bank loan usually requires consistent cash flow and may be difficult for early-stage businesses who struggle to demonstrate that they can afford to repay the loan and meet the interest payments (due to a lack of significant or absence of revenue), as well as the challenge of evidencing creditworthiness based on previous repayment activities.

Fundraising using debt can offer flexibility due to the wide range of loans that may be available, both in terms of amount borrowed and interest rates.

An obvious advantage of debt versus equity fundraising is that debt fundraising (unless it is convertible into equity) does not require the dilution of company's shareholders. This may be a key consideration for founder teams who wish to avoid further dilution before it is necessary. For the vast majority of start-ups, dilution is inevitable at some point in the funding journey and so it is important that founder's do not give away too much equity too early.

However, debt funding may not be suitable if your business is struggling with cash flow, as the monthly repayments are a recurring expense and should be factored in when assessing the suitability of taking on debt. In addition, lenders are usually risk-averse and so will often require some form of collateral to be given and this can mean individuals in the business offering their personal assets. Further, if repayments are not met, the lender may be able to impose charges or even seize the assets of the company (or personal collaterals if given). Another consideration is that it may be difficult for a company to be accepted for a loan at the outset if they cannot provide sufficient financial records and demonstrate creditworthiness.

Options for debt fundraising

• Bank Loans – asking a bank for funding is useful for accessing larger loans and can come with low fixed interest rates as well as structured and predictable payment arrangements, which facilitates accurate cash flow planning. However, as above, obtaining a bank loan may be difficult for early-stage businesses. A further consideration is that applications for bank loans can take a lot of time and resources.
• Venture debt – venture debt is a specific type of loan that is specifically available to venture capital-backed businesses. In other words, lenders will look at the specific venture capital funds that have invested in a company rather than on the basis of a valuation. Therefore, capital is offered based on previous equity funding rather than in return for equity. Venture debt can be advantageous for companies who want to avoid ownership dilution but are in need of capital. However, venture debt is still capital which needs to be repaid and interest rates are often high. Also, the consequences of default can be very damaging, as lenders may be able to force a sale of the company. Venture debt providers will typically require warrants. By granting warrants to a lender the Company is giving that lender the right to acquire shares in the company within a specified period of time at a guaranteed price. Given the level of risk associated with investing in an early stage business, venture debt providers look to balance the economics of the transaction by allowing for the possibility of equity returns through the grant of warrants.
• Government start-up loans – UK-based businesses which have been trading for less than 24 months are able to apply for a government-backed start-up loan. Specifically, each director in the company can take out a loan of up to £25,000 with an annual percentage rate of 6% over five years. This type of funding is advantageous for early stage businesses who need short-term funding. In addition to the capital, mentoring support is given for up to 12 months from an individual with experience in the relevant industry. However, the limitations of these loans include the cap of £25,000 per director (which may not be sufficient for some businesses) and the fact that the loans are personally taken out by directors. Certain businesses are also ineligible to apply, for example those in the banking and property investing industry.

EQUITY FUNDRAISING

Equity funding involves giving away a percentage of ownership of the company in exchange for capital investment.

Key considerations of equity funding 

The main advantage of using equity funding is that the business does not acquire additional financial burdens, namely capital repayments and interest charges, which in turn affects its cash flow. Instead, it allows for existing capital to be invested in maintaining and growing the business. An additional consideration is that, unlike with debt, whereby the relationship between borrower and lender is purely financial, equity investors often bring added value in terms of experience, knowledge and connections.

The most obvious consideration is that the Founders stake in the company will be diluted as investors acquire a percentage of the company’s share capital. Another consideration is that, at the outset, investors will be looking for a good return on their potential investment and so acquiring equity funding may prove difficult and competitive, not to mention time-consuming. Those investors will also look to protect their investment through the economic rights attaching to their shares and contractual controls over the governance of the company.  

Options for equity fundraising

• Friends and family – receiving investment from friends and family is often a quick and easy process, with minimal documentation. However, in most cases, the amount of investment is lower than from other sources and there is always the potential for emotional tension resulting from conflict.  
• Angel investors – usually individuals or groups of individuals who invest in early-stage businesses with high-growth potential in return for shares in the company. According to a report by the UK Business Angels Association (UKBAA), the average Angel investment is £25,000 and AVs will usually request between 15% – 30% ownership of the company. Angel investment can bring additional benefits such as experience and advice, but on the flip side this can create conflict if they use their expertise to dictate the path of the business in a different direction. Angel investors will often want to benefit from the tax benefits of the Enterprise Investment Scheme (EIS) or the Seed Enterprise Investment Scheme (SEIS) and may only invest in companies who qualify for such schemes.
• Crowdfunding – equity crowdfunding involves a business running a campaign on a crowdfunding platform (such as Seedrs or Crowdcube) on which they pitch the investment opportunity to the platform’s users, setting out how much capital they need to achieve their next level of growth and the amount of equity they are willing to offer to potential investors. Crowdfunding is a great way to access a wide range of potential investors and through promotion on platforms, businesses also gain access to new markets and customers and gain exposure while raising funds. However, while platforms offer access to a wide range of potential investors on a large scale, save for the market exposure and testing that forms part of the process, those investors add little beyond their capital and, depending on whether a nominee structure is used, can add complexity to the company’s cap table.  
• Venture capital (VC) – unlike Angel investors, venture capital funding is on a larger scale (usually between £1m and £50m). VCs are a great source of capital, can open doors as a consequence of their experience, networks and value-add services, but they have their own investors’ interests to protect and so the terms on which capital is invested and the associated legal documentation can be more complex and onerous. There can be additional costs involved in receiving VC funding with some VCs charging 'arrangement fees' or 'monitoring fees'. 
• Bridge financing (advanced subscription agreements and convertible loan notes): for more detail on the two most common types of bridge financing, please see our article on advance subscription agreements and convertible loan notes: Advance Subscription Agreements vs. Convertible Loan Notes

Conclusion

There are a wide range of funding options available to businesses at all stages of their lifecycle. However, it can be overwhelming to know which option is most suitable and what the implications are in terms of liability and risk.

If you are unsure as to which type of funding is right for your business please contact Alex Lloyd or Niall Mackle who can guide you through the options.