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Funding your FinTech

The UK, and London in particular, have been at the forefront of the FinTech sector globally, supported by numerous government and regulatory initiatives to help the industry as it develops. These join other funding models, both conventional and alternative.

September 2016

In 2015, the British FinTech sector generated £6.6bn in revenues and attracted roughly £525m in investment. British FinTech businesses employ about 61,000 people, making the UK larger than rival FinTech hubs in New York, Berlin, Singapore and Hong Kong. Of course, London’s crown as the global capital of FinTech could potentially be under threat as a result of the recent Brexit decision, which may take away some of the advantages on which the sector has thrived, resulting in a squeeze on future funding. However, this has not been borne out to date with a number of UK FinTech businesses raising money since the Brexit vote, including Crowdcube, Revolut, MarketInvoice, WeSwap and others. There is, therefore, hope that there is sufficient political will to ensure that the UK and the EU will continue to operate as a single market.

What type of funding can a FinTech business raise?

A business may wish to raise funds in order to, for example, develop its technology, obtain authorisations or regulatory compliance, launch a new product or expand its business. A business raises funds either by issuing shares or by borrowing money from individuals, venture capital bodies or lending institutions. The ability and appropriateness of either type of funding will depend on issues such as: the type of business and its stage of development; the financial position of the business; and the asset position of the business.

Equity: is a term which covers all types of shareholding investments in a company. Equity has the following characteristics:

  • it gives the investor ownership of a stake in the business and a share in the growth in the value of the company;
  • it is unprotected so on a liquidation or winding-up, the shareholders will not recover their funds until all creditors and other costs of winding up the company have been paid in full;
  • a shareholder has rights in the company which are set out under statute and common law and can be varied or supplemented by agreement between shareholders.

Debt: is a term which covers all types of borrowings by a company. Debt has the following characteristics:

  • it ranks ahead of equity on an insolvency of a company, with secured debt ranking ahead of unsecured debt;
  • the lender has no stake in the business and the return on debt is typically limited to interest which accrues on the amount lent;
  • if it is secured this means that the company has charged or pledged certain of its assets to the lender in order to provide greater comfort to the lender when providing funds; a secured loan restricts a company's ability to deal with the assets which have been charged;
  • many lenders will not risk funds in companies with little trading history and/or tangible assets without taking some form of personal security from the shareholders or directors;
  • the advantage to the shareholders of a company borrowing money is that it allows shareholders to retain their shareholdings without dilution.

Convertible loan notes: typically issued as a halfway house between equity and debt and designed to be a flexible alternative which is usually quicker to put in place than an equity investment or a secured loan facility. Generally loan notes are considered to be a form of quasi equity and typically have the following characteristics:

  • whilst outstanding as a loan, it is a debt owed by the company, however, generally the loan will be convertible into shares at a future date and/or on certain events happening;
  • whilst a loan, it usually accrues interest on the capital amount of the loan notes;
  • the loan notes will then be convertible into shares at prescribed prices in certain circumstances, such as the company's next equity funding round or, instead, will be repayable within a certain period or on certain events happening;
  • loan notes are usually unsecured.

What types of FinTech companies attract venture capital funding?

FinTech

Seed and venture capital funding is a type of equity investment usually targeting early stage technology companies. Such early stage companies typically have little trading history and their key assets are not tangible assets, which makes it difficult to attract traditional debt funding from financial institutions.

VC funds typically invest when the valuation of the company is low, allowing for a rapid growth and high return if successful, but the risk to the investor is high if projected growth does not happen. The common expectation is that a fund will be able to realise its investment (typically by a sale or, less commonly, a listing) within three to five years and will want to see business plans modelled on this basis.

What are the typical sources of funding for early stage FinTech companies?

Family/friends and business angels – seed investment

At the initial stages of the lifecycle of a company, the founders may look to family and friends to invest in the company, typically by way of equity for a small stake in the company. Also, high net worth individuals (often called business angels) may invest at this stage to support the initial phase of a company's growth. These business angels can also provide their know-how and experience. Such early investments are commonly called "seed investments". At this stage, the investor often receives the same type of shares that the initial founders hold (e.g. ordinary shares), but may seek some protections under an investment agreement.

There may be tax reliefs available to these types of investments such as the Enterprise Investment Scheme (EIS) or Seed Enterprise Investment Scheme (SEIS). These schemes provide generous income tax and capital gains tax reliefs for individual investors who subscribe in cash for ordinary shares in qualifying companies. It is important to note that certain financial activities such as banking, insurance, money-lending, debt-factoring, hire-purchase financing or any other financial activities, fall outside of the qualifying trading activities meaning that such reliefs may not be available for certain FinTech companies. It is advisable, therefore, to seek advance assurance from HMRC that the company carries out a qualifying business activity for these purposes.

One would expect that the rights of the investors for a seed investment to not be as extensive as the rights of a series A investment (described below) as the amounts being invested are smaller and valuations are lower (for example, there being only one class of shares and the warranties being very basic). At the seed stage, with funds being limited, the company will be seeking, if possible, a simple funding structure. If a seed venture capital fund is investing, the rights of the incoming investor may be closer to the rights of a series A investment (for example, receiving preferred shares).

At initial stages, the investors may provide convertible loan notes and then, if the company is able to progress its business plan or attract additional investment. these loan notes convert into equity. Again, it is important to note that investments by individual investors into convertible loan notes would (most likely) not be eligible for SEIS or EIS relief.

Venture capital funds – series A investment

Venture capital funds are often in the form of limited partnerships which make up a varied source of investments from private funding, pension and insurance funds as well as a range of government and EU schemes established to promote investment. Funds may also be available from universities to support academics in the development and commercialisation of new technology.

Typically, an initial investment by a venture capital fund is called a "series A investment" where the fund seeks a minority stake in the company (although there may be other models) and receives preferred shares in the company, as well as additional protections under an investment agreement. A series A funding round generally involves more complex terms than a seed investment round, given the larger amounts of money that are typically invested, the more sophisticated nature of the institutional investor and the fact that the company's trading history is longer and its activities, therefore, likely to be more extensive than earlier stage companies.

More complex protections that are typically sought in a series A round include: (i) liquidation preferences to provide protected and enhanced returns to the investor for its shares on an exit event; (ii) anti-dilution rights to provide compensation to the investor in the event of a future funding round at a lower price than that paid by the investor; and (iii) negative controls requiring the company to seek approval from the investor before pursuing certain activities. In addition, founders will usually need to provide some assurances to the investors in the form of warranties as to the state of affairs of the company and restrictive covenants to prevent him/her competing with the company in the future. A founder's shares may also be subject to vesting such that if the founder leaves the company within a period of time following the investment, the founder may lose some or all of his/her shares. An Investor is also likely to require that it is able to have an entrenched right to appoint a director to provide positive influence to the operation of the company and demand comprehensive management and financial information rights to enable it to monitor its investment.

Alternative sources of funding:

Equity crowdfunding - the global equity crowdfunding industry has been growing by over 100% year on year, and is expected to overtake angel investing and venture capital in terms of size. Equity crowdfunding is typically suited to early-stage companies. Equity crowdfunding involves investors providing capital to an early-stage company in exchange for shares, with the expectation of profit if/when the business becomes successful. A main benefit of equity crowdfunding for entrepreneurs is the ability to draw upon the knowledge, expertise and networks of a larger crowd of investors.

Corporate venturing - where large corporations invest directly into a smaller company with a new technology often in the same sector. Corporate venture capital is invested in a very similar manner to a series A investment, but the corporate venturer will typically want the company to have a strategic fit to its business, unlike a VC which solely looks for a financial return on its investment. Many of the large global financial institutions, such as retail and investment banks, insurance companies and pension providers, have corporate venture funds ready to deploy into FinTech startups, and will often invest alongside traditional venture capitalists.

Venture debt - specialist providers of debt to technology companies that usually carries an equity element entitling the provider to purchase shares in the company. Venture debt providers will typically invest into a company that is not yet profitable and to which more traditional sources of debt financing are not yet available. As a consequence, the terms of the venture debt are typically more expensive than traditional debt financing. Venture debt providers will often only invest into companies that have received equity investment from a venture capitalist.

Government grants or tax credits - grants or guaranteed loans from government funded or not-for-profit organisations (such as regional development agencies) may be available although these change on a regular basis. In addition, tax credits such as for research and development can be available to companies. Grants and tax credits are neither dilutive to the shareholders nor repayable, and so they are an excellent source of funding to companies, especially in the early pre-profit stages of a company's lifecycle.

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Funding your FinTech
Howard Palmer


Howard looks at funding models for FinTech businesses


"The ability and appropriateness of types of funding will depend on issues such as: the type of business and its stage of development; the financial position of the business; and the asset position of the business."