Understanding the different types of funding

Early stage

Most start-ups phase are eligible for grant funding and to enter competitions carrying cash awards. Frequently such funding does not require repayment and can be used as the owners wish, without operational interference. Note, however, that such funding is usually low value and comes with conditions, such as a requirement for matched funding and restrictions on how the money can be deployed. Receipt of grants and winning awards can be a good base for generating publicity towards future funding. Publicity can also be generated by crowdfunding (see below), and reward crowdfunding - offering product in exchange for cash - can be a relatively easy way of generating funding without giving up ownership.

Traditionally a business’s first port of call for funding would be their bank manager. Today bank managers have practically disappeared and a business must be cashflow positive with secure assets before a bank will lend and then usually with personal guarantees from the owners. The “challenger banks” are now stepping into the shoes of traditional lenders, offering a wide range of products, from invoice discounting facilities to
trade finance for exporters.

Increasingly businesses are turning to alternative debt funding sources. Angel networks now make debt funding available in addition to equity, although usually only to existing investee companies. Peer to peer lending (also known as debt crowdfunding) is becoming increasingly popular. This is regulated by the Financial Conduct Authority and becoming mainstream. Changes to pensions and savings legislation are growing the crowd of lenders seeking a better return than traditional savings accounts.

Equity funding

Theoretically, through equity funding owners of a business give away a slice of their ownership in return for funds invested, ultimately getting a smaller slice of a bigger pie. Equity funding therefore represents genuine risk capital which may be lost entirely by the investor if the business fails. If the business succeeds then the investor makes a healthy return, and may also receive dividends. The investor risk can be mitigated by investing in businesses which are eligible for EIS or SEIS tax relief (a tax relief operated by HMRC to encourage investment in new and growing businesses), which provides for tax free gains and as generous loss relief, subject to certain criteria.  

Multiple funding rounds may be required, giving existing shareholders the opportunity to ‘follow their money’ and bringing in new investors to add specific skills or contacts to the business. Normally equity investors are involved in the business, either through simple ‘investor protection’ rights or a board position.

• Friends and family - to get the business started. Notwithstanding the closeness of any relationships (and perhaps for just that reason) it is important to record investment terms properly to avoid disputes down the line.

• Business angels, a collection of high net worth individuals, expect a high degree of influence over the operation and direction of the business and operate on the basis of proforma investment documentation.

• Equity crowdfunding, where a ‘crowd’ of small investors combine to raise equity funding. Equity crowdfunding can be carried out in conjunction with business angel funding to fill a funding gap. Crowdfunders invest small amounts in several businesses thereby spreading their portfolio. They tend to seek out businesses with EIS or SEIS status.

• Venture capital or private equity funds are investment funds of pooled money from a combination of individualsand corporate entities managed by specialised teams who seek to identify suitable investment opportunities to produce a return for their investors. They tend to be sector specific with set investment criteria, and a heavy involvement in the operation of the business and a sharp focus on an exit. Venture capital focuses generally on early stage technology and healthcare businesses, whereas private equity provides funding to more mature businesses and management buy outs.

Morton Fraser has hugely experienced lawyers in all of the above areas and would be delighted to discuss any aspect covered here in more detail.

Iain Young
Partner, Morton Fraser LLP
Contact: 0131 247 3194
Iain.Young@morton-fraser.com