Introduction
Raising capital is a key but potentially dangerous milestone at the beginning of a start-up company’s lifespan. Start-ups will want to raise funds in line with their values and requirements and avoid falling prey to financing arrangements which are over ambitious or imbalanced. This article provides an overview of the ten key issues start-ups should consider when thinking about financing their future. These considerations include:
1. The type of fundraising required;
2. How to identify the investors you want to approach;
3. The amount of investment you require and when it will be needed;
4. Developing your business plan;
5. Preparing your pitch;
6. Financial forecasting;
7. Non-disclosure agreements for initial discussions;
8. Preparing your template terms;
9. The Cap Table; and
10. Due diligence Preparation.
1. The type of fundraising required
While this is quite an obvious consideration, it is important that you understand the difference types of financing available and the pros and cons of each. The different types of fundraising include:
- Grants – there are various grants available for start-ups on the market. Examples being those offered by the R&D Tax Credit Scheme and Innovate UK. Examples specific to Scotland include the grants offered by the Scottish Investment Bank or Scottish Edge. Many grants are industry specific so be sure to look online for any specific to your field. A good place to start is on the .gov website linked here.
- Debt Financing – this is the standard bank loan, but also includes an option geared for start-ups known as start-up loans or venture debt;
- Equity Financing – these are financing options where money is provided in exchange for a % of the company’s ownership. This type of funding could come from family and friends, angel investors, crowdfunding or venture capitalists.
We have recently published a blog which describes in detail the different types of financing as well as the pros and cons of the different approaches.
2. Identifying investors
Leading on from the first consideration, once you know the type of financing you would like to obtain, the next step is to identify fundraising partners that you want to approach.
It is important that you find fundraising partners which are the right fit for you. Do you want a company or person who can provide support and advice or do you just want them to provide funding. This is a key consideration and should not be taken lightly. Choosing the wrong funder or investor can derail your start-up’s progress, but if you find the match they will help you open doors and take your company to the next level.
Some key points to consider at this stage are:
1. If an equity investor, is the investor interested in providing repeat rounds of investment – finding new investors each time you are looking for finance is time consuming and costly. On top of that, the more investors, the more your ownership is likely to be diluted (which in turn makes investment less attractive to further investors).
2. What do you (and they) anticipate your working relationship to be like – are they easy to get along with? Will they want more or less influence on operations? Or will they support you to get on with your best work? This is best addressed with an open conversation with your potential partner.
3. Do they fit with your start-up’s values – a good equity investor will hopefully be around for a number of years, you want to ensure that they are aligned with your start-up as they will likely have some degree of influence on the companies decisions.
4. The ‘lead investor’ – your first or lead investor will typically establish the terms on which your start-up will look to raise funds. A lead investor typically would invest over 15% of the entire amount you require and is someone other investors will look to. For that reason, you want to ensure that they are credible so that other investors will take confidence in their involvement. You will also want to ensure you are happy with the terms of their investment, which we discuss further below.
5. Diversification of investors – once you have your lead investor and are starting to attract more investors you may want to ensure that their finances are diversified from one another. This will ensure that if one investor ‘takes a hit’ the others will not be affected and will be able to continue to finance your start up.
Not all of the above considerations will be relevant to each start-up depending on which type of financing you opt to go with and considerations will change depending on the sector your start-up operates within.
3. The amount of investment you require and when it will be needed
The final consideration before thinking about approaching potential investors can be split into three points:
1. How much do you need?
This is a simple question but can take some time to work out. To start, consider all costs which you will incur in the early stages of the start-up. Examples would include salaries, development of products and your online platforms. This will involve a lot of educated guesses of course but you need some sort of ballpark figure to work with.
You should also consider your projected first year cash flow. Estimate sales and expenses as well as any payment lags and how that will effect cash flow. You should typically end up with a cash deficit at this stage due to the front-loaded costs of setting up a business. Financial forecasting will assist this process, we discuss this topic further below.
2. When will you need funding?
This involves working out your cash runway (i.e. the number of months until cash runs out). This can be estimated using the following formula: Cash Runway equals current cash balance divided by your burn rate.
To calculate your burn rate: subtract your monthly operating expenses from your monthly revenue. This should be tracked each month to measure progress.
When funding is running low, this is when you will want to inject further capital into the business.
3. How much funding will be needed in the future?
In certain cases this will be known at the start and should be discussed with any potential investor to determine whether they will be interested in repeat rounds of investment (as discussed above) and their attitude to future rounds involving other investors (be they strategic or purely financial).
4. Developing your business plan
To help visualise costs, developing your business plan is a good way to project the early lifespan of your start-up. The UKBAA has a guide for what your plan should include. Please find the guide linked here.
5. Preparing your pitch
You may need to prepare two pitches:
- the classic elevator pitch which should be attention grabbing, succinct and memorable; and
- a longer pitch for once you have a chance to sit down with a potential investor.
There are a lot of materials online about preparing both pitches and even Peter Thiel (co-founder of Paypal) has produced a slide pack template for longer pitches.
6. Financial Forecasting
Financial forecasting refers to financial projections performed to facilitate any decision-making relevant for determining future business performance. This process includes analysis of past performance of the business, current market trends and other factors. Failure to conduct regular financial forecasting can leave you blind to forthcoming dangers and opportunities. There are four types of forecasting with various benefits:
1. Sales forecasting
Sales forecasting involves predicting the quantities of products/services you expect to sell within a projected period. This has many benefits, it assists the company to budget and plan production cycles as well as helping the company manage its resources more efficiently.
2. Cash flow forecasting
This involves estimating cash flow in and out of the company during a set period. Such projections are beneficial as it highlights immediate funding needs and assists with budgeting. This means you’ll be able to accurately plan for future expenses and predict when other cash flow issues may arise.
3. Budget forecasting
Budget forecasting determines the ideal outcome of the budget, it assumes that everything proceeds as planned and relies on the budget's data, which in turn relies on financial forecasting data.
4. Income Forecasting
Income forecasting entails analysing the company’s past revenue performance and current growth to estimate future income. This is integral to cash flow and balance forecasting and it allows investors, suppliers or other interested parties to use this data to make crucial decisions about their dealings with the company.
These four types of forecasting are interconnected and provide a full picture of the company’s financial health. Furthermore, having your forecasting completed, will assist you in conversations with investors.
7. Non-disclosure agreements for initial discussions
A key concern many start-ups will have is protection of their intellectual property. Therefore, a vital tool to have at your disposal is a properly drafted NDA which you can use when holding initial discussions with potential investors. This will allow you to discuss your start-up’s vision openly with the safety of recourse against any party who may share your company’s secrets.
In reality, this is a protective measure and you are unlikely to ever need to call upon an NDA signed between yourself and a potential investor, but it is an agreement you absolutely need, regardless of who you are conversing with.
NDA’s are standard documents in the market but you should take legal advice on having a template NDA prepared for use by your company before entering into discussions with third parties.
8. Preparing your template terms
A template term sheet is something that you may also want to prepare before entering discussions with potential investors. A term sheet outlines the terms by which an investor will make said investment in your company. The term sheet will govern issues such as: how the financing is structured; the type of security; liquidation preferences; target dates; conditions; management rights; undertakings and voting rights. We discuss liquidation preference in more detail here.
Preparing a template term sheet will give you a chance to consider what is important to you and your start-up, however, please note that most investors will provide their own template terms. In this situation, having your own template terms will give you a point of comparison to review the terms provided to you. You will then be able to negotiate the terms if anything is completely unacceptable to you.
We strongly advise that you take legal advice on any template term sheets you plan on using as well as any terms provided to you by an investor.
9. The Cap table
The capitalisation table is a document (typically a spreadsheet) which provides an analysis of a company's percentages of ownership, equity dilution, and value of equity in each round of investment by founders, investors, and other owners. This is an essential document to keep up to date as you start to attract investors. This will help you keep track of founder equity and can be used to price any future funding rounds.
Again, there are a lot of useful templates online which give a good starting point.
10. Due Diligence
There are two key due diligence exercises which should be undertaken in anticipation of meeting with investors.
The first is to undertake a ‘self-DD’ exercise. In doing so, you should consider what an investor would be looking for and consider whether there are any gaps that should be addressed pre-investment. This exercise will pin point what you are missing so that you can plug any gaps. Depending on the sector your start-up operates in, there will be different information that investors will want to see during the DD process, please see the graphic below for general considerations to take into account.
The second exercise can be completed in conjunction with the first exercise as it involves compiling your key due diligence documents. You will want to have a pack prepared for investors which includes all of the key contracts the start-up has entered into and its key governance documents. These will include: employment contracts, IP agreements / protections and your current company constitutional documents (such as your Articles of Association and Shareholders' Agreement), and will also include corporate records such as the company's statutory registers and key filings made to HMRC. Lastly, investors will expect a section on finances and accounting matters, which should likely include statutory and management accounts. Typically these documents are uploaded to an electronic data room.
Completing these two exercises will expedite the investment process as all the information will be available to investors at the outset. It will also impress investors that you are prepared for due diligence which will build their confidence in you as an investment.
Conclusion
There is a lot to consider while preparing for your first round of investment and while it can be daunting, once broken down and tackled systematically it becomes much more manageable. Beyond this article, there is a lot of guidance and information online which should not be ignored. Starting a company is an expensive process at the beginning and you will want to find ways to cut the cost without cutting corners. That is why our BScale platform is ideal for start-up companies. BScale aims to support start-up companies by:
- the provision of required legal documentation free of charge through our BScale Document Generator;
- providing high-quality bespoke legal advice at a price point that is realistic for early stage businesses; and
- ultimately, building lasting and strategic relationships with the most exciting and innovative technology companies and their investors.
This article was written by Elliot Hawes and Niall Mackle from our Corporate Finance team. If you would like to discuss the investment process in further detail, please contact Alex Lloyd, Niall Mackle or visit the BScale page linked above.