Top Ten UK Startup Finance Myths (IMHO)

This is a guest post by Nick Pelling, Fonder of Nanodome a startup which designs, manufacturers and sells a new kind of PTZ (Pan Tilt Zoom) security cameras developed from its patent-pending IP. Nanodome says these are “tiny, light, low-profile, low-power, strong, quiet, precise and fast and can be mounted anywhere. However, Pelling has met with 120 UK-based Angels so far, drawing a blank on financing. Here’s his personal view on raising capital as a startup.

Here, for all you lovely TechCrunchers, is my Top Ten list of the startup funding myths currently doing the rounds in the UK. It’s based on my “Funding Startups & Other Impossibilities” blog, a place where I try to purge my psyche of the toxic claptrap that generally passes for entrepreneurial wisdom out there. Feel free to disagree and comment all you like!

Myth #1: “Banks support startups”

For any passing bank lawyer, I agree with you that UK banks do support startups. However, because banks broadly define ‘startups’ as “businesses that have been making decent, regular money for 12+ months”, and ‘support’ as “lending them money they probably don’t need to borrow”, this means almost nothing at all.

However now, for once, the new UK government isn’t fooled: it knows that UK banks don’t want to lend money to anybody, let alone startups [as defined by everyone else]. However, until it can find a way to coerce the high street banks (particularly the two it owns) to do so, they might as well be huge chains of dinosaur soup kitchens for all the use they are.

Myth #2: “Venture capitalists support startups”

As with the banks in Myth #1, VCs also do technically support startups. But once again, they define ‘startups’ as “2+ year-old companies that are already strongly profitable” and ‘support’ as “put £2m+ in under unbelievably one-sided contractual and control terms, while dismissing ~50% of CEOs within a year”. Sorry, but if you’re a startup talking with a traditional VC, there’s literally a 99% chance (from their own conversion rate figures) that you’re wasting your time.

Though there’s a lot of talk about low-end VCs (such as Octopus Ventures, which makes seed investments alongside its own group of business angels), the jury is out on whether or not this is a new ‘third way’ for seed. Nobody yet knows…

Myth #3: “UK angels support startups”

Weaving all the strands of evidence together, there seems to have been a big dip during early 2010, with the BBAA’s Dec 2010 newsletter noting that activity picked up in the second half of the year. Yet from talking with over 120 UK angels since late 2009, my impression is that many remain in ‘TK Maxx’ mode, only tempted by out-and-out bargains: for these, the ideal seems to be small companies where the owner / manager doesn’t realise that he/she could get bank funding instead of equity funding.

Analytically, angels know that this is opportunism rather than investment, and that the bottom of a macroeconomic cycle is instead the right time to put money into small high-growth companies with the capacity to go super-big. But many have been badly burnt (one Surrey angel told me how he lost £235K in a single hit), while few angels’ portfolios have even one clear exit in sight. Hence, the best-case UK angel-startup scenario right now is typically a pledge to come in second with £20K (my startup now has about ten such soft pledges): but without an angel to lead a round, this means nothing. It’s the end of an era, but there you go. Or, to be precise, there it went.

Myth #4: “The Enterprise Finance Guarantee supports startups”

The way this is supposed to work is that if an EFG-backed bank loan to a startup goes bad, the government underwrites 75% – a pretty sweet setup for the lender. Although, according to my (Lloyds TSB) bank manager, entrepreneurs only now qualify if they’ve first mortgaged every available penny out of any property they own or part-own and put it into their startup.

The problem is that the bulk of serious entrepreneurs (according to the stats) are in their 40s and have a partner who thoroughly objects to putting their primary residence on the line – A.K.A. “blow our savings on your stupid dream, sure, but not the damn house, OK?” – all of which sharply reduces the usefulness of the EFG.

Incidentally, the government is about to finesse this so that 20% of any one bank’s total EFG defaults are covered (rather than 13% as at present). Again, this probably won’t change anything; banks still have no desire to lend anything to anybody (see Myth #1). Still, I’m hopeful enough to think that changing the rules back to prevent banks from requiring entrepreneurs to put their primary residence at risk would enable several thousand startups to get going, particularly around London where entrepreneurship and home-ownership are both very strong. (But see Myth #6).

Myth #5: “There are plenty of startup grants out there”

Hilarious! Unless your company is located in an utterly deprived area and plans to employ a small army of semi-skilled people (when it may possibly qualify for a European regeneration grant), or you are a female entrepreneur (a few positive discrimination cash-pots still remain out there), or the laughably narrow timing and focus of a Technology Strategy Board call just happen to precisely fit your R&D timetable… you’re way out of luck, sorry. Basically, you’re a decade too late.

Myth #6: “London startups don’t need state support”

London is full of entrepreneurs: it always has been, and always will be. In fact, I’d guess at least 50% of UK startup activity comes directly from the London area. Yet Silicon Roundabout notwithstanding, it seems to me that government policy is to actively discriminate against London startups, by promoting funding elsewhere in the UK. Sorry to point out the obvious, but London is the economy’s engine, and right now it’s stalling not for lack of office space (which is why, for me, the whole Tech City agenda misses the point) but for lack of fuel. In fact, I’d argue that London should get special finance treatment to help kickstart the entire startup sector: if any initiative won’t work here (and fast), it probably won’t work anywhere in the UK.

Myth #7: “UK startups get sensible valuations”

Anyone who tells you that valuations are in any way related to balance sheets or projections or assets is a liar. In reality, valuation only works competitively (i.e. when there’s a non-collusive market, even two will do), while UK startups are lucky if they get even a single offer – which by definition implies an uncompetitive valuation. Why else do US startups appear to get valuations at a 3x multiple relative to UK startups?

Myth #8: “Startups can help turn the national finances round”

Sadly, this is where comedy yield to tragedy. Even though the UK has actually produced plenty of decent-sized companies in the past, research shows that a startup’s growth curve is largely defined by the amount of money it initially raises, probably by defining where the founders will come under sharpest pressure to exit. Which is why none of the current generation of bootstrapped, low-raise UK startups seems to me to be on a big enough curve to even blip on any macroeconomic radar. “Aim low & exit fast” is a lousy way to build companies… but right now, that’s where things are at.

Myth #9: “Things can only get better, this startup pain is just cyclic”

Most of the UK angels I have met (including some of the richest) are cashed-out entrepreneurs, looking to use their money and experience to somehow kickstart new, high-growth businesses: this matches the 73% figure given by BBAA & NESTA [PDF]. For them, the (build – exit – invest) ‘angel loop’ typically sits at the core of their whole angel ‘mission’.

Yet with the retreat of many UK VCs from even early stage investment, pay-to-play mid-cycle rounds from troubled portfolio companies, the death of IPOs, lengthening times to trade sale (7+ years is now routinely quoted), and with new rounds taking longer both to open and to close (typically 12 months and up), the whole angel loop has found itself stretched to the point that it barely resembles a cycle any more.

According to a recent US study, 65% of angel group members in 2010 are “latent angels” (2009 / 2008 saw 54% / 36% respectively), which are angels who haven’t yet made an investment, for all the kind of reasons given above: while UK groups seem very similar. From an entrepreneur’s point of view, this is one bad-looking trend.

Myth #10: “With no effective finance available, startups should just give up”

I’m not Santa Claus, so I can’t make all your startup finance wishes come true: but despite bringing so much bad news in one go, I’m not Scrooge McDuck either. Yes, things are bad – OK, they’re terrible – but the bad old days of “if you build it they will come” tech startups (one industry grandee once told me “but my dear boy, they will”) are long gone. Instead, modern professional startups are more tightly run and more consciously customer-oriented than ever before, and I believe now offer a terrific potential return on investment, probably the best for a generation. If much of that return will have to be via dividends rather than exits for a while, then so be it, I guess.

Hence I’m confident that new ways of connecting investors to startups will emerge. To many entrepreneurs, the UK may currently feel like Narnia enduring a hundred years of the White Witch’s snow, but my sunny forecast is that (for example) AngelList investors and Bay Area ex-pats will invest more in UK startups in 2011 than all UK angels combined. The future of startup finance is bright, just not in the way you might be expecting it. Merry Christmas and a Well Funded New Year!