Funding a tech start-up takes grit
It’s not unusual for a start-up business to gobble up extraordinary amounts of cash before making a sale, let alone a profit.
This is especially true of the high-tech and pharmaceutical sectors, where sophisticated products, highly skilled labour, research and development, product development, prototyping and testing all add to the expense.
As Johnston Carmichael Partner Shaun Millican CA explains: “Companies that are so-called ‘execution plays’, where it is essential to get to market quickly, will often have higher burn rates, as they deploy capital to get market traction.”
Others, says Stuart Mitchell CA, a Director with Quest Corporate, may require a large number of individual subscribers in order to leverage their products or create valuable data opportunities. This can also burn through funds quickly.
Some, according to Corporate Finance Partner at AAB Brian McMurray CA, include: “People-intense businesses or those that require outside expertise/consultants. In particular, those businesses that require highly skilled personnel, which come at a cost.”
Such businesses usually carry high risks and, while there are successes, there are also failures – some spectacular.
One is UK-based Blippar, which started out in 2011 as a marketing agency before morphing into a technology play with plush offices around the world, aiming to make money from “augmented reality” and “computer vision”. It went bust last December, after burning through $120m, when investors blocked further funding.
How much cash?
The first challenge is to understand how much funding the business will need.
David Dennis, Senior Associate with law firm CMS, says: “If you don’t have the cash to burn, you won’t go anywhere. You need a really good idea, coupled with a strong business plan and the ability to sell the idea, to get the sort of investment required to fund the early stages of a high-burn start-up. It takes a lot of cash and is usually high risk, so it will be difficult to get investors on board."
Shaun advises: “Start-ups need an accurate view of their cash requirements so they can establish a funding strategy that fits with those requirements and is achievable in the context of the development of the underlying business.
"There is often no right answer, and it can often be a trade-off between the cash needed to fuel the business and what investors are prepared to invest – and at what price. Planning is essential and running different scenarios based on differing funding strategies will help to identify the preferred route.”
Start-ups need an accurate view on their cash requirements so they can establish a funding strategy that fits with those requirements and is achievable in the context of the development of the underlying business
Good judgement is critical, says Richard Heap, a Partner at RSM UK: “If you ask for too much, it can dilute the founding shareholders; but if you ask for too little, then you could run out of money before a critical point in development or before your next funding round.”
Most likely, follow-up funding will be needed. Stephen Trombala, Partner with Shepherd and Wedderburn, says: “Typically, several rounds of equity finance will be required and the structuring of that can be fundamental to future success.”
The trick is knowing when more funding will be needed. Shaun says applying different scenarios to different funding strategies will greatly aid planning. “Start-ups need an accurate view on their cash requirements so they can establish a funding strategy that fits with those requirements and is achievable in the context of the development of the underlying business,” he says.
The cash reserve
Critical to a funding strategy is the “cash reserve”. Quest’s Stuart says that any start-up with a high cash burn must have at least six months’ cash reserves, as a new funding round can take that long.
He adds: "If you don’t have a well-thought-through plan and a viable market opportunity, then any burn rate is unacceptable, whether you have one month’s or one year’s worth of cash in the bank."
According to Brian, the cash reserve is very important. “This gives the business credibility for its ability to maintain financial discipline,” he says.
“A start-up should only deviate from its most recent plan if there is a commercial rationale to do so and this must have been approved by the management team and/or investors,” he adds.
Shaun advises: “Monthly cash burn versus cash reserves – the amount of ‘runway’ – is the only measurement that counts. A minimum of six to nine months is required… how long you have got is all that matters, along with a good understanding of the levers you have to extend if necessary.
"Think early about raising capital. All too often, we see companies with an extremely short cash runway seeking to raise capital. Investors see weakness in this strategy, which can make the task harder.”
So where will a high-cash-burn start-up find investment? From square one, some types of funding will not be available. This will include, says David, “any sort of secured lending, unless the founders are willing to put personal assets or guarantees on the line. A start-up, as a business, is unlikely to have any assets on which lending can be secured.”
He adds: “In some cases, intellectual property (IP) can be used as security, so that might work for a start-up that has key technology that is protected by IP rights such as patents.”
Brian adds: “Other than small business start-up loans, debt funding is unlikely to be available. Even where security is available (i.e. asset finance), the business must be able to demonstrate that it can service the borrowing, which can be a challenge for start-ups.”
Over time, however, this can change. “As a start-up matures, it may be able to secure venture debt as an additional source of finance alongside a development equity financing round. Properly structured, venture debt can reduce the dilution of a development equity financing,” says Stephen.
Stuart adds: “One of the earliest forms of ‘traditional’ bank funding that is likely to be available is invoice factoring. This can have a positive impact on net working capital.”
Properly structured, venture debt can reduce the dilution of a development equity financing
So what options does a start-up have? Typically, notes Stuart, “they are reliant on angel funding, as most venture capital funding is very wary of pre-revenue or loss-making businesses. Public sector funding can help, but it is limited in quantum.”
Then there are grants. Stephen says: “Suitable businesses can secure ‘soft’ funding by means of grants or awards (of which there are a number).”
David agrees: “You really want patient capital or grant funding that doesn’t require a short-term return for investors. That will allow you time to establish your business without needing to refinance along the way.”
Examples, says Stuart, include European/UK (Smart) research funds, a mixture of grants or soft public sector funding. However, a major source of “patient” funding for UK start-ups – the European Union – has effectively dried up since Article 50 was triggered.
The European Investment Fund put just €61.1m into UK-focused funds in 2017, compared with €708.8m in 2016. The fund had, at times, accounted for up to a third of all the investment in UK-based venture capital funds.
More ambitious start-ups might choose to look further afield: investors in Blippar reportedly included Khazanah, an investment fund owned by the Malaysian government; Candy Ventures, a fund set up by property tycoon Nick Candy; and Qualcomm Ventures, the investment arm of telecoms giant Qualcomm.
Challenges and priorities
Money isn’t the only challenge: others include getting the right people on board and controlling spending.
Richard says: “Having the right people in place to allow the business to scale up is crucial; sometimes businesses don’t have the right skills in place before growth accelerates. In the tech sector, if you have the right product in the right market, then growth can be very quick, so you need to have the right team in place. This can be difficult due to a shortage of IT developers in the UK.”
With regard to spending, start-ups are not – whatever you may have heard – about shiny offices, business-class travel and flashy cars. In fact, cost control should be seen as a top priority.
Having the right people in place to allow the business to scale up is crucial
Stuart advises that start-ups avoid building fixed administrative overhead in the business. He says: “Focus cost on those areas that drive validation of the business model and give greatest opportunity to deliver on business plan goals.”
David adds that everyone in the business should be aware of the burn rate. “It keeps everyone focused and encourages the team to hit deadlines and keep costs down,” he says.
As one expert in start-ups, Rishi Khosla, CEO and joint founder of OakNorth Bank, tells us: “Spending more money than is necessary becomes a part of the company’s DNA and changing this is hard. Having little to no money forces businesses to operate from a mentality of scarcity and these businesses end up operating much more efficiently."
Two final points
To conclude, while there are many other challenges, I’ll mention just two.
First is “communications”. Stephen Robertson CA, Director with intellectual property specialists Metis Partners, sagely advises: “It’s important to be honest with investors when timelines are falling behind and deadlines are being missed.”
Stephen also stresses the importance of communicating steady progress in achieving key milestones. These could include:
- “IP and technology development milestones”, such as patents filed, industry certifications secured, working prototype completed, software testing completed, patents granted and key supplier manufacturing agreement signed.
- “Business development milestones”, such as innovation grants secured, global partnership/distribution agreement signed, business and innovation awards won, and customer beta testing phase started.
He says: “These milestones should be mapped to the business plan to make it clear that the high cash burn rate underpins IP value creation in advance of revenues being generated.”
A second priority is to make sure you’re on the same planet as your stakeholders!
“Understand your investor and ensure that your vision of value build is aligned,” explains Stuart, adding: “If the investor feels that the most important thing is that the product is ‘pink’ and you build a ‘blue’ product, how does this impact follow on?
"As the entrepreneur, you may feel that ‘blue is better’, but, that has little relevance if you are looking for ongoing support from an incumbent investor.”