Equity finance: a game for grownups

‘It’s not getting any easier,’ says Jim Rogers, Grant Thornton’s head of
growth and strategic services. ‘It is still pretty difficult to raise anything
within the so called “equity gap” of a quarter of a million to £3m or £4m.’

Rogers says venture capitalists may receive hundreds of proposals, from which
they might approve only five or fewer equity investments.

This makes the return so unlikely that many small and medium-sized companies
may consider it is not worth committing management resources and advisers’ fees
to chase.

But Robert Coe, a partner at Wilder Coe, suggests that SMEs should look at
the situation differently. ‘It’s a route to finance used by larger SMEs as a
transition period, which helps them get used to a different environment,’ he
argues. By learning to work with equity partners, companies are adapting to the
situation they have to live with if they eventually float.

Nor does Coe accept that there is a lack of equity finance for small
companies. ‘There’s a lot of capacity in the market, with a lot of private
equity houses,’ he says. ‘Venture capital trusts are looking for appropriate
acquisitions. There is probably more money than appropriate acquisitions or

For Coe, the issue for SMEs isn’t necessarily a dearth of available VC funds.
He believes that the overwhelming majority of small company proposals to venture
capitalists are not ‘appropriate’ for investment. Venture capitalists are
looking for a standard in business plans and management capacity, criteria that
he believes most SMEs simply cannot meet.

But if venture capitalists see most SMEs as not ‘appropriate’ for investment,
the feeling is pretty mutual, with many small companies believing that investors
will probably want a significant return and possibly a big say in the running of
the business.

‘The difficulties begin with the valuation of the business,’ explains Coe.
‘The directors of an SME usually consider their business to be more valuable
than the equity finance house does. Then what tends to happen is that the equity
financiers have a shorter term view than the directors of the SME, the
investment is structured to provide an exit route for the venture capitalists in
three to five years.’

The structure of the deal may include a mix of debt and equity and could
contain what amounts to a penalty clause at the end of the defined period, after
which most of the business’s profits will go to the outside investor if they
could not sell on their holding.

‘Longer-term equity is more expensive (than loans)’, once the directors’ loss
of equity value in the business is taken into account, explains Daniel Shear,
chairman of the UK200 Group’s corporate finance panel.

Venture capitalists will be looking to double the value of their investment
in three years, before they sell their stake. If they succeed in doing this,
then the loss in equity value for the founders is likely to be substantial.

But as Shear points out, ‘there are good equity investors and bad ones’, and
a good venture capitalist will bring a lot to the table.

‘The good ones will help the SME by giving management resources that they
don’t have. They will help them to get clients,’ he says.

Shear has seen a significant shift in the concept of venture capitalism in
recent years. Most investors today are passive, demand quick and easy returns,
and are less willing to supportively invest for the long term. It is difficult
to obtain equity finance for less than £2mor so, says Shear, because of the cost
to investors of undertaking due diligence.

Grant Thornton’s Rogers makes a similar point – venture capitalists have
become increasingly risk-averse, not least because of the impact of the failure
of so many investments through the bursting of the dotcom bubble.

Increasingly, it’s the qualities of solid management, long track records and
proven capability that are top of the investor wish list.

An alternative approach that SMEs might want to consider is to look to larger
competitors to back them, rather than the venture capital market. ‘If you make a
loud noise in your market, then you hopefully have something that bigger
competitors want,’ says Rogers. ‘Then the quickest way to equity investment is
for them to stay in a niche market and position themselves for a sell-out.’

Whether the directors are looking to sell to a competitor or to otherwise
engage equity investors, there is a good chance they will have to relinquish
some control. But giving up control is not necessarily something that owners of
small businesses should resist, Rogers stresses. ‘Some people are best at
starting up small companies – the “serial entrepreneurs” who are great at
start-ups, but less good at running and consolidating mature businesses.’

Shear offers a further piece of valuable advice – companies and advisers need
to understand the Financial Services and Markets Act 2000. Seeking investment
is, subject to some exemptions, now a regulated activity.

‘The Act introduced the concept of “financial promotion” and if the owner of
an SME asks someone to invest in their business they are potentially committing
an offence,’ he points out. ‘A lot of people are unaware of this and it has
scared off a lot of advisers.’

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