We have observed a lot of noise in the market about support and investment for companies at the startup and scale-up end of their business journey. It seems that investors are pulling away from the smaller end due to reduced risk appetite. In this webinar, we discuss where the capital is coming from for early-stage ventures, and what founders need to consider when they are raising funding.

It is important to put these ideas into context. What is going on in the market at the moment in terms of deal volumes? How many deals are being done?

Fundraising Trends

First of all, we looked at the volume of fundraisings of greater than £500k. This limit was chosen to strip out smaller friends and family investments. We also added a pre-money valuation of £1.0m in order to further reduce the sample size. We have focused on startups, excluding businesses that are trying to recapitalise because of trading blips and older, more established businesses raising money for reasons other than growth.

The data we gathered goes back 18 months, to the start of 2021. Within these parameters, equity deals trend at around 300 per month. We can see a few spikes, in particular towards the end of the year when people are looking to complete deals before Christmas, and also in the run-up to the end of the tax year. What is clear is that from March 2022, there is a significant tail-off in deals which has lasted five months or so. This coincides with the broader market risk appetite reducing around that time.

Trends in Capital Raised

The next thing we investigated was the trends in gross capital being raised. This is a similar story. Using the same sample we can see the venture/growth capital raised by private companies is trending at around £3bn per month. Again, there are seasonal spikes within the 18-month time period. Looking at the last five or six months, it is a very similar story to that of deal volumes. There are fewer companies being funded, with less capital going into those companies. 

Valuation Trends

Looking at valuations, if there is less capital and fewer companies being funded as a consequence of reduced risk appetite for earlier-stage companies, we might see some pressure on pricing. 

We have looked at this in two ways, splitting into Seed and Series A. Our parameters for Seed are £1-£3m raises, and Series A are £3-£10m raises. If we had expected to see valuation pressure, it is not coming through at the Seed stage. In a similar time period, valuations for companies raising capital at the seed stage have been trending up. However, if we look at Series A, it is a different story. There is more consistency between that and what we are seeing with deal volumes. Whilst they were trending up towards the end of last year, we have seen a material drop off in valuations of Series A companies over the last six months since February and March 2022. 

We re-based our Seed and Series A valuation sample groups at 100 18 months ago. What we have seen is that there is a small appreciation in Seed valuation over that time period, but a contraction of valuations in Series A. If we look at Series A valuations over a shorter time period, towards the end of 2021 relative to now, there is a 23-24% contraction in the median valuation of companies raising capital at that stage.

Looking at regional variations in valuations, geography matters. There is a perception that companies raise capital at high valuations in the south, and the data bears that out. We split the valuation data by region and ranked it by Series A valuation. The highest valuations are coming out of London. Of the top five regions, four are in the South and Midlands, with Scotland and the regions lagging behind.

Doug was then joined by Nick Keenan, Portfolio Director at Cazenove Capital and John Nimmo, Partner at MBM Commercial for further discussion.

Panel Discussion

 

In terms of the companies you are advising, is it normal for companies to seek funding locally, and why are the better valuations happening in London? Should companies be looking for capital in London, or even moving there?

John: What we see is that there is a big difference driven mainly by the stage at which companies are at and the level of funding they are seeking. Particularly at the smaller end of the spectrum, a lot of people will find funding locally. This is for a number of reasons. If a company is at an earlier stage, then the emotional connection with investors is quite important. Also, a lot of the government funding is regionally based. If you are trying to access that funding, as a Scottish company, you are not going to get those funds out of Manchester. So there are some people it is not worth talking to, and there are others to whom you would go in advance. 

As companies that are more advanced start looking for more funding, there are other elements to consider. First of all, they have been around a bit longer, so they are more visible to potential investors. At a certain point in a company’s life cycle, investors start to seek them out and make offers instead of the companies needing to seek the investors. Secondly, because of the larger amounts of funds being sought (often £2-£5m), very frequently there will be a number of investors, syndicating the company. In this situation, it would not be uncommon for there to be an English-based investor, plus a German investor and potentially a few French or Swiss etc. to raise the amount. 

Would you agree with what John is saying? At an earlier stage you have to source capital locally because of the emotional connection between investor and founder.

Nick: If you have wealthy investors and clients who are looking to employ their money beyond traditional investments of course there are two or three things that drive it for them: Investment opportunity – is it diversified to what they are currently doing? Do they have an expertise in it themselves and is it an emotional thing? If you are a Scottish-based client with money to employ in other private businesses, you will probably largely look for businesses in Scotland. Especially at the early stage. 

Looking at the regions, do Scotland and the North have the right environment for startup fundraising? Is the investment environment less conducive to raising capital in the North relative to the South?

Nick: The short answer is yes. But we need to challenge ourselves more on how we join the dots. How can we make ourselves aware of the capital that is there and the investors that are interested? The businesses are there. The data backs up that the south of England has done particularly well, and it has done so ever since the financial crisis and even further back. There is access to capital, a large population and wealthy clients. All the pieces are there. 

As a consequence of that, in the last five years, I have seen a big increase in private investor networks, angel groups, and VCs that are looking much further afield, beyond the South East of England. These are now either basing themselves elsewhere or at least expanding their reach outside of the South East. 

The other thing that I see in wealth management is that there are wealthy clients around the country who are sitting on large amounts of cash or have access to very low-cost borrowing, looking for other opportunities beyond traditional listed investments. These clients are expecting wealth management businesses to bring these opportunities to them and make them aware of what is out there. Another thing we see is that the demographic of someone exiting a business is much younger than it used to be. This is very heavily tech-driven but is not exclusive to the South East, and these people are looking to go again. I also see more collaboration in terms of joining the dots. We have just seen the news of the Scottish investment bank and Tom Hunter collaborating together. I think the real challenge is how we pull the ecosystem together.

The economic environment in the short to medium term is challenging. So what we may see is that VCs and private investors become even more selective in terms of what they are looking for. This may be the right thing to do but history shows they should invest. This points to the idea of deeper collaboration across key businesses, people looking for investment, and the various pools of investment both in the regions and in Scotland. 

In terms of talking about the expectation among clients for introducing opportunities to them – how much of this is coming from the client side, and how much is coming from your top-down asset allocation? Should your clients have more exposure to early-stage investments, whether that is direct or whether that is through Cazenove allocating capital to venture capital funds and so on?

Nick: It is a bit of both. Starting with macro themes, there are five key themes that are driving our long-term investment.  

At a macro level, we look at healthcare – we are all living longer in the western world and need access to medicines, state healthcare systems are under real pressure and people want to live healthier lives. So whether it is bioscience, medicines, technology, or infrastructure, healthcare is such a massive thing that will dramatically impact the world. The second is technology. Irrespective of the challenges technology companies have faced in the markets this year, technology is here to stay. It will impact every single facet of our lives, and who knows who will be the Amazon or Google of the future.

The third thing for us is sustainability: people, purpose, and planet. Everyone seems to be on the ESG bandwagon at the moment, and there is an argument for greenwashing, but actually, my view is that it is permeating through everything. Whether that is a new startup or a long-standing business that is having to dramatically change its profile. It is the face of modern capitalism and will be for decades to come.

Next is China – an interesting and divisive one for some people, largely because of political views. Apart from their challenges recently with Covid, supply chain challenges, and political issues with Taiwan, China is still the world’s second-biggest economy, and they think big. Even when they have a tough year, they produce growth that we could only dream of in the West. The final theme is private assets. Ever since the financial crisis, the number of companies that are choosing to stay private for longer, de-list, or even not list at all has become massive whether that’s equity or debt. This market is massive across the globe and our clients want access to that.

On the other side, however, there are a few things. Firstly, they are not independent of each other. These themes are obviously very codependent. They are macro themes that we talk about, but at the same time, our clients want us to introduce those themes at a more local and regional level. Going back to what we were discussing before, the clients are driving that. All wealth management businesses have listed investment portfolios, but there is a race to the bottom in terms of fees, some of that is caused by technology.

As a modern wealth management business, they want us to bring more. How do you access these on a macro level, on a global level, and also how do you access that locally? Wealthy private investors, most of whom are business owners and entrepreneurs themselves, will be expecting us to bring those themes to them at a local and regional level, and indeed they are asking us for these. 

John, those are the Cazenove themes. Certainly, a lot of the clients you are advising will fall into the healthcare and tech categories, but out of those categories are there any hot areas or specific themes that you are seeing more of? 

John: There are two points that I would make. The first is that we are seeing fewer fintech and crypto businesses at the moment. Obviously crypto has hit a number of problems, and there is a confidence problem in that sector. There are not none, but there are a lot fewer opportunities than there were three or five years ago. Secondly, we do not see a rush into any particular sector other than to say that most of the companies that we help now are fairly specialist and fairly niche. A lot of them actually have really exciting and interesting ideas, but they are spread across every single sector. There are some industrial, some comms, some tech, some healthcare… 

Ok, so a broad church, but less in terms of crypto and digital currencies. The number of opportunities you are seeing is maybe correlated to the price of the cryptocurrency?

John: I think so. As an example, five years ago we were seeing all sorts of coin offerings and being asked to do all sorts of white papers, often for things that were really quite racy. That just seems to have dropped away now. There does not seem to be as much investment interest in it. 

Moving on, earlier, I alluded to the different types of investors. Different investors want different things and will behave differently. A lot of that will filter through to the term sheet; whether that is the conditions, the consents or the structure of deals. From your point of view, do you see any differences in the term sheets that are issued by, for example, an angel syndicate vs an EIS fund, vs an institutional investment fund, vs a high-net-worth investor etc. Can you help us with that?

 John: There are three points to look at: deliverability, structure and conditions or consents.  

Deliverability is becoming more and more important in the current environment. The slide shown earlier showed the number of deals decreasing. Certainly, there has been quite a big change that we have noticed in the last six-nine months. Back then the companies were very much in the driver’s seat. Now the investors have the upper hand because capital is becoming a bit scarcer for reasons discussed earlier. So deliverability is a really important thing.

As far as the differences in the structure of term sheets, conditions and consents are concerned, at one end of the spectrum, you have individual investors who will very often just take a punt based on their knowledge of the individuals running that company. They would often take ordinary shares and look for very few consent rights or protections. 

The next level up would be the business angel syndicates. They vary between groups where there is a lead investor and the others follow, and groups that are professionally managed and run.

Once you get up to the more professionally managed and run groups, if someone’s neck is on the line for the deal terms and they are supposed to be looking at, you would expect them to pay a lot more attention to those terms, and there will generally be a lot more consent rights. Examples would come under undertakings on how the business should run, and requirements for investor-director and shareholder consents. Very often they will be interested to preserve EIS or VCT reliefs as well which can get quite complicated for the founders of the company because VCT rules, in particular, are very complicated and vague. EIS rules are slightly less complex, but if you are being asked individually to guarantee that people will retain their EIS reliefs then that is quite a lot to take on. 

As you get further up the chain, you will see things start to get very different. Once you get into the private equity sphere, people will often look for more onerous control rights over the company, including swapping rights if things go wrong, where they can take over the company. There is a big difference between different nationalities’ approaches as well. A US term sheet will look very different from a UK one. An obvious example is that US term sheets will often look for creeping equity or hybrid equity, which could start at 20% of the company, but each year it takes you to get an exit they get an extra 3%, 4%, or 5%, so if you do not manage an exit quickly you can often end up losing a lot more equity than you anticipated.

And that is something that would be inconsistent with EIS relief, or you would be able to impose that kind of condition and protect your EIS relief?

People do not generally do it within an EIS structure. Technically you could, but it would be complicated.

Flipping it round to the founders. In your experience, are founders comfortable with the investment being in a new class of shares, benefiting from some kind of downside protection or maybe a liquidity preference? Can you explain what a liquidity preference is, and whether you think founders are comfortable with that idea? Or is it just the market and you have to accept it at that early stage?

John: It used to be, in the EIS market, that everybody was granted ordinary shares. However, it is becoming more commonplace for there to be a liquidity preference. What that means is the investors would get their money back first in the event of a non-successful exit, or a liquidation. Our experience is that founders are usually focused on success, so they would very commonly just accept that, whether or not it is necessarily fair or in their best interests. If they have taken £2m of funding, they are looking for an exit of £50-£100m and are focused on it. 

Lastly on that: Do you have any views on non-dilutive instruments? We are seeing more of the idea that loans to startup companies may be secured on their Software-as-a-Service (“SaaS”) revenues. Have you seen any of that yet, and do you see that as a welcome alternative to traditional equity funding?

John: In the EIS market you have advance subscription agreements. In the US market, you have SAFEs – Simple Agreement for Future Equity. Both of those are a way for the company to borrow money and issue shares. Secondly, we have seen a lot of convertible loan notes recently. This was boosted by both the future fund during lockdown, and the relaxation of the EIS rules. This meant people did not lose their EIS relief. When you move further up the value spectrum, you would expect quite a lot of the investment to go in as loans. The upside of this would be increased equity retention for the founders.

Moving on, back to the comment about joining the dots. How can big enterprises help the startup ecosystem? Is it just capital provision and that kind of trickling down, or are there other ways that companies like Schroders and Cazenove can and do get involved?

Nick: I think there are a number of steps to this. Culturally these businesses need to see that they have a part to play in the startup ecosystem, even if fundamentally as businesses that is not what we do. So culturally these businesses need to be more patient and play the long game. They need to use their networks, their scale and their access to resources and research to benefit the ecosystem as a whole. They also need to be smarter about how they work at different stages of the journey. and realistic about what value they can add. So whether it’s early stage, whether it is scaling up, or exit; what resources can we bring and what part can we play? 

If we look at early-stage companies, there are probably three things we can and are doing. Firstly matching companies and individuals from our network. There are lots of wealthy families who would be interested in exploring other opportunities. They are looking at broader opportunities and expecting us to engage around these, almost like a family office. We cannot explicitly promote a company, merely bring people together. However if, for example, we are hosting an event for healthcare investors, there is nothing wrong with having a number of buyers around the table as well to talk to potentially interested clients. It is all about talking and connecting people, which we can all still get better at regionally. 

The second point is joining networks. Wealth management networks and big businesses need to be more involved in local networks. We can support private investor events. There are lots of them, and we need to keep doing them. Whether that is being on a panel, sponsoring events, or being a mentor and giving up time. It is important, as we have the economies of scale to do that. The other thing we can do is allow access to resources. A lot of big businesses have a lot of great office spaces that are still quite empty, so let us use them and get people in. Lots of smaller businesses might not have the facility to have a lot of people around to use the technology. There are hubs around the country, and some of the big retail banks are offering more. So sharing infrastructure will be a massive benefit. 

Thirdly, how do we help entrepreneurs who want to go again? Many of our clients are business owners and entrepreneurs, and the vast majority want to get back into some kind of enterprise. How do we create that environment when our clients are advising them to do that? A lot of that is really a combination of access to low-cost liquidity and creating investment portfolios where they know that they are doing quite a sensible, conservative thing on the side. This allows them to take risk and go and do things that are more exciting and more interesting. We are aware of both sides of the balance sheet, and that is hugely important, rather than working in silence. 

So the three core ideas are matching companies; being part of the wider system of networks and playing a part in that, and enabling wealthy investors to go again.

In terms of these introductions, you work in a very risk-focused industry. The way you manage that risk is you cannot tell one of your clients to invest in a particular startup. But you try to match the experience and expertise of the client with the specific industry or problem.

Nick: A lot of clients are wealthy individuals who are still sitting on a lot of cash. When you really look at why they are sitting on it, it is that they are looking for other interesting opportunities. Usually, they are searching in the sphere in which they made their money and from where they have come. It is not just about money. It goes back to the point about being emotionally connected to your region or industry where you were successful. People want to put some money back in while making a return themselves, really they want to play their part. 

Among your client base, there is an awareness of the benefits of supporting the early-stage ecosystem. Have you seen a greater acceptance and desire to invest in private markets and earlier-stage enterprises over the last few years? 

Nick: It goes back to an earlier question: Is there an appetite there, and are we allowing those discussions to be had? Wealth management businesses 10-15 years ago were quite narrow-minded – ‘we will speak to you on exit and we will put investment strategies together from there’. Fortunately, we have moved forward. The client demand and appetite are definitely there.

In terms of EIS and VCT, we do a lot of these for clients who have an interest. Because a lot of our clients have come from private business, it comes naturally to them. Really what it comes down to is: do all the wealth management businesses, banks and big players have that culture? Are they enabling those discussions? There has always been an appetite, but you have to be realistic with these clients. It is about balance on both sides of the balance sheet. You are taking meaningful risks with your money. They are clients because they took more of a risk with their money than we would have, but that risk paid off. It is about creating the platform with what they have to allow them to invest in riskier projects. That means seeing both the corporate and private sides of the balance sheet.

Culturally the better wealth management businesses have got their heads around that now. Rather than a narrower view of when you have cash, we put it to investment use and off we go. We prefer to take a step back and look more broadly. There has definitely always been that appetite, but now we are creating the right culture and environment to happen.

Moving back to the founder side. We have talked a bit about term sheets. What are the key things when you are advising clients and founders? What should be aware of when considering investment from a third party? 

John: One of the first questions that you should ask is what is their ultimate aim? Is it to make a lot of money on exit? Is it to still be in charge of that company in five to ten years’ time? That probably informs quite a lot about the type of investors you would go and look for. 

First of all, you would examine the investors’ track records. Often they will all have very different ones. Some investment groups can be very supportive – they will provide investment directors who are knowledgeable in that sector. Other groups will not. They will place someone who is only interested in their paycheque and looks at it simply as a way of earning money.

You would also look at how far your backers can go with you on the journey and what is likely to happen when they reach the end of their capability. Are they good at bringing in follow-on investors, or are they not so good? 

After those macro points, you get down to what is in the term sheet itself. Again, a key point is not just what the investor is getting for their money on day one, but what are they getting for their money further down the line. Once again, there is a great disparity here. Some people will look for quite penal conditions if there has not been an exit event, or there has not been sufficient growth in the value of the company. Others at the opposite end of the spectrum will just take the same class of shares as the founder.

For founders, do you find it is just about the capital? Or do they need, and want, that support and expertise provided alongside it?

John: The lucky ones who end up with a good investor-director benefit from that expertise and appreciate it quite a lot. Whereas those who are unlucky and end up with an investor-director who does not have much to offer can regret it.

Looking at the type of investor and their expectations. You were talking about their time horizons. Can you talk about that and what they might be looking for in terms of return of capital?

John: Earlier on we spoke about the emotional investor – for example, a Scotsman who has decided that they want to support small Scottish companies. They would have a very long investment horizon. EIS investors on the other hand generally do not want to exit before the three-year period is up without a good deal. It differs for follow-on investors. VC and PE investors also have their Internal Rate of Return (“IRR”) to think about. They will have a timeframe of three to seven years to recirculate the money. The key thing is if there is someone at the end who is willing to step in and take the company to the next stage you are ok. 

Nick, what do you think founders and their advisers should be thinking about when they make investments? Should they be thinking about exit at this stage or can that wait until an exit event happens?

Nick: I have two standing rules: Think beyond the transaction (which admittedly can be difficult when you are in the middle of one and there are big sums of money being talked about, deadlines fast approaching, and negotiations going on). As advisers, we like to get in very early. That way you can plan ahead and make sure you have the right team in place, the right structures, and ensure they are talking to one another. For example, is it as tax efficient as it needs to be? But you are also building that relationship. This is a long-term strategy. The key is to find out what life is beyond the exit. Are they looking to get back in (many do)? If so, in what form? What would you like to do? Who is the money for? Do you have a particular purpose?

Going back to sustainability, for example, some people become far more philanthropic. It is about spending that time to think beyond the numbers in a transaction which are hugely important. The overarching view is that it is much harder to unwind things after an exit, whereas it is easier if you plan before. Estate planning is an obvious solution. Most businesses qualify for business property relief. So you have a large entity that most of the family wealth is going into which, in most cases, is not subject to inheritance tax. If you exit and don’t plan, suddenly it all is within the estate. This can be done pre-exit. It is a well-known strategy, but the tricky part is actually engaging somebody to get it done in advance. That means getting all the advisers talking, again going back to joining the dots. 

What you find if people don’t plan in advance is they sit on cash for too long after the event. It is important to take stock, and there might be a big sum of money sitting in the bank account. People might sit on cash for too long for two reasons: One, they don’t know what to do because no one has talked to them about what to do with it. Or two, they are holding onto it for another business opportunity. But that doesn’t always come along. Sometimes you find that two, three or four years down the line they are still sitting on it.

The other one is that when they decide to draw an income, their structures are not talking to one another. They are taking the wrong things in the wrong way from the wrong structures. However, take a step back and understand what the plan is post-exit. What are they trying to do, and what is their goal? Have you got the right structures in place, have you got the right team, are you getting the right advice? This can change a lot and returns to a point made earlier: make sure there is sufficient access to liquidity for these serial entrepreneurs. 

How do you bring wealth advisers, legal, PE, closer together to enhance activity in the regions? 

Nick: Networking events, culture, patience and playing the long game. These are all important fundamentals to pull together. Going back to an earlier point, the key thing is access to data. All businesses have access to data, we just do not devote enough time to using it. It is not just about seeing who is about to make an exit and then making introductions to see if they would be interested in using our services. But what other services do they need? Companies need to use and share data; be it sharing deal flow data with other businesses, or sharing it with intermediaries. Sharing and pooling data will allow everyone to get better visibility on what is going on in the marketplace.

We have clients looking to exit but have no idea what kind of multiples they could get. Should they scale up? Do they just come out? Some of it is just down to a number. Some of it is because they do not really know. So use of data and sharing data in a really easy way can give people something to work on. 

Do you see anything on the horizon that would lead to a step-change in the current investment environment? (positive or negative)

Nick: In terms of looking too far ahead, no one really knows. However, interest rates rising could have a marked impact on things. Uncertainty in the short to medium term might dissuade people from putting capital at risk when ironically they probably should. Yet they could also snap up some businesses and opportunities out there at lower valuations. There is a lot of cash and liquidity out there.

The inflation point is creating a lot of challenges for us all, but it is also eroding wealth. Even the wealthy can see it and are thinking of ways to invest their cash sensibly. It might not stop them from investing, but they might invest smaller sums or spread the risk around. There is still an appetite to invest, but time is your friend. You have to take a long-term view. Which goes back to the point of having access to liquidity pools and more conservative strategies. This buys you time to take a longer-term view on some of the riskier, but potentially more lucrative, opportunities. 

John: I would add the EIS sunset clause in 2025 is starting to concern people. Most people in the EIS sphere think this will get extended. If it does not, this valuable tax relief would be lost. 

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To continue the discussions about early-stage valuations and to see how data can support your negotiations, contact Doug Lawson.