At a glance

• Upront funding provides certainty, but gives away value
• Funding in stages is a natural path, but it can be difficult to devise suitable targets
• A hybrid model may offer the best of both worlds
  

Upfront funding

Funding upfront provides certainty to start-up companies. It also removes the need for further funding rounds that drain resources and attention away from development of the business. However, it does give away value by setting the price at such an early stage, even if adjustments can be made over time.

Start-ups are generally bad at strategically planning their capital requirements beyond a six- to 12-month period, and often fail to consider the cash that will be needed in years two and three. Compounding this is the fact that venture capitalists tend to have short-term profits in mind, and will often expect start-ups to prove themselves by achieving difficult goals in a short space of time. Start-ups should therefore be alive to the reality that their interests are not aligned with those of venture capitalists, who have their own agenda and are not simply a benevolent source of cash. They should look for venture capitalists that offer strategic partnerships rather than those who offer the best hard numbers.

Funding in stages

Funding in stages is often the natural path for UK start-ups. After the initial bootstrap stage of securing small amounts from personal savings, friends and family or individual angel investors, expansion will be funded first by UK venture capitalists, then their US counterparts, who will then exit by way of a US listing or trade sale. This path will provide a start-up with a wide investor base. This diversity will not only provide the necessary capital, but also the knowledge and contacts of each investor, which will be invaluable to the business and will aid the eventual exit. By committing to a single investor, start-ups lose the ability to spread the net in this way.

In reality, it is not always easy to get funding from UK venture capitalists and start-ups are often pushed towards seeking funds from the US. BVCA figures show that the number of companies that have seen investment has been dipping since 2006. Start-ups will also often leave later rounds of funding until the last moment, resulting in very short lead times of only one or two months. This drives further resource from the business and increases financing costs. Funding upfront will avoid this interruption.

Target-based funding can present a sensible method of investment. The difficulty, however, lies in devising suitable targets. In the early stages of a venture it can be difficult to establish what these should be, and the focus of the business may change as it develops. For instance, a web service may be set a target of achieving a certain volume of users; it may then become apparent that the quality of users is a far more important metric for the business.

The benefits of hybrid models

Given the challenges of both methods of funding, the use of a hybrid model often crops up in discussions. These involve arranging a facility that allows further funds to be drawn down if and when necessary. Investors have traditionally been reticent to agree to such structures, but they provide a measure of certainty to the start-up without sacrificing value, as it allows for negotiation further down the line.

Mike Young and Gregor Pryor are partners at Reed Smith.