Mastering Equity Financing: SEIS, EIS, and Venture Capital in 5 Steps
There are a range of costs for which a startup founder is liable when starting a business. This places a significant financial burden on business owners and constitutes a potential roadblock to those considering creating a startup.
This article focuses on equity financing options as a way to help fund your business. This article is Part 2 of a Finance for Startups series, in which we detail several ways to fund your startup and to help you manage extra expenditure, including Part 1 on government funding and Part 3 on debt financing.
What is Equity Financing?
Equity financing describes the means by which companies exchange stock (or equity) in their business for cash. It provides a way to finance a business in the short-term, and can be used multiple times throughout the business lifecycle.
There are various forms of funding for your startup. Most commonly, businesses are funded through investments from both angel investors and institutional investors such as venture capital firms. Funding can also be provided by the government through equity finance under the Seed Enterprise Investment Scheme (“SEIS”) and Enterprise Investment Scheme (“EIS”). We explain these options in further detail below.
Government Contribution
The Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS) are government schemes used to encourage equity finance into high-risk, high-potential businesses. Both the SEIS and EIS operate by means of offering tax reliefs for investors who invest in businesses under these schemes, encouraging investment in small businesses.
To apply to both SEIS and EIS, your company must meet the following requirements:
The company must have a permanent establishment in the UK. The objective is to ensure these investments contribute to the UK's economy, creating a balance to the loss made to the economy through tax benefits;
The business is carrying out a new qualifying trade: a qualifying trade which has not been carried out for more than 2 years. Though most business trades qualify, there are cases where a trade will not qualify, including where over 20% of the business’ trade involves coal or steel production, energy generation and financing services, for instance. For a full list of non-qualifying trades, see here; and
At the time of investment, the company must not be listed on the stock exchange. If the company was listed on the stock exchange, there would be a lesser need for the government to allow SEIS or EIS where it is easier for companies to find investors.
SEIS
The SEIS aims to help startups secure outside investment by encouraging investors to buy shares in early-stage businesses and consequently help boost the economy.
A company (or companies, if you are operating through a parent company) must:
Be less than 2 years old;
Have less than 25 employees;
Not have carried out a previous trade; and
Have a gross asset value amounting to less than £200,000.
These requirements are in place to help the government focus their target for SEIS on small companies. Limiting the number of employees and company value through these conditions allows investors to centre their attention on a pool of small, high-potential enterprises.
The maximum amount that a business can receive through SEIS investment is £150,000. Note that if your company has already qualified for venture capital funding, your company will not qualify for SEIS.
EIS
Similarly to SEIS, EIS aims to encourage investment in early-stage startups through a range of investor tax incentives.
EIS aims to help slightly larger companies grow and achieve their business targets. This scheme is designed to help companies that are considered startups and fall under the category of small to medium-sized businesses. A company (or companies, if you are operating through a parent company) must:
Be less than 7 years old;
Have less than 250 employees; and
Have a maximum gross asset value of £15 million.
With larger sized business, comes larger expenditures. The EIS acknowledges this by increasing the maximum available investment to £12 million over the life of the company, with a maximum of £5 million a year.
To qualify for EIS investment, you must also meet the risk to capital condition, requiring that the money invested into your business through EIS is used for the growth of the business, including revenue, employment or customer bases.
Advance Assurance
Importantly, consider that with both schemes, tax benefits to investors only apply once conditions for EIS and SEIS are met. Fulfilment of these conditions is only confirmed after the purchase of shares, and as a result, shareholders are not guaranteed tax relief until much later than the date of their investment.
Advance assurance is available as an incentive for investors to buy shares under EIS and SEIS. This refers to a semi-binding agreement between your company and HMRC which confirms your company’s commitment and compliance with the relevant scheme.
Companies must apply for advance assurance. To apply, you must complete the online application form here.
Angel investors
An angel investor is a high-net-worth individual with the means of providing finance to a startup in exchange for part ownership or a stake in the company.
Startups can connect with angel investors through angel investing platforms, or through angel syndicate groups (such as AngelList, Mumbai Angels, and Let’s Venture) as well as through social platforms and personal connections.
Angel investors in startups have more influence on the company’s activities as they will have an automatic seat on the board/the option of a position on the board. This is in contrast to investing in a company through the stock exchange.
Angel investors interested in startups will tend to invest in a company within the sector or practice group which they have the most experience. This is important to keep in mind when researching and connecting with angel investors, whose experience and expertise may be able to greatly benefit your business in ways other than funding.
Angel investors tend to be aware of the risks involved in investing in startups, and have expertise in important investing concepts such as capital loss, share dilution and illiquidity. Gaining an understanding of these inherent risks from angel investors can be a valuable tool for startup founders.
Venture capital
Venture capital (VC) is a form of private equity financing where wealthy investors, investment banks, and other financial institutions invest in startups and small businesses that have the potential for long-term growth. This investment need not be monetary but can also include technical or managerial expertise. The purpose of venture capital is to facilitate the growth of businesses. The company, therefore, should display exceptional potential for growth.
A venture capital investment consists of 5 stages:
Stage 1: Seed stage
This is where your startup seeks funding.
This applies to companies still developing a product or service to prove its value and potential success in the marketplace. At this stage, a company is seeking investment to grow and develop their product or service from angel investors or venture capital. Potential investors in the company then investigate the viability of the product or service in the market, and the technical aspects of the product or service itself. If this succeeds, investment into the company will be in small packets, enough to start development, as an investor is unlikely willing to invest large portions into a seed-stage company.
Stage 2: Start-up stage
If successful, the new company enters the startup stage.
This is where startups typically have a sample product available but require more funding for further development, business plan formation and market research. Market research also benefits the venture capital firm, as they analyse findings to predict the business’ economic success.
This is an important stage as it allows investors to determine if they will continue financing the growth of the company or whether there is no space in the market, and will terminate their contribution.
Stage 3: Initial Stage
At this point, the product or service is being sold in the market.
This allows investors to see the product in comparison to its competitors. Here, funding is typically used for manufacturing, sales, and additional marketing. The investments increase in comparison to the earlier stages, as investors see the potential success of the company moving forward, and are willing to finance the growth further for greater rewards. The company should also see profits here, encouraging more investment.
Stage 4: Expansion Stage
Now, the company can extend their products.
The earlier three stages allowed the company to reach a point to allow expansion. Funding should increase with market shares, and the increase in funding can allow for new opportunities, such as expanding the product or service nationally and internationally.
Stage 5: Mezzanine Stage
At this stage, the start-up can go public so that investors can profit from the venture.
Funds received at this stage are typically used for activities such as acquiring or merging with other companies, eliminating competitors, preventing new competitors from entering the market, or financing the steps involved in an Initial Public Offering (IPO). This is typically the final step in the venture capital financing process.
The 5 stages outlined above represent a usual life cycle of venture capital investment into a startup. If you are interested in seeking venture capital investment, consider which stage of development your startup is at, and what your goals for growth are. With that in mind, you will be equipped to determine your startup’s next steps for development with venture capital funding.
Importantly, consider that investors who have invested in your startup from the seed stage intend on earning their investment back, as well as a reward for their time and consideration into your business’s growth. As a result, venture capital firms usually seek 25-50% of a company’s equity.
Investments can alleviate the financial burdens of starting your own business, and allow for further growth and expansion. By considering whether the options above are available and suitable for you, your startup could be open to exciting potential investment.
We hope this article has provided you with insight into what Equity Financing involves. Part 3 of this series will cover Debt Financing so make sure to stay tuned!
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Authors: Tanisha Shah & Rita Almazuri - Editor: Gaia Freydefont -
Authors: Tanisha Shah & Rita Almazuri - Editor: Gaia Freydefont -
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DISCLAIMER
This article has been written by law students for the sole purpose of providing informative insight. The information in this article is intended for educational purposes only and does not constitute legal advice, nor should the information be used for the purpose of advising clients. You should seek independent legal advice before relying on any of the information provided in this article.
Sources
Craig R, ‘7 Types of Funding for Startups and Scaleups’ (Rapid Formations Blog29 December 2021) <https://www.rapidformations.co.uk/blog/funding-startups-scaleups/>
GOV.UK, ‘Apply for a Start up Loan for Your Business’ (GOV.UK20 June 2017) <https://www.gov.uk/apply-start-up-loan>
‘Use the Seed Enterprise Investment Scheme to Raise Money for Your Company’ (GOV.UK2022) <https://www.gov.uk/guidance/venture-capital-schemes-apply-to-use-the-seed-enterprise-investment-scheme#newtrade> accessed 19 July 2022
GrantTree, ‘UK Startup Funding Guide’ (GrantTree14 June 2021) <https://granttree.co.uk/resources/funding/uk-startup-funding-guide/>
Peterson C, ‘11 Reasons Angel Investors Choose to Invest in Startups’ (www.growthcapitalventures.co.uk22 July 2018) <https://www.growthcapitalventures.co.uk/insights/blog/11-reasons-angel-investors-choose-to-invest-in-startups> accessed 19 July 2022
SEIS.co.uk, ‘Seed Enterprise Investment Scheme (SEIS)’ (SEIS.co.uk) <https://www.seis.co.uk/>
Startup.org, ‘Venture Capital Investment Stages’ (Startup2 February 2018) <https://startup.law/venture-capital-investment-stages/>
