Early-stage funding for startups – The personal approach

Proverbially, start-ups are funded by one or more of the ‘four Fs’: friends, family, founders and fools.

It’s significant that the list does not include banks. Four years ago, when those institutions were still blithely buying up billions of sub-prime mortgage debt, 23-year-old Ben Taylor was rejected in his application for a £15,000 overdraft. Taylor wanted to develop an online tool for nightclubs to promote and sell tickets for their events.

It wasn’t an outright rejection: the bank was prepared to extend the facility if it was secured against the tool hire business owned by Taylor’s father. Fortunately, his father agreed, and even invested £25,000 of his own money six months later. Taylor’s business, Fatsoma, is now profitable with sales of £2 million.

‘Dad had been in business for 20 years; he’d been through it all before,’ says Taylor. ‘It was quite reassuring to hear him say that businesses do take a long time to get off the ground.’

Experience counts

People who have been in business themselves can make patient, supportive investors, even if they aren’t members of your family. Shane Taylor and Richard Neale co-founded cloud computing company Esselar several months ago with funding from established IT entrepreneur Simon Rogan. They knew Rogan from working with him at a business he went on to sell, Sirocom, for more than ten years. ‘It was never our strategy to borrow money from Simon,’ says Taylor. ‘We were going to build Esselar the traditional way, starting off very small from our front room and grow from there.

‘Simon asked a lot of questions [about our plans] and seemed genuinely interested in what we were proposing to do. Then the conversations took a different direction.’

Those conversations saw Rogan invest £250,000 in early-stage funding, with an equal sum promised at a later stage. Ironically, the deal was scheduled for completion on 2 February, the day the UK saw its heaviest snowfall for 18 years. ‘A big driver of our business is remote working – well, the snow didn’t stop us working, but it did stop our solicitors getting to their office,’ Taylor reminisces. Contracts were signed the following day.

Rogan now has a ‘significant stake’ in Esselar, which the company has the option of reducing by repaying the money. ‘He’s offered to be as involved as we want him to be, but he is very clear that he doesn’t want to step on our toes, or to run another business. The experience he has is almost as important as the funding,’ says Taylor.

Active investors
Oliver Woolley, a partner at business angel network Envestors, says angel investors fall into three camps. There are the entrepreneurs who, like Rogan, tend to have sold their own business and want to help others grow theirs. Then there are the serial non-executives with a background mainly in listed companies who are ‘fed up with playing golf all day’. Finally, there are the ‘professionals’ – laywers, bankers and accountants investing their bonuses – although for obvious reasons that source of funding ‘has largely dried up’. What all three types have in common is that they want to be actively involved in their investee businesses, providing useful contacts, generic skills, and often industry-specific insight.

Those seeking angel investment have one thing in their favour at the moment, according to Woolley: it’s very hard to get a return on your money anywhere else. There’s also the tax benefits of investing through the Enterprise Investment Scheme, a government initiative to encourage investment in growth companies (see box).

Tony Hayday set himself up as a business angel three years ago after selling his direct mail company, The Software Bureau, for £8 million. Since then, he has invested £1.5 million in eight businesses, and is still actively involved with all of them.

‘I made the conscious decision I didn’t want to grow a single business by myself again and then ten or 15 years down the line look for an exit,’ explains the affable Hayday. ‘But I love business – I love negotiating, doing a deal, looking at opportunities and networking. I don’t care what industry it’s in.’

Gut instinct
Hayday’s investments include a mortgage business, an Australian film company, and a web venture that helps ISPs generate revenue from error traffic. Though he insists his investments are more than a hobby (‘they’d be a pretty expensive hobby’), he admits his approach is far from scientific.

‘I don’t make investment decisions based on looking at something on paper. I have to decide, yes, I feel safe working with these people: we can have good fun, they’re driven and have the endgame in mind.’

As for exits, ‘I think you have to be a bit relaxed about it. When you make plans, that’s the only time God laughs.’

So how does a budding entrepreneur go about finding someone like Hayday? ‘That’s tricky,’ he remarks. ‘If you’ve got a good relationship with your bank or accountancy firm, they’ll know people, or they’ll know people who know people.’

Another way to locate strangers with money is through a network such as Envestors. Woolley reveals that the organisation receives proposals from about 100 ventures a month, three of which are selected to pitch to its members. Of these, 40 to 45 per cent attract funding, making the overall success rate just over one per cent. ‘A lot of people are unrealistic in their expectations,’ Woolley observes.

The most common error made by those who get to the pitching stage is talking too much about the business and not enough about the investment. ‘You have got to be talking about the investment in terms of pre-money valuation and what the exit is,’ Woolley counsels. ‘That’s the investor’s main interest.’

The DIY approach
Avoiding external investors altogether may seem like an easier option, but potential problems shouldn’t be underestimated. David Pratt is co-founder of hosted IT company ThinkGrid, which was set up last year with £1 million from himself, co-founder and CEO Rob Lovell, and four other executives who are involved on a day-to-day basis in the business.

‘We’ve had experience of building businesses and we’ve learned some lessons, including some painful ones,’ says Pratt. ‘There is a tendency, when you invest with people you know, to think “we’re mates, so it’ll all be fine”. But just because you’re good friends doesn’t mean you’ll share the same vision and approach, or jump the same way when there are difficult decisions down the line.’

To pre-empt such problems, Pratt advocates nailing down issues such as whether the company will grow organically or by acquisition; its exit strategy; and whether it will seek further, external investment. Another important question is whether all the current investors still have extra money to put in if there is another round of funding.

‘Making time to talk about these things can be difficult – it’s easy to focus on the short-term thing of just getting the business off the ground,’ says Pratt. ‘But it’s very important to assume you will get to where you’re aiming for and think about the choices you’ll have to make when you do.’

Rewarding risk
Celebrating its 15th birthday this year, the Enterprise Investment Scheme (EIS) allows investors to claim tax relief on investments of up to £500,000 in trading companies with gross assets of less than £7 million and fewer than 50 staff.

A key draw for investors is the ability to set 20 per cent of their investment against their income tax liability for the year, allowing a maximum benefit of £100,000. In addition, gains they make will be exempt from capital gains tax, while losses can be set against income for the year when tax is calculated.

Qualifying private companies can raise a maximum of £2 million a year through EIS and the two other government venture capital schemes and must use the money within two years.

Nick Britton

Nick Britton

Nick was the Managing Editor for growthbusiness.co.uk when it was owned by Vitesse Media, before moving on to become Head of Investment Group and Editor at What Investment and thence to Head of Intermediary...

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