The fundamentals of raising equity
Finance & Funding
Key learnings
- Only around 1% to 10% of businesses seeking investment are successful in doing so.
- For businesses looking for capital to grow, it’s essential to ensure they are raising the right amount of finance and at the right time.
- Before looking for investment, you need to understand the obligations you’ll have as a result and what they will mean for your business.
- Raising equity finance is a marathon, not a sprint.
If you’re looking to raise equity to grow your business, there are some fundamental things you must consider first. Here, Oliver Woolley, CEO and co-founder of Envestors, covers the essential questions businesses need to answer to maximise their chances of success when raising capital.
Raising equity finance is a marathon, not a sprint. It can be as short as six weeks to close investment, but typically it takes six or more months.
Businesses need to factor this into any fund raising plans, including deciding if raising equity is the way you should be going. The objectives you set out will dictate the type of finance you should raise: the two key options being equity (selling shares in your company) and debt (borrowing from a bank or financial institution).
There are two types of business:
- A 'lifestyle' business that you want to develop but have no real expectation of selling
- A 'growth' business that you are looking to grow and scale and then sell in the foreseeable future (e.g. the next five years)
If growth and sale are not part of your plan, then an equity raise is not the right choice for you. But if it is, you need to be aware of the challenge you face. There have been several research studies on the success rate of companies raising equity from external investors, excluding friends and family. The results range from 1% to 10%.
One study by Mason and Harrison shows what happens to business plans presented to investors. Only 2% succeed, with 60% being rejected immediately and a further 25% after an initial review.
Furthermore, the Business Growth Fund say they invest in fewer than 1% of the propositions they receive. Out of 1,500 applications, 33% of business plans are reviewed, only 3% of management teams receive meetings, and from this, only 1% receive investment.
Click below to find out what questions you need to answer before you start...
1
Have you considered all sources of funding?
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.
2
Are you raising the right amount from the right people at the right time at the right valuation?
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.
3
Do you have the correct legal structure?
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.
4
Are you eligible for UK tax relief under the Enterprise Investment Scheme (S/EIS)?
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.
5
Are you aware of the obligations of having external investors?
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.
6
Have you got, or will you work towards getting, an independent board?
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.
7
Have you prepared balanced financial projections?
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.
8
Have you kept the investment structure simple?
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.
9
Are you prepared to provide full disclosures?
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?
10
Is your valuation reasonable?
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.
11
Is your fundraising spread sensible?
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.
12
Do you know how you will spend the investment?
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.
13
What are the most likely exit routes?
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.
14
Do you have enough cash to raise cash?
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.
Next steps...
- For more information, check out our articles understanding the different types of business finance and equity finance vs debt finance.
- Use UMi’s finance, funding and grants finder to be aware of local and national funding schemes.
- Use UMi's Loan Finder Tool to find a tailored finance provider for your business.