Early stage financing still has lots to offer and some exciting ventures have succeeded in raising funds.

It was one of the toughest decisions Chris Tanner, founder of business software company BrightPearl, ever had to make.

In 2009, less than two years after starting the company, Tanner found himself a finalist in the popular and highly respected SeedCamp competition, where winners receive €50,000 (£43,000) in growth capital to develop their business.

But instead of accepting the money, Tanner, on the advice of the company’s non-executive director, serial entrepreneur Doug Richard, turned it down and walked away.

‘We deliberately didn’t win,’ Tanner says. ‘At that point, the company was worth more than that initial valuation and effectively that valuation would have put a peg in the ground. We decided it would have been hard to leverage a real seed round at a higher valuation.’

It was a risky strategy that paid off for Tanner. Eighteen months later, in mid-2010, BrightPearl closed its first formal seed round after securing £750,000 to £1 million from venture capital firms Eden Capital and Notion Capital.

‘It was really hard to say no,’ Tanner recalls. ‘It’s really hard for any company, especially if you are struggling for cash and you have started paying people. In some situations, you just don’t have the choice, but we felt we had a choice.’

Funding the future

For start-ups with a good story, there is an increasing choice of providers proffering funding. Bank lending continues to be constricted, but a growing number of incubators and accelerators are active across the UK ready to inject funds in very early-stage businesses.

In addition to the traditional avenues of seed funding, such as family, friends and business angels, there are also new online crowdfunding platforms, including CrowdCube and Bloom VC, which enable companies to secure finance from strangers, and a resurgence of interest in very early-stage financing from venture capital firms. Major players such as Index Ventures and Greylock Partners have recently launched dedicated seed funds, while DFJ Esprit is contemplating a move into the space.

According to business information company UKFunders, there were 131 deals involving an investment of £1 million or less in companies in the past year. Of the 99 deals where the deal amount is known, the total invested was £38.7 million and the average is £390,000.

Unsurprisingly, business angel networks are very active at the seed level. London Business Angels leads the category, having made 15 investments of £1 million or less between October last year and September this year, followed by TRI CAP, a Scottish network, with seven deals.

Regional funds have also been active, namely The North East Accelerator Fund, North East Technology Fund, Scottish Co-Investment Fund and the North West Fund for Venture Capital.

Technology companies were the primary recipients of seed funding in the period, accounting for 52 per cent of deals, with popular subsectors including life sciences and software.

Angels rush in

London Business Angels managing director Anthony Clarke says angels are popular at the seed level because they understand the need for ‘patient capital’. He explains, ‘The angel knows that the money is going to be locked into that company for a fair period of time, three to seven years, more likely seven at the moment. The venture capitalist probably needs a return within three years, so the approach of the investor is different.’

The average investment for members of the angel network is between £250,000 and £500,000. Though these sums are smaller than those typically invested by venture capital firms, angels are also more likely to take risks, adds Clarke.

‘If the angel deal doesn’t work, you might as well see it fail, and, dare I say it, keep your tax losses and move on,’ he says. ‘The venture capitalist is much more wary of admitting failure – they have to report that failure to their investor base.’

On the negative side, Clarke concedes, some angels might not be able to follow through with the company in later financing rounds because of a change in their circumstances. Follow-on funding is where venture capital firms usually are strongest, he says.

Exciting times

Veteran venture capitalist Robin Klein, partner at Index Ventures and founder of seed investor The Accelerator Group, says the UK’s current start-up and early-stage business scene is ‘as active as I have ever known it’.

‘There are many more sources of funding than there have been in the past too,’ he continues. ‘It has never been a perfect market because the supply of funding is not as clearly defined as it might be in later stage, but there is a lot of capital about, especially in technology.’

In April last year, Index launched Index Seed, which has so far made 13 investments. Klein says Index Seed focuses on technology companies, and represents an attempt by the firm to redress the balance as its other funds have moved away from early-stage ventures towards ‘private equity-type’ growth stage investing. He says an average seed investment for the firm is about €250,000 (£214,000).

While there has been much talk about a second technology bubble leading to inflated valuations, Klein hasn’t noticed this happening at seed stage.

‘At a later stage, yes, we are seeing people ask for more at higher valuations, but I think in many ways it is justified,’ Klein observes. ‘I would say in raising a Series A, a first institutional round, expectations for what the company will have achieved by that point are higher than they were in the past.

‘Nowadays, one would not only expect to see a prototype, but the product on the market, users and some growth in user engagement before you make a Series A investment.’

Level best

One of Index Seed’s first investments was Level Business, a provider of UK company information to the public for free via the internet. Founded by director James Dobree, the company secured just under £1 million in November last year from Index Ventures and Eden Ventures that is mostly being spent on hiring staff.

Dobree began developing the company after securing a £2 million research grant through Southampton University. He spent three years on a project for the university before branching out on his own to commercialise his technology last March.

Having launched other businesses in the past, Dobree wanted to try a new strategy when fundraising for Level Business.

‘My strategy in the past has been to broad-brush, and take the VC through a funnel – basically target a large number, go and pitch to a lot of people, and see who came down the funnel,’ he explains. ‘This time, our approach was totally different. We decided to pick three targets we would really like to get funding from, and go and talk to them. They were one angel and two VCs. Amazingly, it worked.’

Nurturing growth

There are a number of other avenues for businesses seeking early-stage finance or investment and support to grow operations. Incubators, which are also known as accelerator programmes, have grown rapidly in recent years.

In November, clean technology company Pilio became the first company to graduate from the Isis Software Incubator. Isis Innovation is Oxford University’s technology commercialisation arm, and launched the incubator in January this year.

Pilio, which has developed an online energy monitoring tool for small and medium-sized businesses, spent one year as part of the incubator. CEO Catherine Bottrill puts the total amount of support that she has received through being involved in the incubator at £500,000, taking in grants, services gained, contracts won and salaries paid.

Third-party funding aside, Sharon Brennan, partner in the commercial tax unit at law firm Lewis Silkin, says many early-stage companies forget to look internally for additional sources of finance.

‘There are so many ways to raise money by thinking outside of the box,’ she says. ‘My experience is that a lot of start-ups don’t even think of the fact that there may be tax reliefs available to them.’

Brennan explains that there are a number of tax advantages for young companies. These include research and development credits, PAYE deferral and pension structuring.

Activity looks likely to increase in the seed space next year after Chancellor George Osborne announced a boost to the Enterprise Investment Scheme, which offers tax relief of 20 per cent for backing young UK companies and smaller, unquoted companies up to an investment limit of £500,000 a year.

In his autumn statement, Osborne said those investing in start-ups would receive enhanced relief of 50 per cent on investments of up to £100,000 per annum, with effect from April next year.

Cynics have argued that the overall impact on the economy will be minimal, pointing to the fact that the government estimates the cost to the Treasury of the Seed Enterprise Investment Scheme at just £50 million. But surely the whole point of seed finance is that a little goes a long way.