Financing of Start-ups. A financing framework for technology start-ups in the UK for the seed & start-up round


Master's Thesis, 2015
49 Pages, Grade: 1.0

Excerpt

Table of Content

1. Introduction
1.1. Background & Problem formulation
1.2. Purpose & Research Question
1.3. Limitations
1.4. Structure

2. Literature Review
2.1. Theoretical background
2.1.1. Stages of financial need
2.1.2. Most common financing options
2.2. Empirical evidence
2.3. DTI Framework

3. Methodology
3.1. Research Design
3.2. Collection of data
3.2.1. Secondary empiric data - Case study approach
3.2.2. Secondary empiric data – Brief introduction to the case studies
3.2.3. Secondary empiric data – How the case studies are analysed?
3.2.4. Secondary empiric data – Scientific literature
3.3. Verification and generalization of empirical data
3.3.1. Validity
3.3.2. Reliability
3.4. Generalisation of Case Studies

4. Research Findings & Discussion
4.1. Just Park
4.2. Landbay
4.3. Kano Computing
4.4. Dojo Limited
4.5. Discussion
4.5.1. External funds really needed?
4.5.2. Is a grant a possibility?
4.5.3. High-class management team or early traction?
4.5.4. Is your business able to create momentum?
4.5.5. Is your business in a high growth sector?
4.5.6. Are you willing to share control?
4.5.7. Do you not only need money?
4.5.8. Do you have the securities to get a bank loan or overdraft?
4.6. Outcome: The Financing Framework
4.7. Further remarks

5. Conclusion
5.1. Which kind of financing is needed in the different stages of a start-up business?
5.2. What sources of funds are available for technology start-ups?
5.3. What sources of funds are used in the real world?
5.4. How to improve an existing financing framework to make decision making easier?
5.5. Limitations
5.6. Final remarks

Bibliography

Table of Figures

Figure 1: Start-up Financing Cycle

Figure 2: DTI Financing Framework

Figure 3: Methodical Approach

Figure 4: New financing framework

Table of Tables

Figure 1: Applied sources of funding of Just Park in comparison to DTI

Figure 2: Applied sources of funding of Landbay in comparison to DTI

Figure 3: Applied sources of funding of Kano in comparison to DTI

Figure 4: Applied sources of funding of Dojo in comparison to DTI

Figure 5: Overview financing sources case companies

1. Introduction

1.1. Background & Problem formulation

Start-ups as source for economic success have gained significant attention lately. This is mainly caused by the ability of these young and innovative companies to create new employment, new industries and in the best-case more economic growth. UK start-ups, together with small and medium sized companies, create 59.3% of private sector employment and 48.1% of turnover at the beginning of 2013 (Department for Business Innovation, 2013). Because of these attributes, politicians and governments all over the world put the stimulation of these businesses as top priority on their political agenda (Henrekson and Johanson, 2010).

However, the lack of funding for start-ups is still a major concern of entrepreneurs all around the globe. Amongst others, this lack of funding is caused by the missing track record of the founders or the risky business model, which prevents venture capitalists or banks to supply funds. And without the possibility to access the necessary funds, a new venture cannot survive in the long run (Vanacker and Manigart, 2010). These circumstances are even worse for technology start-ups, which have to spend large amounts of money to develop new disruptive products in emerging industries (Baum, 1996).

The academic world has recognized this development and has therefore produced a large amount of research in this field. However, the majority of this research focuses on start-up fundraising from the supply side, with special regards on venture capital funds (Wright and Robbie, 1998), and in some cases on business angels (Paul et al., 2007). Unfortunately, the understanding of financing from an entrepreneur’s point of view is still not very clear (Sorheim and Rasmussen, 2010). This is a big limitation, because it is the entrepreneur at the end, who makes the decision which source of funding is the most suitable one and worth pursuing.

1.2. Purpose & Research Question

The purpose of this thesis will be to combine the existing literature about sources of financing with a case study approach to create a framework to help entrepreneurs to make the right financing decisions. The knowledge creation will be based on four case studies of start-ups in the technology sector with the focus of how these companies have accessed external capital. The thesis will look at how these companies acquired funds during the different stages of the business life cycle and will relate these findings to the existing theory. After analysing the different case studies, the research findings will be used to develop a financing framework for young UK start-ups in the technology sector. The created framework should therefore answer the following research question:

What sources of funding can a UK technology start-up access in the seed and start-up stage?

The major goal of the dissertation will be the development of a financing framework to help entrepreneurs to choose the most viable option for their company. To answer the main research question in the best way possible the thesis will use four-subordinated research questions:

Abbildung in dieser Leseprobe nicht enthalten

1.3. Limitations

As the scope of a dissertation is limited per nature, this thesis will mainly focusing on the UK because of the leading position of this economy when it comes to start-up creation in Europe (OECD, 2015). The thesis will start with a broader view on the topic financing of start-ups but then focus on sources for technology start-ups and ending with a specified framework for the UK business environment.

Furthermore, this thesis follows the approach to reveal as much financing sources as possible. However, the dynamic developed especially in the start-up financing world makes it almost impossible to account for every new invented source. As a result, this thesis will focus on the major sources of funding used by today’s entrepreneurs and will leave it to other researchers to investigate niche market capital. What is more, the legal implications for the choice of funding is a very important one but can not be included in this thesis because this would exceed the scope of this paper.

1.4. Structure

The literature review can be found in the second chapter, where first the funding life cycle of a young firm is described. Moreover, the second chapter includes a review of the potential sources of funding with special regards to the availability for young technology start-ups and new emerging resources. Chapter three introduces the methodology of the applied research method. In the fourth chapter, both the data from the case companies and the literature review are used to create a financing framework for founders. The final chapter provides a conclusion with answers to the research questions combined with a further discussion of the dissertation’s limitations and implications for further research.

2. Literature Review

The availability of funds is crucial for the realisation of growth for every company, but especially for start-ups. In this dissertation start-ups are defined as a company, which is formed with the aim to search for a scalable and repeatable business model (Blank & Dorf, 2012). The European Commission (2015) also uses the term innovative SMEs for start-ups.

When making financial decisions, the entrepreneur is facing a paradox coming from the ambiguous relationship between the need for external finance and the loss of control over the own business (Burns, 2007). In the following chapter the different forms of external and internal ways of funding will be critically discussed. This review should build the groundwork for the development of a financing framework for start-ups in the technology sector with special regards to the UK business environment.

2.1. Theoretical background

2.1.1. Stages of financial need

The availability of funding is strongly related to the start-up’s business life cycle. To provide the reader with a better understanding, the different stages of the business life cycle and the related financial needs will be defined in the following section before discussing the available funding options in more detail (Adelman and Marks, 2004).

Seed financing

For any company in the start-up stage it is crucial to secure funds to meet the initial needs by its founders. In this first stage, when a founder starts to convert an idea into a venture, there is often a gap in being able to access funds. At this point, seed capital is necessary in order to help the founder to create the business model and product. Family, friends and fools often provide this kind of capital (Adelman and Marks, 2004). A more detailed discussion will follow in the section “internal funds”.

Start-up financing

In the start-up stage, capital is needed to take the venture form the written-on-paper stage to the stage of start trading. Often the capital comes from business angels and venture capitalists but also grants from the government are a possibility. These sources will be described in more detail in the external financing section (Burns, 2007).

First round financing

The first round financing stage provides a company with the funds needed to further expand the business and reach the profitable zone. Options to access funds in this round are commercial banks, suppliers and customer, grants from the governments on a debt basis but also venture capital (Adelman and Marks, 2004).

Second round financing

Second round financing is needed in the case that a company requires capital to expand its core business, for example create new, more advanced products. The sources of funding are banks and suppliers & customers based on previous business relationships but also venture capitalists (Adelman and Marks, 2004).

Mezzanine finance / Third round financing

This type of funding is widely used for marketing purposes, business expansion and improvements in product and service. Mezzanine capital is often obtained through convertible debt, such as warrants (Adelman and Marks, 2004). Mezzanine capital exists as hybrid financial security that contains both debt and equity characteristics. Mezzanine finance is often used for later stages of funding.

It often goes hand in hand with Venture Capital and Private Equity financing (Burns, 2007).

Bridge Financing

Mostly venture capital firms may provide bridge financing to a firm either before or after the mezzanine financing. This kind of finance is normally offered just a few months before a firm goes public, and repayment usually comes from the IPO money. Bridge financing is also a good way to get prestigious investors on board, which then can improve the outcome of an IPO (Burns, 2007).

Abbildung in dieser Leseprobe nicht enthalten

Figure 1: Start-up Financing Cycle (Jaguar Capital, 2013)

After defining the different stages of financial needs, the possible financing options for the seed and start-up stage will be discussed in the next paragraph. The focus hereby lies on the discussion of the different ways to obtain capital starting with a definition followed by a discussion of strengths and weaknesses supported by empirical studies and an application to technology start-ups. This paragraph, together with the previous one, is aimed to build the groundwork for the development of a financing framework.

2.1.2. Most common financing options

Internal Funds

The capital of the founder is always the first and often the only possibility to provide seed funding. The reason for that is the missing turnover and a lack of experience of first time entrepreneurs, which makes external finance hard to obtain. Founder’s capital is a part of the so-called insider financing and is the main sources of informal finance for start-ups such as owner’s equity, private loans and credit cards but also family, friends and fools (Berger & Udell 2006). These sources provide support in form of interest free loans, or even donations to new ventures without formal requirements. One of the biggest strengths is the fact that these sources normally not get involved in any form of monitoring, such as banks or venture capitalists would do (Burns, 2007). On the other hand, with the missing financial controlling, there is the possibility of moral hazard, for example investing in high-risk business opportunities, such as technology start-ups (Scholtens, 1998).

Insider finance is important because young companies have no collateral or a proven sales record, which is a big risk for banks, venture capitalists or other external sources. This is especially the case for first-time founders with ideas in the risky technology sector (Winborg & Landstrom, 2001).

Another possibility of internal financing is the way of using retained earnings. However, in the case of first time entrepreneurs it is almost impossible to finance the venture with the help of retained earnings because simply spoken: there are none (Berger & Udell, 1998).

As mentioned before, external funds are very restricted in the early stage of the venture unless the company can proof that there is a big growth potential and the possibility to scale the business very fast (Scholtens, 1998). If a company is able to do that then the doors to venture capitalists or business angels will open very fast.

However, owner’s capital remains the first primary source of financing option for the start-ups. Another possible and in recent studies explored way to acquire funds internally is bootstrapping. With the help of this technique, a founder creatively acquires either financial or human resources to develop the venture. This technique is often very useful if a strong governmental support network is put in place, where advise and money can be accessed for almost no costs. In the case of a technology start-up started by students, bootstrapping is often easier as there is plenty of support available on the student level (Winborg & Landstrom, 2001).

External financing

The most common forms of external financing will be discussed in more detail in the following.

Equity financing

As mentioned in the previous paragraph, because moral hazard and asymmetric information are more present during the initial stages of start-ups, internal financing is often the critical source of funding for new enterprises. However, to develop or grow the business alternative channels and sources of capital are needed. Retained earnings or equity capital are just two examples how start-ups can access capital to finance growth and expansion (Reid, 1996).

Per definition, “...equity capital is capital invested in the firm without a specific repayment date, where the supplier of the equity capital is effectively investing in the business” (Ou & Haynes, 2006, p. 156). These funds can be accessed in two possible ways: internally or externally. Internal equity is capital acquired from company management, family, and friends or from the retained earnings within the firm as discussed in the previous paragraph. External funds, on the other hand, is capital obtained from new external sources and not from existing business partners or relatives. In an early stage equity capital has the strength over debt that the company normally has a cash shortage and is therefore not able to secure loans with collateral. That is especially the case for young technology firms with no proven track record. Equity provides funds with a long-term focus combined with less money outflow compared to interest payments, which come with debt. Furthermore, equity increases start-ups’ creditability by showing that the company was able to get the approval of financial investors. Turning to the to main weakness of equity financing: Some founders don’t like equity capital because they have to share control. This share of control means in reality that investors participate in the decision making process of the venture (Reid, 1996). Founders, nevertheless, are going to choose external equity based on risk sharing reasons and therefore partnering with less risk-averse investors. At the end of the day, however, a substantial assessment of the significance of external equity for every individual start-up should be based on the success factors of companies that receive the capital (Berger & Udell, 1998).

Business Angels

Berger and Udell (1998) define business angel capital as an informal market for direct capital. Business angels are selective wealthy persons with a proven business track record. These individuals invest directly in high growth start-ups, often in technology start-ups, with which the angels did not have a previous relationship. This investment is usually equity based (Madill, Haines, & Riding, 2005).

Chemmanur and Chen (2014) found three main features that make angel investment a good source of funding for young start-ups, especially technology related ones. First, angel investors are usually more active in the early stages of a venture and often closing the equity gap. Second, business angels usually have a lower level of rejection compared to venture capital and they are a more patient source of finance because of a longer exit horizon combined with a greater understanding for the needs of entrepreneurs. Last but not least, business angels have a preference of investing in the local economy, which can benefit founders, which attended for example the same university. Weaknesses can be found in a paper from Hellmann and Thiele (2015). They stated that business angels are often not very active investors. Furthermore, business angels are not very keen to provide additional capital for further growth to become a key player on the market. This can be a major problem for technology start-ups because in this industry a fast growth is necessary to become successful. What is more, most business angels do have neither the skill set nor the interest in putting money in a company after it can access other funds, for example public equity markets.

Venture Capital

Venture capital is per definition a form of financial intermediation. It is the form of capital in which money is collected from investors and then invested in high-risk companies, which often are young technology start-ups sector (Potter & Porto, 2007). Furthermore, venture capital plays a major role in strategic planning and decision-making process in the company. In comparison to more conventional capital sources, venture capitalists have some special characteristics. First, venture capital investments are very risky caused by the high level of asymmetry information, moral hazard and few collateral to secure the investment (Festel & Rammel, 2015). Furthermore, venture capital firms have a strong need for pro-active monitoring as venture capitalists often invest large amounts of money for a significant stake. This often leads to more meetings with the managing team of the start-up (Hellmann, 1998). What is more, a venture capital firm can provide the start-up with useful access to a broad network of support, such as new clients (Potter & Porto, 2007).

Turning to the weaknesses, venture capital is risky caused by moral hazard and adverse selection (Smolarski & Kut, 2011). Furthermore, there is the agency problem (Bergemann & Hege, 1998). This is especially the case if the founder or the management team don’t have enough information or skills to execute the business strategy and therefore risks the whole venture. This problem can be worsening by imperfect information about the project (Berger & Udell, 1998).

To conclude, venture capitalists not only are a further way of funding for small companies, venture capital is also very useful when it comes to resolve informational problems affecting start-ups. By raising the financial flexibility of small companies, venture capitalists offer start-ups the opportunity of getting funds from more sources, for example banks. However, venture capital can be found in the inflexibility, especially in the short-term, as the process of getting venture capital involves a lot of preparation time and skills to succeed in front of experienced investors. Nevertheless, for today’s technology start-ups venture capital is an important source as these funds can provide large amounts of capital if needed (Kortum & Lerner, 2000). However, especially in the case of venture capital, but also for business angels and other equity-based investors, start-ups need to have a high growth focus, with the potential to reach considerable scale. Unfortunately, this is not true for the majority of technology start-ups, which makes venture capital and also often business angels virtually impossible to access for these start-ups (Festel & Rammel, 2015).

Debt Financing

When it comes to capital structure decisions, it all comes down to equity versus debt and that is the case either for small or large firms. However, when it comes to small companies, debt has some favourable attributes over equity caused by information opacity, which are more severe in small firms. When issuing more equity to meet company’s financial requirements, this can then lead to share dilution and a loss of control. Hence, when full ownership and control of the company is preferred, founders of small enterprises may choose to use debt (Berger and Udell 1998).

In the literature one can identify three major differences between debt financing for start-ups and big corporations (Wu et al., 2008). Compared to big corporations with a broader range of debt financing opportunities, start-ups are facing a strongly limited field of resources available and are normally more dependent of commercial lenders. With the strong presence of asymmetry information in start-ups compared to established corporations, lending relationships in the long-term become crucial for start-ups to handle agency problems. Furthermore, in cumulative owner–managed start-ups it is not certain if debt can decrease agency costs, which results from asymmetric information caused by different motives of shareholders and managers (Wu et al., 2008).

The biggest benefit that drives start-ups to apply more debt compared to other external sources of funding is the possible tax shield, because interest rates decrease the taxable profits. However, in the case of a young business this argument losses some of its force as especially technology start-ups have a long way to go until profits are realised (Wu et al., 2008).

Bank financing for Start-Ups

According to existing research, banks are the primary source of external capital for small companies. That is the case for the developed and developing economies (Vera & Onji, 2010). De Bettignies and Brander (2007) state that the availability of loans from banks can be seen as competitive and based on a fair basis. Moro, Lucas, Grimm, & Grassi (2010) went further when stating that start-ups should only use bank capital for financing purposes to optimise the capital structure. This can be explained by the higher expected return, despite the higher costs, which are associated with bank financing. Furthermore, financing from banks can help start-ups to gain a better performance level compared to other sources of funding, because of the monitoring and controlling process processed by banks (Vera & Onji, 2010). On the other hand, this argument applies to venture capitalists as well, which objects the argument that start-ups should only use bank capital (Festel & Rammel, 2015).

Banks lend or invest in start-ups because it can be a real profitable business opportunity. De la Torre, Martinez and Schmukler (2009) are supporting this argument with describing the relationship between banks and small firms as integral. The three scholars stated that banking institutes offer not only capital for starting or expanding the business opportunity. Banks provide a wide range of additional services, which then can create new sources of income. Two other scholars supplement other factors, which drives to supply start-ups with capital. First and foremost, the high profitability potential related to an involvement in start-ups, as banks see this sector as unsaturated with plausible outlook. Furthermore, start-ups getting more attention form banks because of the increased competition in the more traditional large business or retail-banking sector (Beck, Demirgüç-Kunt and Martinez 2008).

Governmental Support

Governments all around the globe have recognized that a viable start-up sector is an important source of innovation but often lacks the access to external funds, which then adverse the economic situation. As a result, many governments have implemented financial programs to support start-ups. These programs often come in the form of guaranteed loans, grants or subsidising fees for starting a business (Burns, 2007).

Per definition, government official schemes are implemented by the public sector often supported by donor agencies to improve efficiency and the amount of support available for young companies (Mensah, 2004). Researches state that these programs have the ability to improve the access of start-ups to other sources of funding (Boocock & Shariff, 2005). Furthermore, as start-ups are affected by credit rationing caused by their small size and asymmetric information it is necessary that government programs should decrease the level of discrimination against start-ups when it comes to lending costs and unmet fund demand (Zecchini and Ventura, 2009).

Three major arguments support financial support from the public sector: on credit market imperfection, price biases and dynamic externalities (Mensah, 2004). Nevertheless, such government programs with the aim to improve access to capital can have a downside, such as ineffective distribution of credit or moral hazard, which then can offset the positive characteristics (OECD, 2004). In order to have an effective governmental financial support system in place, this system should follow two principal criteria (Bechri, Najah & Nugent, 2001). Starting with helping start-ups to access the necessary amount of funds. Second, the funds should help the firm to grow in a sustainable way. In the U.K. there are several possible ways to get the government support your business, such as the Smart award initiative or loan guarantee schemes. These initiatives are adapted pretty well in the last years and are one reason why the start-up culture in the UK, especially in the technology sector, is superior compared to their European pears (OECD, 2014).

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Details

Title
Financing of Start-ups. A financing framework for technology start-ups in the UK for the seed & start-up round
College
University of Glasgow  (Adam Smith Business School)
Grade
1.0
Author
Year
2015
Pages
49
Catalog Number
V451790
ISBN (eBook)
9783668861336
ISBN (Book)
9783668861343
Language
English
Tags
Financing, Business Start-ups, Technology, Entrepreneurship
Quote paper
Patrick Renner (Author), 2015, Financing of Start-ups. A financing framework for technology start-ups in the UK for the seed & start-up round, Munich, GRIN Verlag, https://www.grin.com/document/451790

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