Secondary fundraising: the facts

Approaching investors for more funds requires good sense, guile and, in certain instances, a degree of courage. Robert Tyerman speaks to CEOs who have raised another round of finance and lived to tell the tale.

If you thought that raising the initial capital to launch your business was hard, try returning to your original backers or seeking new ones to fund the growth you need to survive.

This presents a formidable set of challenges. Your backers may not be keen to stump up more equity, certainly not at their original valuation, unless you need it to seize a promising new opportunity rather than simply to fund your cash burn.

Assuming they remain enthusiastic about your prospects, backers may see a second or later fundraising as a chance to reduce your holding and even, ultimately, to take control away from you. If your progress has been disappointing, your exit could be vastly different from the one you imagined – your backers may follow the mantra of YFM’s Nigel Barraclough: ‘Same team, same market, same result.’

Barraclough recalls a recent case in which one company backed by YFM was not performing: ‘We replaced the whole team and then felt reasonably comfortable about refinancing.’

On the other hand, even if your progress has been disappointing, some venture capitalists may be willing to keep you going simply to protect the apparent value of their portfolio. Other more hard-nosed institutions might have agreed to certain terms, acceptable to you, in an initial funding, when they may be competing with other capital providers. In later fundings, however, they may insist on a lock-in, preventing you from canvassing other potential investors. Consequently, they can impose much harsher terms.

‘It took me more than a year to raise a second round of £5 million, and it was brutal,’ says François Mazoudier, who tapped the venture capital market recently for the UK
and international product launch of Speakanet, a Danish company with a patented mobile office phone system.

‘Your aspirations at the initial fundraising tend to be greater than what you have achieved by the second and so they kick your backside and water your stake down,’ comments Roger Sinclair, who has raised nearly £1 million in several stages since 2004 for Baby TV, which provides an information platform on screens in waiting rooms at National Health Service ante-natal clinics. ‘We were valued as a start-up even though we’d been going for some time and had examples of what we had done.’

Philip Dumas of corporate finance group Dowgate Capital, which handles smaller public companies, reflects: ‘It’s difficult to come back unless you can show you have used the first amount you raised responsibly. Nobody wants you to come back too soon, and the first question will be: “Why has the first lot gone?”’

Dumas adds: ‘You must show either a new growth opportunity or a suitable acquisition for which you don’t have enough capital left.’ He notes that institutional investors ‘will not be happy and they might insist on a big valuation discount, which would dilute your holding’.

Dos and don’ts
Robin Slinger, deputy chairman of AIM-quoted insurance broking and financial services specialist CBG (pictured), says the company raised money on flotation in 2003 and then tapped investors for £1 million in 2006 and £3 million in two tranches last year to fund an acquisition: ‘We were oversubscribed every time. The process takes a great deal of time and strategic planning.

‘We needed capital for acquisitions that were earnings enhancing, not to languish in the bank. And we had a track record of successful acquisitions.’

Speakanet’s Mazoudier, who has vast experience in investment as well as in running businesses, insists that if you want a second funding, especially from venture capital trusts, ‘you must show your vision is starting to happen and that it will grow faster
through funding. That needs thorough planning and forecasting’.

He believes the secret is to avoid going for visionary declamations and to be ‘practical, detailed and precise’. The ideal funding sequence, he says, starts with around ‘£250,000 of seed capital to assemble your first team and generate your first revenues’.
Mazoudier continues: ‘Then go for £2 million for more marketing and something like a down payment on a distribution deal and, later, seek backing for expansion into
new areas. Remember, venture capitalists (VCs) don’t want a visionary à la Bill Gates, but a very practical person.’

On pricing, Mazoudier is bleak: ‘In a second-round funding, you will want a 30 to 40 per cent higher valuation to compensate for diluting your ownership with outside backers. But that will be hard to achieve nowadays, with pension funds and investment groups
like 3i pulling out of the VC arena.

‘Brains, good customers and good prospects will bring you nothing at this stage. The VCs will discount your forecasts and lower your rating.’

Dumas of Dowgate offers some down-to-earth advice for dealing with institutional investors: ‘The entrepreneur must sell themselves as well as possible, as they may have just 20 minutes to persuade total strangers to part with millions.’

He claims: ‘Any presentation should be a printed flip-chart – never use PowerPoint and never make it more than 20 pages.

Always number the pages and use paper that people can write on with pens.’

Where to look
You will need to consider a range of potential backers for secondary funding, starting with your original investors.

Sinclair, a former media hand, recalls how, after ‘spending my own money and scrounging’, Baby TV obtained £250,000 seed funding in 2004, partly from ‘two post-production TV pals’ with £100,000 under the Small Firms’ Loan Guarantee Scheme, a joint venture between the government and lending institutions.

The following year, the company raised £275,000, partly from Sinclair’s own group
of investors and partly from co-investment group London Seed Capital. After another £200,000 in 2006, London Seed Capital had almost reached the cap on what government regulations allow it to invest, but last year it matched a £50,000 contribution from Creative Capital, a £5 million fund backing ‘creative industries’.

Business angels put in modest sums along the way, but, because Baby TV had not yet reached enough clinics and was still losing money, the terms became tougher. ‘Your backers beat you up and water you down more, unless the business takes off,’ explains Sinclair, who recalls the second round dilution as ‘fierce’.

Simon Crisp, CEO of Dublin-based electronic sandwich board pioneer Adwalker, speaks warmly of the institutions that have backed the loss-making company since its AIM float in 2005, when it raised £4 million. Recently, Enterprise Ireland put in £185,000 and private investors stumped up £55,000.

Far from being persecuted over elusive profits, Crisp says that ‘the institutions are supportive of our story’. He claims he and his team work ‘seven days a week’ and that investors will back you ‘as long as you demonstrate you’re not wasting their money’.

Investment rules
Sometimes, you may have to bring in one or more new backers for a secondary funding because of the tax legislation. Your original backers may not qualify for the Enterprise Investment Scheme or other tax relief, but they may be able and willing – lock-ins aside – to introduce you to other like-minded investors.

Most VC groups and other specialist investors keep a close eye on the companies they back and, if you come back to them, will have a good idea of why you’re asking for more. Barraclough, for example, says: ‘YFM stays close to its investments and often appoints non-executive directors.’

If you don’t yet know your way around, Speakanet’s Mazoudier suggests talking to
the Department of Business, Enterprise and Regulatory Reform’s Business Link for help with a business plan to dodge the pitfalls.

‘Talk to small funds and ask the British Business Angels Association for a list
of angels,’ he says. According to Mazoudier, you could also apply to a ‘small, early-stage venture capital trust. They’ll strip you but they will take a risk’. He warns that some VCTs will act decidedly aggressively: ‘With a very profitable company, you may have to give away 25 per cent at the seed-funding stage and then cede 40 per cent at the second stage – then you start to lose control.

‘Often entrepreneurs refuse to give that much away, so the VCT funds through a new class of preference shares. This method keeps them in control, allowing them to sell out first at the exit stage, taking out compound interest before dividing up the disposal proceeds. They will take most of the cash, plus commission.’

YFM’s Barraclough argues that a less ruthless approach works better for both
sides: ‘If the management thinks we’ve stitched them up, they will spend a lot of
time trying to reciprocate.’