Understanding investors and funding.

This article was written by Michael Buckworth, a partner in Buckworth Solicitors. Buckworth Solicitors is a London based law firm specializing in assisting start-ups on a range of matters. The firm works on the basis of affordable fixed fees.

Commentators, politicians and professional advisers often apply labels to different types of investor: angels, VCs and private equity. The purpose of this article is to set out in simple terms the cast of potential investors and to explain the meaning and relevance of various commonly used jargon.

What type of investor

Many startups are funded, at least in the initial stages, by friends and family often on an informal basis. However, when businesses grow and/or need larger quantities of investment, entrepreneurs are often forced to look to outsiders.

A common and effective form of fundraising is to take investment from one or more high net worth individuals who have an interest in (and ideally experience with) the company’s business sector. The upside to the entrepreneur of such investors is that he can benefit from money and experience and the upside to the investor is that he can better judge the performance of the business and can, to some extent, influence its future direction and therefore the security and return on his investment. This type of investor is commonly classified as a "business angel."  

Angels need not be involved in a business in which they have invested. They can be entirely passive investors and indeed can invest in parallel with a number of investors, as part of a so called "Angel Network" or "Angel Syndicate." 

An alternative to angel funding is provided by VCs (or “Venture Capital”). VCs manage the pooled money of others in a professionally-managed fund. Their funds are often derived from a variety of sources including private equity, angels and corporate strategic investors. They look for companies in which to invest with high growth potential and tend to expect high returns within three to five years.

VCs tend to be most suitable for companies with large upfront capital requirements which cannot be financed by cheaper alternatives such as debt.

How much funding?

Identifying in advance how much funding is needed is crucial. A company in need of investment is at its most vulnerable. A cash-flow insolvent company is generally treated as being valued at a discount to its asset value and/or multiple of earnings valuation. The temptation for investors is to leverage the company’s weak financial position to win a better funding deal. For this reason, businesses should try to avoid repeatedly returning to investors for funding.

In addition, each round of investment tends to involve the issue of new shares to the investors. This may result in the existing shareholders (including the founders) being diluted. Too many investment rounds can leave the founders with little more than a nominal stake in the business.

Debt or equity

Current trends are for companies to issue investors with shares in exchange for their investment. This is largely due to the current structure of favourable tax incentives for equity investment in the UK (via SEIS, EIS and VCT) and the desire for investors to have an uncapped share of the upside if the business is successful.

However, there can be benefits both to entrepreneurs and certain types of investor to seeking investment by way of debt rather than equity (or generally a combination of both debt and equity). The investor can benefit from a regular cash flow (deriving from interest payments), a greater than average return on investment and potentially security over the assets of the company. The founders of the company can benefit from having to dispose of less equity, retaining control of the business and potentially being freed from the constraints of an active investor shareholder.