Are entrepreneurs brave enough to remain bullish starting to look deluded? The latest insolvency figures were seized upon by pessimists as further evidence that the financial crisis is starting to hit small business hard. During the third quarter of this year, 4,001 UK companies went into liquidation, a 26.3% increase on 2007 and a 10.5% jump from the previous quarter. But taken in the context of the remarkably fertile period for entrepreneurship the UK has enjoyed over the past decade, the figures aren’t necessarily as alarming as they first look.
A booming economy, cheap and easily available credit, and a rich variety of sources of growth capital gave fledgling entrepreneurs all the encouragement they needed. Remarkably, there are one million more businesses in the UK today than in 1997. It’s inevitable that some of these firms won’t be strong enough to survive a tougher trading environment. But what happens to robust small businesses that are considering expansion in the downturn? We met the entrepreneurs behind some of the UK’s fastest growing businesses to discuss funding growth in a recession.
“People are looking into a fear pit – regardless of whether there’s a return on investment and an agreement that they should do something, everyone gets paralysed in a new
decision-making process.” It’s a dramatic introduction to the discussion from Richard Muirhead, chief executive and founder of IT service firm Tideway Systems, but it’s hardly surprising if the conversation is driven by the consequences of the providers of the most obvious source of growth finance battening down the hatches.
The paralysis in the markets and the risk-averse attitude of the banks is leading entrepreneurs to re-evaluate their relationship with debt providers. “The environment is very different now,” says Muirhead, who secured $35m in three tranches from investors for Tideway. “How much do you want to stack up on debt? It makes your corporate organism that much more sensitive to something as yet unforeseen happening. Being more leveraged increases the risk in the business.”
While alarm bells are ringing, can businesses that are succeeding secure growth capital from banks? With great difficulty, our guests suggest. Ken Scott, chief executive of training firm ILX Group, advises shopping around. “We’d been with HSBC for many years and they helped finance several investments,” he says. “I had two earn-outs to deliver, £2.5m each in cash or shares. This time last year it was all looking fine and financing was agreed in principle.” The Northern Rock saga heralded a change of tack, and the funding was withdrawn. An appeal by their relationship manager and his boss was also rejected. “We started looking for alternative sources of finance and got funding though Barclays on better terms than we had with HSBC.”
The AIM-quoted firm – a market that’s experiencing a very tricky time and is not a viable source of funding in the current climate – secured a £5m amortising term loan and an invoice finance facility of £1m.
While the whole banking sector has been affected, banks have varying levels of exposure to toxic bad debts. “I think a lot of it has to do with which areas they’ve been playing in and how badly they’ve been burned,” Scott says. “Barclays hadn’t at that point, so we got all we needed from them.”
Banks renegotiating lending facilities is a recurring theme. Philip White, chief executive of Syscap, which provides IT finance and leasing, says small firms are now competing with businesses that need capital to survive, not to grow. “You almost become a victim of your own success,” he says. “The banks are diverting their attention to the investments that are failing and need capital. It might be the same leveraged buyout team that made an investment in the first place whose jobs are on the line, so actually you’re not top of their priority list.”
So what can you do to get to the front of the queue? Keep the lines of communication open, for a start. “We have instigated quarterly reviews where the bank comes in and we present the last quarter’s results, some trends and opportunities in the market, as well as the requirements for the business,” explains White.
Of course, this won’t guarantee an audience with the credit team. When you do meet them, sell them a story that appeals to their self-preservation instinct. After all, fixing the problems of today is one thing, but what’s happening tomorrow?
Any heavyweight experience on your management team should also be emphasised. “I appointed a chairman three months ago who’s an ex-chair of Lloyds of London. I walk into RBS with him and it’s a different conversation,” says White.
That’s all good advice, but until bank lending returns to 2007 levels, giving up equity will become increasingly attractive. It’s not a bad time to be a venture capitalist (VC). With a depressed initial public offering market factored into any exit projections, entrepreneurs will be forced into a more realistic valuation and be more desperate for the money. With less competition, it’s a great time for them to invest at a good price. The upshot for entrepreneurs is that if you can negotiate a fair deal, VC money is still available. “Finding equity was painful when debt was cheap,” says one guest. “We, as businesses, will have to start entertaining the prospect of giving away equity.”
VC and private equity funding brings added benefits, including the lack of debt and interest repayments. While there will be concern over control of the business, a mix of equity is desirable for many businesses.
The right investor
White became chief executive of Syscap in 2006, following a private equity funded management buyout. The investors, AnaCap Financial Partners LLP, have “an intimate understanding of the financial services arena”, White says. “Their whole team and process of engagement is based around our sector. Today, they’ll look at their investment differently to when they did the deal two years ago, but there’s no knee-jerk reaction or unpredictable behaviour.”
An investor that knows your space will bring expertise and contacts that will add value far beyond the financial investment, and may strengthen your management team accordingly. Of course, there are risks. VCs’ shark-like reputation does have some justification, but the right investor can steer a company’s growth in a way bank debt can’t.
If you do give up equity, Tom Ilube, co-founder of online ID fraud detection firm Garlik, advises explaining the long-term commercial viability of your business when pitching for funding. “VCs invest over a five to seven-year period, so there’ll be ups and downs,” he says. “If you can’t show them that return over the period of their investment, they won’t do the deal.”
As a mix of debt and equity becomes desirable, the popularity of previously peripheral financial products, such as mezzanine finance, grows. Both Muirhead and Ilube use venture debt, a source of additional capital for VC-backed firms, which potentially reduces equity dilution by slowing the burning of cash reserves, lengthening the cycles a company goes through before securing new investment rounds. “Venture debt is horribly expensive compared with bank debt and cheap compared to equity. They will typically charge 12-15% on the debt and 10% on warrants. They’re providing a loan on top of someone else who’s in deeper than you, betting that your current VCs will bail you out if things go wrong. It’s widely used in the US, but isn’t so well known here,” Ilube explains.
This kind of open-minded thinking about how you’ll fund growth over the coming months could prove invaluable. Whether you’re securing debt or equity, sell your story and identify potential partners that know your market. And, as White notes, remember that “the cheapest deal isn’t always the best”.
The views in this article were expressed at a
lunch sponsored by Wingrave Yeats, an award winning medium-sized fi rm of businesses advisors and chartered accountants.