Jargon Busting

Author

Date

1st December 2016

The varied funding structures used by new companies can be a bewildering topic for the uninitiated, not least because they are mired in financial jargon.

How many non-financial people could explain how seed funding differs from mezzanine finance for example? Or who supplies these different types of funding?

Let’s cut through the jargon and take a look at the key concepts.

When any company is created, or in its early stages, it is described as a startup. They are often not profitable or even generating revenue.

Thus, they desperately require a financial lifeline to help navigate through this formative period. This seed capital, as it is known, is usually equity rather than debt and allows startups to invest in areas such as product development and general operations to get them on their feet.

So where do they look to obtain it? It is hard to come by from traditional financers such as banks, or venture capitalists, as it considered a very high risk investment, so startup directors must often look to friends, family and their own savings for this initial cash. It is also likely that some angel investors (like TV’s dragons) will be interested in investing at this very early stage. These are often wealthy veteran entrepreneurs who invest their own money and can offer advice based on experiences.

Latterly, of course, crowdfunding platforms have also offered equity-based funding.

If the startup moves forward, the business may then be in a position to launch a new round of funding and attract new investment when the initial funding runs out. This is likely be referred to as a Series A funding round and may be followed by a Series B, C, D and so on. These are sometimes termed alphabet rounds.

These will usually be for an equity stake in the business, though some businesses may offer debt instead if their balance sheets are robust and directors do not want to dilute their ownership.

Unlike the initial round, however, the business will now likely be able to attract institutional investment from venture capitalists to stabilise them over the medium-term.

Venture capitalists invest through a business, rather than as individuals or part of a syndicate as angel investors do, and also tend to offer larger amounts than angels. They will likewise offer a growing business support and contacts to help them, but will generally take a more active role in its running and require a seat on the board.

All these companies will now have traded for at least a few years, acquiring a financial track record and hopefully a steady customer base. This increased business maturity and stability tends to translate into lower risk (and lower reward) for potential investors, something that changes the nature of the available sources of finance.

Some companies with more robust balance sheets will now be in a position to seek out senior debt in the form of loans secured against assets of the business.

Senior debtholders are those that are most likely to be repaid in the event that a business gets into financial difficulty. Gaining a loan from a bank at this this stage of development is notoriously difficult however. As such, businesses are increasingly turning to newer sources of finance, such as peer-to-peer lending platforms, to provide them with the credit lines they need.

Others businesses that lack assets against which to secure debt, or the stable cash flows to service it, may look to invoice financing to improve their cash flow.

Invoice financing can be split into discounting and factoring, both of which involve the third party finance provider advancing the money owed to a business by its customers, minus a service fee. With factoring, the finance provider takes control of the debtor book, while with discounting the relationship between a business and its customers is left untouched.

For businesses in certain sectors, manufacturing particularly, there is an increasing availability of supply chain finance (SCF). SCF links buyer, seller and financier, providing short-term credit to optimise working capital for both buyer and seller. More simply put the buyer uses the financiers money to pay the suppliers invoices, with the financier taking title to the raw materials provided and the goods that the buyers manufactures from them. SCF is available from both banks and P2P business lenders.

Mezzanine finance is usually unsecured and sits behind senior debt in terms of repayment priority. Because of this increased risk for the lender, it carries a much higher interest rate and often a clause that converts the debt into equity in the company if the loan is not repaid.

These types of funding will suffice to meet the business requirements of many companies, allowing for growth while keeping ownership in private hands. The next step, if the company chooses, is to go public with an IPO (Initial Public Offering).

There are a number of reasons why a company might consider going public, such as reducing the burden of interest payments or generating publicity. Over and above any of these considerations though is the ability that being publically listed brings to raise large amounts of capital on a consistent basis.

That said, firms must take into account the significant costs of the listing process, as well as the increased regulatory requirements.

Falling Further Down the Rabbit Hole

Author

Angus Dent

Date

3rd August 2016

The rate at which the Bank of England is prepared to lend short-term money to financial institutions looks set to fall below its current historic low of 0.5 per cent to 0.25 per cent, a move designed to stimulate the stuttering British economy. However, I would argue that further suppressing the cost of credit will do little to help British businesses battling Brexit uncertainty. Instead this rather negligible Interest Rate reduction will inflate the debt bubble while further punishing pensioners and savers, thereby diminishing waning economic confidence; thus costing companies dear. So what is the MPC’s rationale?

In Money Creation in The Modern Economy – a paper published by the Bank of England in 2014 – Michael McLeay, Amar Radia and Ryland Thomas explain how commercial banks create money via the provision of loans to households and companies. Contrary to economic theory outlined in most textbooks, ‘rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits’ (McLeay et al., p.1, 2014). It is thus the commercial banks (not the Bank of England) who create money. The interest rate – otherwise known as the ‘repo rate’ – acts as the ultimate constraint to commercial bank’s ability to create money as it determines the price and consequently the profitability of lending. By lowering interest rates, the MPC are reducing the price of credit and thus imploring commercial banks to conjure up more money by writing new loans.

The MPC hope that more ‘fountain pen money’ – money created at the stroke of bankers’ pens – might help to sand over the cracks our decision to leave the EU has created. It will not. Rather, it is a vote of no confidence in the UK economy, an economy currently plagued by uncertainty. What’s more, it proves we have learnt little from the 2008 financial crisis. As Mervyn King (2010) suggests, ‘for all the clever innovation in the financial system, its Achilles heel was, and remains, simply the extraordinary – indeed absurd – levels of leverage represented by a heavy reliance on short-term debt.’ Would raising interest rates be such a bad idea?

Jargon busting the journey from Startup to SME: Part II

Author

Angus Dent

Date

10th August 201517th May 2016

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So far then, our startups have traversed the so-called “valley of death” and toiled their way to revenue generation and potential profitability. First they took seed funding from friends, family and angel investors to kick start business development, then they looked to professional investors for series funding to provide working capital, strengthen areas such as sales and marketing, and perhaps even facilitate expansion of property and other assets. So now that these startups are past the early stages of the business cycle, where should their directors turn to fund the next phases of business growth and development?

All these companies will now have traded for at least a few years, acquiring a financial track record and hopefully a steady customer base too. This increased business maturity and stability tends to translate into lower risk (and lower reward) for potential investors, an evolution in the risk profile that changes the nature of the available sources of finance.

Some companies with more robust balance sheets will now be in a position to seek out senior debt in the form of loans secured against assets of the business. Senior debtholders are those that are most likely to be repaid in the event that a business gets into financial difficulty. Gaining a loan from a bank at this this stage of development is notoriously difficult however. As such, businesses are increasingly turning to newer sources of finance, such as marketplace lending platforms, to provide them with the credit lines they need.

Others businesses that lack assets against which to secure debt, or the stable cash flows to service it, may look to invoice financing to improve their cash flow. Invoice financing can be split into discounting and factoring, both of which involve the third party finance provider advancing the money owed to a business by its customers, minus a service fee. With factoring, the finance provider takes control of the debtor book, whilst with discounting the relationship between a business and its customers is left untouched.

For those businesses that seek to expand aggressively though, either of these forms of financing alone may not be enough, leading them to seek out mezzanine finance to help them achieve their goals. Mezzanine finance is usually unsecured and sits behind senior debt in terms of repayment priority. Because of this increased risk for the lender, it carries a much higher interest rate and also a clause that converts the debt into equity in the company if the loan is not repaid.

The above types of funding will suffice to meet business requirements of many companies, allowing for growth whilst keeping ownership in private hands. At the end of the financing road though, for those that choose it, is an IPO, or Initial Public Offering. There are a number of reasons why a company might consider ‘going public,’ such as reducing the burden of interest payments or generating publicity. Over and above any of these considerations though is the ability that being publically listed brings to raise large amounts of capital on a consistent basis. That said, firms must take into account the significant costs of the listing process, as well as the increased regulatory requirements that will be in place once public.

And so with IPOs we reach the end of the startup cycle, and the jargon that comes with it. It goes without saying that following the path through from seed funding to listing involves a huge amount of hard work and I dare say an element of luck. But with 99.3% of UK private businesses ranked as “small firms,” it is a journey we must hope many will complete successfully.

How will a “no” vote by Greece affect UK business?

Author

Angus Dent

Date

3rd July 201517th May 2016

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The Greek debt crisis that has been troubling Europe since 2010 will come to a head this Sunday when the country holds a referendum on whether to accept the bailout conditions put forward by the so-called troika of lenders – The European Commission, The European Central Bank, and the IMF. The rather wordy question that will be put to the Greek people will require a ‘yes’ to accept the troika’s proposals and a ‘no’ to reject them. And whilst the ruling Syriza party has taken pains to stress that a ‘no’ vote will not necessarily precipitate a Greek exit – or ‘Grexit’ – from the single currency, this is indeed the outcome that many commentators believe would result.

Polls released today show the dual campaigns to be neck-and-neck in terms of support. But increasingly eminent figures, including Nobel Prize winners Paul Krugman and Joseph Stiglitz, have lent their clout to the ‘no’ vote. Both make similar arguments about the failure of the current package, which has led to a 25% decline in GDP, and the inability of the Greeks to devalue their currency to restore competitiveness as reasons to vote ‘no.’ More, they fear that adhering to the demands of the Greeks’ creditors will deepen the nation’s recession under an ever-increasing debt burden.

So a rejection of the creditors’ demands is a distinct possibility. And if these leading economists are to be believed, a return to the drachma may even be a desirable outcome if this occurs. Directly this would have a rather limited impact on UK businesses, as the Greek market represents just 0.55% of the UK’s global exports. But the repercussions of Grexit would be felt acutely by Britain’s biggest trading partner, the EU, and this would create problems. The fallout would clearly create fear and uncertainty in the currency markets which would erode the value of the Euro, making it more expensive for European businesses to import goods from the UK, whilst credit conditions would also likely worsen. The combined effect of these two events would be a fall in demand for British goods from the Eurozone. As John Longworth, Director General of the BCC, has put it “many UK businesses may be hit by the resulting market upheaval, changes in trade flows, and payment issues.”

The looming referendum presents a dilemma then. Whilst a ‘no’ vote appears the only long-term solution to Greek financial woes, the nation’s likely subsequent exit from the single currency would have a deeply negative effect on the Eurozone and its trading partners. UK exporters would be forced to find new markets for many of their goods which, in the current global economic climate, may not be a simple task. A tense weekend lies ahead.