UK: Enterprise – For Entrepreneurs, Growth Businesses and their Advisors - Spring 2011

EDITOR'S NOTE

Looking for funding in Entrepreneur Britain

Where's the best place in the world to start a business? According to recent surveys reported in The Wall Street Journal, it's Denmark. The UK comes 14th – behind the USA (3rd), Ireland (6th), Iceland (9th) and Australia (11th). But another poll from the World Bank says that with regard to red tape, we do rather better, coming 5th out of 183 in a ranking of how easy it is to start a business.

Overall, these results tell us that, in school report terms, it's about a 7 out of 10 – could do better. Exploring the environment for entrepreneurs in the UK was the focus of the recent Entrepreneur Britain event held at Smith & Williamson in conjunction with PR specialists Seven Hills. More on this opposite.

A hot topic at Entrepreneur Britain was the confusion for many entrepreneurs about where to go for funding. This edition of Enterprise provides a guided tour of the types of finance available from business angels and investor clubs, to venture capital and private equity. Our contributors from each of these areas explain the types of businesses they invest in, how much they invest, the criteria they use to select investments, as well as offering advice to potential investees. To hear about the process from the other side, we spoke to 10CMS, a software business that has recently completed £2.1m funding from a venture capitalist. And we run through the rules for raising equity through venture capital trusts and under the enterprise investment scheme.

With many businesses still finding it tough to get bank finance, we also consider the range of government funding initiatives currently available.

Other key talking points among the entrepreneurial community at our recent event were the issues of enterprise education and communication. Later in this issue Nick Giles, co-founder of Seven Hills, the PR company specialising in the entrepreneurial market, explains how the finance community could get a clearer message across to the media.

Finally, Graham Stedman and Verity Sayers of law firm Nabarro explain measures proposed by the Government to change employment legislation for the benefit of smaller employers.

Many thanks to our contributors for their valuable time and advice. Until next time.

Guy Rigby

ENTREPRENEUR BRITAIN - INVESTING FOR SUCCESS

By Nick Giles

Nick Giles of Seven Hills reports on the Entrepreneur Britain debate held at Smith & Williamson.

The Prime Minister has called on Britain's 'doers and grafters' to make this the most entrepreneurial decade in history. But to what extent will the UK's private equity and venture capital community play a role in achieving this ambition, and how can they help to turn it into a reality?

That was the topic of debate at the Entrepreneur Britain: Investing for Success round table event hosted by Smith & Williamson and Seven Hills which brought together over 60 VCs and entrepreneurs to debate the key issues that need to be addressed to bring that vision to life.

Regulation, information and education emerged as key areas to address, according to the venture capital and private equity specialists, entrepreneurs and business reporters who attended the debate.

Expert investors from a host of leading firms including Ariadne Capital, Balderton Capital, Risk Capital Partners and Silicon Valley Bank were joined at the event by the entrepreneurs behind Caxton FX, Make It Cheaper, Brightpearl, Digby Morgan and Trusted Reviews plus reporters from the BBC's business unit, City AM, Business Zone, Unquote and Fresh Business Thinking.

Angel investor Doug Richard issued a rallying cry for the role of venture capital and private equity in spearheading business growth in the UK – citing a host of examples, including web-based start-ups, where the UK has great potential.

Veteran investor and head of Better Capital, Jon Moulton, gave his assessment of the task ahead citing the challenge of driving growth in the current unstable economic climate.

The debate was the first step in the creation of an action plan for the UK's investment community to help forge stronger and more beneficial connections with the UK's entrepreneurs.

Some of the key issues raised during the debate include the following.

1. Engage and educate – The need for investors to forge stronger connections with the UK's entrepreneur community in general and dedicate resource to educating business owners about the role of venture capital and private equity investments in driving growth.
2. Improve image – The need to address the negative perceptions of venture capital and private equity among entrepreneurs through active engagement with the business media.
3. Less private more public – The increasing need to directly engage with the department for business, innovation & skills (BIS) to improve relations with government and improve understanding of the role UK investors can play in driving the UK's economic growth.
4. Invest in training – The opportunity to back entrepreneurship in schools and universities by engaging with those organisations focused on developing young entrepreneurs such as the National Enterprise Academy and the National Consortium of University Entrepreneurs.
5. Creative leadership – Help create solutions to shrink the equity gap – the funding gap that entrepreneurial businesses struggle to fill.

Guy Rigby, head of entrepreneurs at Smith & Williamson, said: "The Prime Minister has called this the year of growth and has committed to making this Britain's most entrepreneurial decade. For that vision to become a reality we need to create the right conditions for growth and the investment community has a major role to play in backing new British businesses. This event gathered the opinions of a group of experts who understand the challenges that investors and entrepreneurs both face and started to outline the steps that we need to take to back Britain's entrepreneurs."

THE INVESTEE'S VIEW - Q&A: FERGAL O'MULLANE, 10CMS

By Fergal O'Mullane, 10CMS

Fergal O'Mullane, co-founder of ecommerce company 10CMS, talks about raising £2.15m in early stage funding.

Q: How easy was it to get funding for your business?

Easy is not a word that springs to mind. It's a process and you need to have a number of items in place before you proceed – a good core product offering, a solid and scalable business model, a large addressable market and a good management team. For us this process took much of 2010, including preparing the business plan, financial model, and so on.

Q: Who did you approach?

We identified three funds which invest in technology businesses at our stage of development, which typically invest £1m to £2m in companies with the ability to follow-on. Octopus Ventures was one of these. We had a positive response from all of the funds, but Octopus moved quickly and we liked their approach.

Q: What are the pros and cons of different sources of funding?

The key is to understand your business needs and ensure you match this with the right type of funding. Angel funding can be good as they tend to be passive investors and rarely take a controlling stake. But your share structure can be fragmented, meaning more effort around shareholder approval, and pitching can be time-consuming. With a VC you're dealing with one investor with deep pockets, who generally can follow-on if you need extra investment. Be aware that they will be heavily involved and take a significant stake and the investment will be wrapped around a comprehensive agreement.

Q: What is the most challenging aspect of the due diligence process?

It's very time consuming and can distract you from the day-to-day business, which, ironically, could impact your ability to raise funds. We were able to split roles, but that might not be possible for others.

Q: What advice would you give to companies looking for funding?

Do your homework before you start fundraising. Format the business plan in the way the VCs expect and create a short teaser version to send in advance. Have a comprehensive financial model that you are confident in and ensure you are raising enough money with plenty of contingency. Identify a short list of suitable VCs and research the size of the fund, their typical deals and types of investment. Research the backgrounds of the fund managers and do some dry runs on your presentation. Prepare as much in advance of due diligence to reduce the level of effort involved and speed up the process.

Q: What would you advise companies to look for in an investor?

Find an investor who understands your business and can bring added value. Ask for references on other investments, talk to them and find out how they find working with them. They may help identify potential pitfalls in the due diligence process.

RAISING EQUITY FOR YOUR BUSINESS UNDER EIS AND FROM VCTS

By Adrian Walton

Adrian Walton looks at how EIS and VCTs can help businesses attract capital from private individuals.

Enterprise investment scheme

Under EIS individuals invest directly in your company, as it can offer significant income tax, inheritance tax and capital gains tax reliefs to passive investors and, in certain cases, to owner-manager shareholders in many trading businesses.

For individuals who are UK resident for tax purposes (or have a UK income tax liability) these tax benefits include:

• income tax relief equal to 30% of amounts subscribed for eligible shares (for shares issued after 5 April 2011)
• ability to dispose of shares after three years free from CGT (currently a 28% saving only available if EIS income tax relief is claimed)
• ability to defer the CGT payable on other chargeable gains by investing the gain in an EIS qualifying company (representing a cash flow advantage plus the potential for actual tax savings).

Venture capital trusts

VCTs are fully listed companies which encourage investment in small and medium-sized unquoted trading companies. Individuals invest in VCTs whose managers, in turn, invest in a portfolio of securities, mainly represented by shares and loan stock in unquoted trading companies. There are significant income tax and capital gains tax benefits available to investors, but only if the VCT retains its qualifying status. To achieve this, a VCT must have at least 70% of its investments represented by shares or securities in 'qualifying holdings'.

Thus, VCT managers are continually looking to invest in suitable unquoted trading companies as part of their portfolio. In recent years, as a result of enhanced income tax benefits being available to investors, there have been significant funds available to VCT managers to invest. As each VCT can invest a maximum of £1m per year in each of its portfolio companies, usually through a mix of debt and equity, this is potentially a good source of venture capital for investee companies.

How to qualify for EIS and VCT investment

• The company must be unquoted at the time of the investment (there are special rules about subsequent listing). AIM companies count as unquoted for EIS and VCT purposes.
• The company's (or group's if applicable) gross asset value must not exceed £7m immediately before investment and £8m immediately after (these limits are being increased for shares issued after 5 April 2011)
• The company, or a qualifying subsidiary, must be trading wholly or mainly in the UK. The Finance Bill No 2 2010 contained provisions whereby this condition will be replaced by one requiring that the issuing company only has to have a permanent establishment in the UK. The operative date for the new rules will relate to shares issued on or after 6 April 2011.
• There is a limit of 50 full-time employees in qualifying companies (or a group if applicable) at the time of the relevant investment (this limit is being increased for shares issued after 5 April 2011).
• A number of trades are specifically excluded from the scheme, such as property development, certain financial services, farming and hotels.
• The company must not be under the control of another company and is restricted to how it holds shares in subsidiaries.
• The aggregate amount of qualifying funds that can be raised by any one company under these schemes must not exceed £2m in any 12-month period (this limit is being increased for shares issued after 5 April 2011).

GOVERNMENT FINANCIAL SUPPORT FOR SMES

There are a number of Government-backed loan and grant schemes available to help SMEs access finance.

In addition to the main two UK-wide initiatives – the Enterprise Finance Guarantee (EFG) scheme and Enterprise Capital Funds (ECFs) – there are separate grant programmes in England, Wales, Scotland and Northern Ireland.

Enterprise Finance Guarantee scheme

The Labour Government set up the EFG to encourage more bank lending to SMEs lacking collateral or a track record. Under the scheme, the Government guarantees 75% of an SME's bank loan.

The EFG is open to companies with an annual turnover of up to £25m. Loans from £1,000 to £1m are available, repayable over ten years. The scheme can be used to access new loans, refinance existing loans, convert overdrafts into loans, gain a new overdraft or extend a current one, and cover cash flow shortages. It is available to all sectors of the economy with a few exceptions.

At the end of 2010, the Coalition Government announced that the EFG would continue for another four years, making about £2bn available to viable businesses. It aims to help around 6,000 SMEs each year.

Enterprise Capital Funds

Enterprise Capital Funds (ECFs) provide equity finance to SMEs by using Government funding alongside private sector investment to help fill the so-called 'equity gap' – where businesses with viable investment propositions are unable to attract investment from business angels or venture capitalists.

Government agency Capital for Enterprise runs the scheme through which the Government now invests in nine venture capital funds. To apply for ECF, SMEs must approach one of these funds directly. £150m of public funds have been invested in the scheme and the Coalition Government recently announced that another £200m would be available over the next four financial years.

Business Growth Fund

At the end of 2010 the Government announced a new bank-led £1.5bn 'Business Growth Fund' to provide equity finance to established SMEs who need capital to secure their plans for growth. The Government will work with other parties, such as the European Investment Fund, to potentially increase its scale.

Regional Growth Fund

The Regional Growth Fund is a new £1.4bn three-year fund that will operate across England to stimulate private sector led sustainable economic growth and employment.

SMEs and larger companies can apply on their own, or in partnership with other firms and/or public sector bodies. Local authorities also usually have grants available for small firms, as do the nine English regional development agencies, who can also advise on what European grants may be available. Note that these RDAs are being abolished by March 2012 and will be replaced by new Local Enterprise Partnerships between local authorities and business groups.

Other funding sources

The Grant for Business Investment

This scheme provides money to obtain equipment, rent or buy premises, promote the creation of new jobs, and maintain existing employment. Grants must help a business expand, modernise and become more efficient. Sums available start at £10,000, and there is no upper limit

The Government Grant for Research and Development

Individuals and SMEs can apply for the Government Grant for Research and Development (GGRD) which finances the creation of technologically innovative products and processes. In England, there are four types of business grants available under the GGRD – micro, research, development and exceptional development.

Domestic and European initiatives

• The Department of Health funds research and development projects that improve medical knowledge.
• The National Endowment for Science, Technology and the Arts has a range of grants to encourage projects for new products, services, and processes.
• The European Commission's Framework Programme offers support to UK companies who would like to work on research and development projects with European partners.
• The European Union's eContent scheme gives finance to help the expansion of the European digital content sector.

GETTING THE PRIVATE EQUITY MESSAGE ACROSS

By Nick Giles

Nick Giles, co-founder of Seven Hills considers how the investment industry can improve its image and highlight the positive role it often plays with entrepreneurial businesses.

For many UK entrepreneurs the idea of securing investment capital is about as appetising a prospect as a grilling on Dragons' Den. They worry about getting in with the wrong partner, agreeing to a bad deal and living to regret big decisions taken early in their development.

The reality is that many of these entrepreneurs, who dream of building large successful businesses, are baffled by the process, lack the understanding of what it is they are asking for and are often in the dark about the role that venture capital and private equity investment can play in helping them grow. Misinformation and misperception prevail.

So, is that the fault of the entrepreneurs or is it an opportunity for the investment industry to educate its audience and win new friends?

I would argue the latter.

Sir Bob Worcester, the former chairman of British Midland who is renowned for having dealt expertly with a major air accident once said: "familiarity equals favourability".

The UK's investment community could perhaps do itself a favour by opening up, becoming more transparent and educating the broader business community about the role it plays in driving growth.

There's no doubt that investors have had their fair share of negative headlines in recent years but this can be turned into a positive. Enterprise and entrepreneurship are high on the national agenda so there is clear opportunity for the UK's investors to enter that debate, improve understanding of the role that VCs play in backing entrepreneurial businesses, and to show the critical role that investors will play in spearheading the much-heralded 'enterprise-led recovery'.

This could be achieved through a more open dialogue between VCs, private equity investors and the business media to provide balance to what is often negative reporting of the sector.

Donata Huggins, City AM's entrepreneur correspondent, told me: "It's vital that investors engage and start a dialogue with the business press, to encourage journalists to report more on the success stories where VCs have played a major role in backing successful entrepreneurs."

A clear challenge identified is to help educate entrepreneurs in the UK about venture capital and private equity investment, given that for many the distinction is often ill-defined and confusing. In turn, there is an opportunity for the investment industry to educate entrepreneurs about the role that investors play in driving growth and backing the UK's economic fight-back.

It's more than a 'nice to have'. The reality is that reputation is arguably your most important asset and negative perceptions can harm any business, however immune it may seem to the vagaries of public opinion. Investors need to rehabilitate their reputations within a sceptical market if they want the deals to start rolling.

To do that, the industry has to win new friends, and be seen to be taking an active role in educating the market about the positive role it can play.

THE SWINGING PENDULUM - COULD (AND SHOULD) EMPLOYMENT LAWS BE CHANGED TO BENEFIT SMALLER EMPLOYERS?

By Verity Sayers, Nabarro LLP

Verity Sayers and Graham Stedman of Nabarro LLP discuss measures being considered to improve employment legislation for small businesses.

You may already be familiar with a report to the Government produced by the Better Regulation Executive in November 2010, called Lightening the Load: The Regulatory Impact on the UK's Smallest Businesses. This report found that, "in terms of specific regulations, employment law was considered to be the greatest barrier to growth" by the 500 "micro businesses" (those with less than ten employees) who were surveyed. These businesses said that they felt that the pendulum has shifted, moving the balance of rights too far in favour of employees, resulting in employers being unwilling to take on the risk of employing anyone.

The report identified a number of 'problem' areas of employment law for small businesses, highlighting dismissal processes and litigation and also family friendly rights such as the right to request flexible working and maternity and paternity arrangements.

The Government has opened consultation on its proposed strategies to help resolve workplace disputes. The consultation paper, which is available on the department for innovation and skills website (www.bis.gov.uk/Consultations/resolving-workplace-disputes) sets out what the Government is thinking about doing to help 'swing the pendulum' at least a little way back in the direction of employers. But are these measures likely to do enough to satisfy smaller employers and if not, what changes to employment law would be required?

Dismissals

There seems to be a widespread belief among small employers that the Government should make it easier for employers to dismiss employees – particularly on the grounds of poor performance.

The Government has indicated that it is considering raising the minimum service requirement for a claim of unfair dismissal to two years, rather than one year. Although businesses welcomed the news, some remain cautious that this will have much practical impact for smaller employers. It may even make the situation worse by encouraging claims which do not require a minimum period of service (such as discrimination).

Tribunal litigation

Another proposal is to introduce a tribunal fee, payable by the claimant, to help separate meritorious claims from vexatious claims at the outset. At present, no fee is payable by the claimant and the employment tribunal system is very much geared in favour of allowing employees who have suffered unfair treatment at the hands of their employers to bring claims with minimal cost to themselves. It is, surely, right that employees in such circumstances should not be prevented from access to justice. Yet tribunal cases can have very serious consequences for small businesses. Depending on the size of the fee and the circumstances in which it is payable, this proposal could succeed in striking the right balance.

Family friendly rights

Since the majority of our family friendly rights originate from European legislation, there is very little that the Government can do to re-balance these rights in favour of businesses. In any event, it could harm rather than benefit small businesses to be exempted, making it more difficult to attract the right people.

Watch this space – the year ahead may be an interesting one for employment law.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.