The fundamentals of raising equity

Investment sources include things like seed funds, incubators, business angel networks, family offices, regional funds, corporate venturing funds, international investors (individuals and companies) and enterprise capital funds (ECFs). 

For early-stage companies, it is especially important to develop a network of industry contacts as it is these connections (individuals that understand your sector or know you personally) who, directly or indirectly, are the most likely source of investment.

For further reading check out the Sat Nav article on Understanding the different types of business funding.

If raising equity finance, you should make sure you are raising the right amount at the right time at the right valuation from the right source. A mismatch here will decrease the chances of successfully raising capital.

There are several business structures in the UK, including sole trader, partnership, limited liability partnership (LLP), unincorporated association, community interest company (CIC) and company limited by guarantee. 

To raise equity finance, you need to set up a limited company that is registered on Companies House, making the buying and selling of shares in your business more practical.

Private investors paying tax in the UK can benefit significantly from tax relief of up to 72.5% of the funds they invest into UK limited companies under the Enterprise Investment Scheme (EIS) and the Seed Enterprise Investment Scheme (SEIS).  

Approximately 70% of private investors in the UK prefer to invest in companies that provide them with tax relief under the S/EIS. In fact, the majority will not even look at an investment opportunity unless tax relief eligibility is explicitly stated upfront. 

There is also 100+ S/EIS investment funds which pool private investors’ funds and look to invest into early-stage ventures to obtain tax relief on their behalf.

One of the biggest complaints from private investors is the fact they get ignored the day after they invest their cash into a business.

If you are asking private investors for money, you need to keep them on board with regular reporting. Inform them on things like quarterly updates and an annual Shareholder Meeting sharing annual accounts and the budget for the following year.

Many early-stage companies will not have a formal board in place, but most successful businesses use their network to persuade two to three key people in the industry to join their board. 

This can be very helpful in terms of: 

• Giving confidence to investors that someone is overseeing corporate governance and representing minority shareholders’ interests
• Assisting with fundraising through introductions
• Supporting the executive management team in acting as a sounding board
• Making introductions to key market and strategic partners
• Giving strategic guidance to manage the growth of the business through to exit
• Providing credibility to external stakeholders

Watch out for chairs or non-executive directors who require annual cash fees as a condition of investing. 

Entrepreneurs need to strike a balance between explosive financial projections, which they believe investors will want to see, and credible numbers that have a realistic chance of being achieved. 

Typically, you will need to show financial projections for five years. The first two years broken down by month and the following years in quarters. It can be helpful to prepare target and realistic (and even worst-case) scenarios. 

Financial projections should include the following:

• Cashflow forecast outlining the company’s cash needs - this will include capital expenditure, exclude depreciation, and allow for delays in receiving payments from clients/customers as well as building in payment terms to suppliers. 
• Profit and loss account forecast outlining the profitability of the company. A company can be profitable and yet still require cash for capital projects.
• Balance sheet forecast outlining the company’s financial position at each year end in terms of assets and liabilities. 

Do keep it simple. Massively over-complicated and detailed excel models that the author can only understand will put off investors. It is important to show the key revenue drivers to enable investors to understand the business model.

When raising investment from private investors (business angels), it is best to avoid complicated investment structures that are difficult to understand. If raising equity finance in the UK, ensure the proposition is eligible for tax relief under the (Seed) Enterprise Investment Scheme (S/EIS).

Increasingly, companies are looking to offer different investment structures such as Convertible Loan Notes (CLN) and Advanced Subscription Agreements (ASA). Some private investors are not comfortable with such structures as they are seen as more complex regarding the treatment of their rights and the treatment of S/EIS tax. 

A pet peeve of investors is business plans that only tell you the good bits. Investors need to see the whole truth to make a decision – that means the good, the bad and the ugly.

If raising money from experienced investors and funds, you will be expected to provide disclosures on a range of matters, including:

• Do you employ your spouse, son or daughter, or any other family member?
• Has any member of the team been involved in insolvency or been disqualified from being a company director?
• Are any of the management team members involved in another business? Ideally, they are wholly and exclusively working for the company without any potential conflicts of interest 
• Have you disclosed all financial liabilities, including taxes due?

Arguably, one of the biggest challenges in the early-stage investment market is setting the pre-money valuation for the investment round.  

A key complaint by investors, especially when viewing propositions on crowdfunding platforms, is that entrepreneurs tend to base valuations upon expected future earnings without considering the associated risks. 

This has led to businesses that have successfully raised investment having to go through a “down-round” later to attract follow-on investment from sophisticated or professional investors. 

Know your worth. Many companies mistakenly believe it is better to let the investor decide. That can be fine if you’re dealing with a single potential investor, such as a fund or VC, but if asking private investors, it is quicker and better to present the investment offer in full, including the share price.

The 'fundraising spread' is the minimum and maximum you are raising, all at the current share price (valuation). For example, you could be looking to raise a minimum of £450,000 and a maximum of £750,000. 

Having a vast fundraising spread can call into question your strategy. It can come across as’ just give me as much as you can and we’ll spend it’, which is never reassuring. In addition, the share price/valuation is likely to be different the more you raise and mature as a business. 

Investors will want to have some idea as to how their money is going to be used. This could be sales and marketing, tech development, new hires or working capital.

Importantly, S/EIS funds cannot be used for certain items, for example, buying a freehold property, acquiring shares in another business or paying off existing loans.  

A clear exit strategy should be part of your investment proposition. The business exit is where investors will get their money back – hopefully with a return.

Business angels research conducted by UKBAA and British Business Bank shows the most common way in which businesses exit are:

• Trade sale 55%
• Sale to other shareholders (including management buy-outs) 10%
• Sale to a third party through a secondary sale process 10%
• Listing on a stock market 10%
• Other 15% 

It is good practice to provide examples of businesses that are similar to yours who have exited.

Raising capital requires assistance in a number of areas, from the legal documentation to the S/EIS application to marketing. As a rough guide, it is recommended you have a ‘war chest’ of around £10,000 to £20,000 plus fees. In total, the cost of raising finance can be around 8% to 10% of the funds raised.