Raising capital in start ups

This column piece was published on 27th June 2016.

Sometimes things do not quite work out as planned.

In September 2012, the then Minister for Jobs, Enterprise and Innovation Richard Bruton announced a €90M microfinance scheme which was expected to benefit 7,700 businesses over the following 10 years. Up to €25,000 worth of credit would be offered to sole traders, and businesses employing up to 10 people, with turnovers less than €2M, and whose commercially viable loan applications had nevertheless been refused by the main street banks. Significantly, start-ups would be eligible to apply for these loans.

Last week, Microfinance Ireland (MFI), which was established to administer the scheme, reported that a total of just €14.1M had been advanced in loans since the 2012, to 944 businesses. Given that the scheme is nearing its fourth anniversary, there is thus some considerable distance to the declared targets. MFI also announced that it would reduce its annual interest rate by 1 per cent to 7.8 per cent for applications made directly to it, and to 6.8 per cent for applications made indirectly through the county Local Enterprise Offices (LEOs). Finally MFI launched an associated mentoring and support scheme for successful loan applicants.

Raising money to launch a start-up is challenging. The MFI initiative to raise its profile by both dropping its interest rate and proactively partnering with the LEOs, is welcome.

Of course, if things do not quite work out as planned, the consequences of an outstanding loan may be damaging. The main street banks almost always require security over any business loan by way of a personal guarantee. In the case of a start-up with young founders this might be given by a wealthy relative. In contrast, MFI does not necessarily require a guarantee. However an MFI loan can only be sought once a bank has already turned down a loan application, maybe precisely because no guarantee was available to the bank.

In addition to the banks and to the MFI scheme, what other sources of finance are there for a start-up? The natural place for a promoter is indeed that wealthy relative, the extended family and network of friends. After all they know, like and trust the promoter. Some of them may very well be willing to loan money, particularly because they can see the personal enthusiasm for the project.

But what if things do not work out as planned? Will it irrevocably damage personal relationships, perhaps for life? Both sides in advance should accept that there is risk that the loan may never be repaid.

Another source of early funds are crowdfunding platforms such as Kickstarter. Frequently a start-up accepts orders for the product whose development would then be funded by the pre-paid contributions. If the start-up fails to reach its campaign funding goal, the funding pledges are released.

One of the most dramatic Kickstarter campaigns was for the Oculus Rift virtual reality headset. Just 18 months after raising $2.5M via Kickstarter, Oculus was acquired by Facebook for $2B.

If things do not work out as planned, a failed Kickstarter project can result in law suits. As an example, in May 2014 the Washington State Attorney General successfully took a case against a Kickstarter funded company when having raised funds, the company then did not fulfil its promise to its backers.

Yet a further source of start-up funding are seed funds and angel networks. In 2015 €44M was raised in seed funds in Ireland, down from €67M in the prior year. This year the total should increase back up again, with a number of new seed funds announced or expected.

In almost every seed investment in a start-up, the form of financing is a convertible loan rather than buying shares. The major reason is that a loan avoids having to place a premature value on the company. It sidesteps an argument with the founders about how much their company is worth, in the absence of revenue just yet. However, unlike a bank or MFI loan, a convertible loan is frequently not repaid with cash. Instead the lender can choose to convert the loan (usually with accrued interest) into shares in the company at a later stage. This later stage is precisely when the company has revenues and its shares have a value agreed when a new investor brings further money to the table.

Start-ups should carefully consider the precise terms under which any loan is offered. Fortunately the Central Bank and European Union now have strict legislation to protect small companies. Regulated lenders are required by law to thoroughly explain their terms, whether or not the borrower also takes legal advice. The lender cannot “disguise, diminish or obscure important information”. The regulated lender has to explain the consequences of its terms clearly and in full detail at the time the loan is offered.

After all, sometimes things do not quite work out as expected.

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About chrisjhorn

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