Pulling a Crowd

For as long as there have been SMEs there have been challenges in raising capital for business growth. Now a new website-initiated crowdfunding option is becoming available. Glenn Baker reviews this new kid on the block, along with more traditional funding options.

Entrepreneurs Simeon Burnett, Richard Allen and Francis Reid have teamed up on various business projects – but their latest venture arguably offers the most potential. That’s because it addresses one of the most fundamental requirements of any business: cash for growth.
“There are thousands of Kiwi businesses that have their growth constrained because the banks won’t lend, and other sources of funds don’t fit or are cost-prohibitive,” says Burnett. “There are also thousands of bright, capable people with brilliant ideas and concepts that struggle to breathe life into them because start-ups are very often funded by loans from friends and family. Not everyone is lucky enough to have a wealthy uncle.
“On the other side, investors currently have limited access to the dynamic SME and start-up markets – unless they are lucky enough to be someone’s wealthy uncle!”
The three business partners saw an opportunity in the fledgling crowdfunding market with the changes to the relevant provisions in New Zealand’s Financial Markets Conduct Act taking effect on April 1st. Snowball Effect is their online portal (www.snowballeffect.co.nz) which will be one of the first to trade off the new rules covering equity crowdfunding – a concept that allows entrepreneurs and business owners the opportunity to pitch ideas and growth plans to the public online – effectively selling shares to their most passionate supporters; expanding the pool of potential investors while reducing the cost and complexity associated with raising funds.
Crowdfunding as a concept has been around in various forms for centuries. Wikipedia describes it as “the collective effort of individuals who network and pool their money, usually via the Internet, to support efforts initiated by other people or organisations.” However, ICE Angels director, Ken Erskine, believes there is some confusion surrounding the concept. “Until now, crowdfunding has primarily been a product validation and investment platform under the banner of ‘rewards based’, or alternatively a ‘social’ investment – or, as some people prefer, ‘Internet busking’. What investors get for their reward focussed commitment is an early edition of a new product that sparks their interest.”
An example is local website PledgeMe or international crowdfunding platforms IndieGoGo and Kickstarter (the latter has operated here since late 2013).
Historically ‘social’ crowdfunding has been primarily associated with funding for the arts and charitable projects. But it is ‘equity’ crowdfunding [investors get a share of the company being invested in] and ‘debt’ crowdfunding or ‘peer-to-peer lending’ [investors get a dollar percentage return on their invested funds] that’s going to create all the excitement after April 1st.
Not surprisingly, ICE Angels, Australasia’s largest angel investment group, is working with two start-ups in this space: Snowball Effect (equity) and Harmony (peer-to-peer).
“Regardless of what crowdfunding platform it is, there will need to be a balance between ‘borrowers and lenders’, or ‘investors and investees’ for it to be able to function properly,” explains Erskine.
He’s predicting a wave of interest and excitement around these new funding platforms with the new regulations coming into force.
“I see this as the next stage in the development of the entrepreneurial ecosystem. A new way to empower the mass market using standardised platforms to engage with a far wider [business investment] market.
“Crowdfunding is for smaller businesses that historically have not attracted investment through traditional channels; perhaps manufacturers of certain types of products that investors have stayed away from.”
Erskine is conscious of the huge volume of businesses in the crowdfunding space – demonstrated by the fact that last year ICE Angels invested more than $7.8 million into 26 early-stage companies – from an initial pool of 300-plus enquiries.
Angel investors traditionally look for investments of $250k to $2 million; businesses with existing customers. He believes crowdfunding will cater for those businesses requiring a lower level of investment. “But it will depend on each platform, what they’re aiming for and looking to do.”
When it comes to business investment, the most common adage amongst investor circles is that it takes twice as long and costs twice as much than originally estimated to develop a business. The same can be said when raising capital, says Erskine. “Each crowdfunding platform will need to carry out due diligence of application, of selection, and of investment.”
And although he has seen angel deals happen very quickly, generally a crowdfunding platform will provide a quicker source of capital than other platforms, he predicts.
Inevitably there will be traps with the equity crowdfunding process – after all, says Erskine, “how well will business owners know their investors (who may be less sophisticated) and what they bring to the business, and vice versa”. And there may be question marks over the due diligence process. But the possible upside, he believes, is that younger, perhaps time poor, professional investors will be attracted to the market.
“At the end of the day, the success [of any crowdfunding agreement] will be based on the quality of opportunities brought to the table, and how well they go down the track.”
No investor limits
Simeon Burnett has already applauded the fact that, under the new approved regulations there will be no investor caps for equity crowdfunding, other than the previously announced $2 million cap that a company can raise through crowdfunding each year.
“The next few years will be intriguing as the equity crowdfunding market becomes established, and other countries adopt equity crowdfunding-specific legislation like us,” he says.
“New Zealand is well positioned to be a global leader in equity crowdfunding. We have conducted extensive market research and validation and the response from both businesses and the investor community has been overwhelmingly positive.”
Burnett points out that equity crowdfunding is not about replacing existing venture capital and IPO funding channels – but creating a new intermediary step.
It’s not ideal for every company either.
“For example, low-growth and early-stage businesses may not be suitable. Successful crowdfunding requires a well-crafted pitch which takes time and effort to develop.
“During the funding period, a company needs to dedicate resources to answer questions from potential investors.
“Equity crowdfunding requires you to sell a stake in your company to members of the public, so it’s important that companies are aware of the implications.”
If you’re thinking of investing in SMEs, but just have a small amount of money to invest, equity crowdfunding, through the new regulations, opens up a whole new world, says Burnett. “It will provide access to high growth potential SMEs, and help those looking to diversify their investment portfolio.”
Funding basics
Crowdfunding aside, there’s not much else grabbing the headlines in the business funding marketplace. But there is a solid range of more traditional funding options, involving banks, angel investors (high net worth individuals who generally invest in technology-based companies and may want a governance position within the company) and venture capitalists. Remembering, of course, that the latter two generally involve giving up some equity in your business and the expectation of a healthy return on investment.
“The key question to ask yourself,” says ICE Angels’ Ken Erskine, “is ‘What is the most efficient and effective way for me, as a business person, to secure the funds I need?’”
The bank has always been a good starting place for sourcing capital and is, not surprisingly, the second most common source of funding for business development, after personal equity, friends and family. Business banking managers are a far cry from the stuffy old bank manager of yesteryear and provide advice on how to improve your chances of successfully securing a loan and identifying the stumbling blocks to business growth.
David Blakey, head of corporate and specialised finance at BNZ, says once a business reaches a certain size, simply raising debt against house equity is no longer sustainable and any further fund raising will rely on the performance and assets of the business itself.
He says invoice finance, a product unique to the BNZ, is an ideal way to release capital for a fast growing business that requires immediate funding. The bank will audit and assess the quality of the business’s debtors list and lend up to 80 percent of its value immediately. “It’s a modern alternative to the traditional overdraft facility,” he says, “a form of working capital that can, for example, allow you to fund growing stock levels in order to acquire new customers.”
Invoice finance can also allow you to negotiate better terms with your creditors – quicker payments can often lead to bigger discounts.
BNZ also offers a stock finance facility, trade finance, and asset finance facilities that allow companies to invest in plant and equipment.
With the increase in economic activity and business confidence predicted for 2014, Blakey believes funding for growth will become even more of an issue as companies attempt to grow with the market. “Now’s the time to lock funding in place to support any increased sales activity.”
He also sees potential for crowdfunding in the market – particularly for new businesses with a nil track record, minimal equity and a need to secure cash quickly in order to grow.
Stacking the odds
If you want to improve your chances of successfully raising capital from a bank, Blakey says first you’ll have to be prepared with a well thought through business plan. It’ll need to show you understand your business model, your cashflow cycle, how you expect the business to perform, what shareholder support there is, and so on. “You’ll also need to consider various ‘what if’ scenarios. What if sales underperform by ten percent? What if currency rates or interest rates fluctuate? Or fuel prices? What if you had to recall a product?”
The business world is dynamic, volatile and ever-changing, Blakey points out, owners must understand the risks. “The Christchurch quakes in particular threw up a lot of business continuity lessons. How would you manage if you could no longer operate from your current premises?”
Lenders also take into account the quality of management, says Blakey, and level of governance. “Is it just one person making all the decisions or does it have a management structure, independent directors or advisors involved?”
He says they like to encourage people to become involved in business education programmes in order to better master the management of their business, and, to quote an old cliché; work on the business, not just in the business.
If the business owner is new to the game, the banks will want to make sure they understand the cashflow of the business. Do they understand the implications of a change of trade terms with customers and suppliers? While a simple Profit and Loss statement gives as an indication of a business’s profitability it is distorted by accounting principles and non-cash items. Ultimately it’s the cashflow of a business that will determine its value and ability to raise more debt to fund growth.
Fred Ohlsson, ANZ’s MD Retail and Business Banking, says successful funding applications revolve around strong ideas and sound business plans. “A business with a well thought through business plan is more likely to succeed. Although some of those plans may not eventuate in the long run, it shows that they have considered all options.”
The business owner’s own personal experience and equity also come into play, but Ohlsson’s advice is to seek advice early – and ANZ’s many business bankers are only too happy to vet ideas and provide feedback.
Many business owners fall down when it comes to raising capital by overestimating revenues and underestimating costs, says Ohlsson, “and that’s easy to do”.
“It’s also easy to overestimate how quickly money will come in initially, so make sure you’re well-backed for the start-up phase.” He reminds us of Statistics NZ figures showing that business deaths have outnumbered births for the past three years.
However, on a positive note, the December 2013 ANZ Business Micro Scope survey revealed that business confidence is at its highest since comparable data was first collected in 1999. Record numbers of firms are expecting to up activity, hiring and profitability in 2014. Ohlsson is convinced the increased level of business and consumer confidence is here to stay – and that confidence will be reflected in more proposals and intent in the loans market and more funding options.
“When business owners are more confident, they’re more likely to put more money into those ideas and are more likely to achieve backing,” he says, adding that in 2013, ANZ lent record amounts of money to Kiwi small businesses, including start-ups.
The final word on raising capital goes to ICE Angels’ Ken Erskine. “Understand the options: the costs of each option and the positives and negatives of each option. Don’t leave it ‘til the last minute – [raising funds] needs to be part of a structured plan.
“Remember, the greater the uncertainty of risk, the higher the price of investment. That’s a fact of life.”