Surviving the new business investment drought

Raising capital to grow has become a bigger ask. MIKE PRESTON runs through the options that are left, plus gives five tips for your business to adapt and survive the funding famine.

By Mike Preston

Raising capital to grow has become a bigger ask. SmartCompany runs through the options that are left, plus gives five tips for your business to adapt and survive the funding famine.

It’s official – the credit crunch has come to the small end of town, and it’s leaving start-ups and emerging businesses battling for the limited funds available to fuel their growth.

Over the past decade Australian businesses have grown accustomed to using external funding – whether from banks, venture capitalists or through private investment – to help accelerate growth.

Almost one in five businesses sought debt or equity finance in 2005-06, according to the latest Australian Bureau of Statistics figures, with growth being one of the main uses for the money raised.

But the global credit squeeze is changing all that. Venture capital firms are finding it harder to raise investment funds, the business angel sector is shrinking, and banks are hiking rates and cutting lending volumes.

For start-ups and early stage businesses, this shift means growth expectations and strategy must change. For those who are quick to adapt, however, it needn’t mean an end to growth.

Venture capital feels the squeeze

A little over a year ago Danial Ahchow was able to secure $5 million in venture capital from a syndicate that included Seek founder Matthew Rockman and Sydney property developer Shaun Bonett for his dot-com start-up Service Central. He admits it would be tough to get the same funding today.

“Frankly, I don’t think we’d be able to do it today,” Ahchow says. “My sense talking to people around the place is the money just isn’t there. People still believe in the business plan and the founders and the opportunities for growth, but the investors are just too conservative now.”

Ahchow says there is a growing view in the start-up community that the climate for venture capital has got decidedly chilly in recent months.

The appetite for riskier early stage investment has declined as institutional players such as superannuation funds respond to the uncertain times by adopting more cautious investment strategies.

Doron Ben-Meir, chief executive of Prescient Venture Capital in Melbourne, agrees that it is harder for companies to attract venture capital, but sees this as a return to normal conditions. “The market has come back to what is probably a more natural and sustainable level of funding for the early stage,” he says.

Ben-Meir says he is finding it more difficult to attract backers for his firm’s venture capital investment funds in the current environment. Venture capital firms like his are facing tight times at the moment because superannuation funds – the cash cows of the private investment world – are pulling back their allocations for the sector.

As the value of super funds’ share holdings has fallen, the relative value of their venture capital holdings have grown, prompting cut backs in the sector to bring investment ratios back into line.

The result is less money allocated to venture capital firms, which in turn has put a squeeze on the funds available to early stage companies.

“For those looking for venture capital the situation is not terrible, but it is tight. There is money around but there is less of it, and it is in the hands of a very few, so diversity of supply is down,” Ben-Meir says.

Other firms emphasise that there is still funding available for good companies. For example, Starfish Ventures, one of Australia’s biggest venture capital firms, this week announced $4 million in funding for information communications technology business Audinate.

Starfish investment director Malcolm Thornton accepts that institutional backers of venture capital are more cautious at present, but says that is only affecting firms seeking new funds.

“We’re not looking for new funds and we have more than $250 million under investment at the moment, so the equation hasn’t really changed for us,” Thornton says.

But that in itself presents a disturbing prospect for businesses – the longer the credit squeeze lasts, the more venture capital firms will be out there competing for the same limited pool of funds, and the more prolonged the funding drought for companies seeking capital.

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Business angels are taking their dollars elsewhere

Business angels and other wealthy private investors can be a difficult bunch to categorise, with widely varying investment preferences, exposures and responses to changed market conditions.

In the current market, however, it appears private investors generally are moving away from investment in smaller and early stage businesses.

Christine Kaine, principal of Business Angels, a business dedicated to matching private investors with growing businesses, says investors are pulling right back from early stage investment because of the crumbling sharemarket, compounded by exposure to margin calls and the likes of Opes Prime.

“It’s scary out there,” Kaine says. “They’re not looking at much at all at the moment. A few are still active, but most obviously have their mind on other things. Six months ago it was very strong; we had some really good matches and even some of them have fallen over.”

And it’s not just a diminished appetite for risk that is driving away the business angels – the changing environment is also creating lower risk, higher return options that are drawing the angels’ attention away from start-ups.

Service Central’s Ahchow says he believes the credit crunch is making investment in more established later stage businesses a more attractive prospect.

“In the current environment later stage and even very big businesses – Wesfarmers is out there at the moment for example – are desperate for cash and are paying a premium for it. If you’ve got a choice between a later stage business with established revenue and a start-up, and the returns are similar, the start-up will lose every time,” he says.

Bargains on the commercial property market are also presenting stiff competition in the battle for the investment dollars of high net worth individuals, Ahchow says.

“I have an ear to the ground with these guys, and hearing rumours that they are seeing commercial property on the market for a 50% discount on what it was selling for a year ago, so that sort of thing is bound to suck money away from early stage companies.”

Banks – lending less, charging more

So if equity is becoming less of an option, what about debt? Unfortunately, the picture in the banking sector is just as grim.

David Knowles, a partner with accounting firm Pitcher Partners, says there has been a cooling in the banks’ hunger for new lending in recent months.

“Business lending has become much more common in recent years – until recently, a week wouldn’t go by without a bank or non-bank coming through to make a pitch to lend to our clients, but that is certainly not the case now,” Knowles says.

Apart from the unofficial hikes in interest rates implemented by all banks this year, Knowles says lending criteria are also being tightened.

“They are rationing credit generally. That means businesses are being required to put up more security, criteria for lending are tighter and funds are more expensive,” Knowles says.

And it is not just new loan seekers who are finding it hard to get in the door – Knowles says banks are also running the ruler over existing facilities.

“We are getting calls from bank managers who six months ago was quite happy with arrangements, but now they’re taking a closer look at their loan book and they are quite prepared to move on non-performers,” Knowles says.

His experience is backed by Paul Dowling, principal analyst with independent banking analyst East & Partners.

“The cost of debt is going upwards quickly and security requirements placed on borrowers by lenders are becoming tougher, so while they are all still obsessed with market share, we’re seeing a general tightening in how business credit is managed by the banks,” Dowling says.

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And it is the banks that are usually most favourable to fast growing small and medium sized companies – the second-tier and regional banks – that are being forced to clamp down the hardest.

“The regionals and non-bank lenders, without the balance sheet and retail deposits to fund that lending, are in a much tougher situation than the mainstream banks. They are seen to be becoming a lot more selective in the kind of lending they’re doing. They’re becoming a lot more targeted in who they lend to as well,” he says.

The Bank of Queensland falls squarely into the category of a regional bank with small and medium company focus. Daniel Musson, the bank’s group executive, people and corporate services, acknowledges that the credit crunch will hit business lending volumes.

“We’ve seen a bit of slowing in the amount we’re lending, although it’s fairly marginal at this stage. It’s really only started in earnest over the last month or so, but there is some slowing down in inquiries and lending,” he says.

But Musson says that fall has been driven solely by higher interest rates and falling demand from more bearish businesses rather than credit rationing.

“We haven’t changed credit criteria. We think we already run a tight book and we certainly are still targeting business around the under $5 million lend to SMEs, so what has really happened is the price has increased,” he says.

Adapt your business to the funding drought

There is clearly less money out there to fund business expansion, but that doesn’t mean business owners need to give up on growth. Here are five tips on how to adapt your business, and continue to grow, during the funding drought.

1. Consider cash flow funding

Cash flow and inventory funding has grown in popularity as a business funding option in recent years, but that trend has accelerated since the onset of the credit squeeze.

Cash flow funding has become relatively affordable thanks to increased competition in the sector and the sharp lift in the price of mainstream borrowing.

More importantly, however, these forms of alternative funding generally rely on limited security, such as a business’s debtor book or plant and equipment. That frees up other assets of the business to help fund growth or for use in meeting the increasing security requirements banks are now imposing for larger loans.

2. Your current banker is more likely to help

In uncertain times, banks go with what they know. Pitcher Partners partner David Knowles says an existing relationship with a bank is crucial for businesses in the current environment.

“The message is don’t change banks for the sake of it. Banks are in the process of vetting existing clients, so the first thing they think when a new person walks in the door is ‘why was this person rejected by their previous bank?’

Knowles says businesses need to start talking to their banks about obtaining finance well in advance of when they will actually need the money.

“If a new idea comes in out of the blue, banks are now wondering why this has come up now and wasn’t floated with them in the last six months. If you raise things now they might well be ready to go ahead in six months when you actually want the funds,” Knowles says.

3. Take advantage of the down times

Slower economic times can present a great opportunity for a start-up to prepare themselves for a big push to market or to obtain investment. Good staff are cheaper, rents are cheaper, and competitive pressures are likely to be slightly less intense.

It can also be a good time to start building relationships in the investor community. Research where the money is now, and where it is likely to be in six months. Know which venture capital firms are now in the process of completing funding rounds and make it your business to get to know them – and, more importantly, for them to know you.

4. Everything will take longer

Even if you are able to find a potential investor, they are going to want to examine every nook and cranny of your business and your plans before they commit their dosh.

That means a more extensive due diligence process, more information asked for and supplied, and a generally longer time frame before the money is in your business account.

It will vary depending on the circumstances, but if the rule of thumb waiting period from initial application with a venture capital firm to seeing the money was three to nine months in the old market, plan for a six to 12 month wait in the current conditions.

5. Stick to your knitting

The availability of business investment may have tanked, but the wider economy hasn’t – or at least not yet. That means plenty of scope remains for organic growth.

“It will never be as fast or lucrative as more leveraged growth, but in the days before venture capital and business finance was common, that is how it always happened,” Knowles says.

That means plenty of emphasis on sales and marketing, online communications, product development – anything that will help boost customer spend or numbers.

“Now is the time to grow by giving customers what they want, rather than simply buying more customers,” Knowles says.

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