By Mark Sykes, Head of Entrepreneurial Business, BDO
When the founders of Yoto set out to create a screen-free audio platform for children, they quickly found themselves facing the difficult task of securing the funding needed to cover the costs of production and expansion into new markets.
Relying too early on equity capital could risk diluting the very vision they had fought so hard to shape, but traditional lenders were wary of the complexity of building a hardware product in a niche children’s market.
As co-founder Ben Drury explains: “Proving the strength of our business model to attract the right level of funding was a real struggle. We worked hard to convince banks – educating them on our business and demonstrating its potential – and now have a strong relationship with HSBC.”
Yoto is now a global success story, but it took a lot of hard work and perseverance to get the funding it needed to get there.
A common obstacle
Yet, the funding challenges that Yoto faced are far from unique. According to the latest edition of the ScaleUp Institute (SUI) Annual Review, nearly half of fast-growing SMEs (47%) cite a lack of finance as their single biggest obstacle to growth, with an incredible 70% saying they currently lack the right funding to push their businesses to the next level.
The SUI has identified that this national ‘finance gap’ equates to around £15 billion, reflecting a significant shortfall between the growth capital ambitious growth businesses need versus what is currently available.
And the gaps in the SME funding environment go beyond purely financial. With 9 in 10 scaleups currently unaware of significant capital market changes that could affect their funding options, for example, there is also a significant knowledge gap.
This is further exacerbated by a parallel trust gap. Over half of those small and medium sized growth companies feel unsupported by existing policies and many are sceptical of current initiatives designed to direct more institutional capital to innovative businesses.
What the gaps mean
These gaps are a significant issue both for SMEs looking to grow, as well as to the wider economy. After all, high growth potential SMEs are a driving force behind the UK’s economic ambitions, creating jobs, boosting exports, and strengthening local communities. But when they struggle to access sufficient finance, these businesses simply can’t invest adequately in meeting their full potential.
Lacking access to the right funding may also push founders to accept solutions that don’t align with their long-term vision, whether that means giving up excessive equity or taking on restrictive debt.
Worse still, as an economy we also face an increasing threat of overseas investors sweeping in and encouraging the most promising British companies to list abroad or relocate operations. Only 43% of Series B investment comes from UK sources, for example, potentially weakening the UK’s potential for future wealth and job creation.
Industry progress and continuing scepticism
Of course, there have been positive steps to enhance the UK’s SME investment landscape in recent years, with many new and exciting initiatives currently in the works. Institutional capital is beginning to open up in a way never before seen, led by initiatives such as the Mansion House Compact, the Edinburgh Reforms, and the Venture Capital Investment Compact.
These initiatives aim to direct pension funds, local government investment vehicles, and private asset managers towards high-growth ventures. Similarly, the Rachel Kent Review of Investment Research and the Spinout Review are examining how to boost awareness, reduce barriers, and create more conducive investment environments for innovative small businesses.
Despite this, many SME leaders remain sceptical. The disconnect between their needs and policy efforts underscores the complexity of the funding landscape and the challenges involved in ensuring that capital flows to the businesses that need it most.
What does the right finance look like?
What’s clear is that many growing SMEs are not only seeking funding, but also need guidance on the options available for their business and connections to investors.
Finding the right funding source for your business can be a daunting task. With so many options and organisations to approach, the process can quickly become overwhelming. However, cutting corners could lead to even more challenges. Raising too little from a source or not investing in the wider business are just a couple of the common mistakes that can end in business failures.
With so much a stake, a useful first step can be to review some of the more common funding routes and examine the pros and cons for each. This can provide a clearer initial assessment of which routes could work best for your business and its long-term goals.
- Grants and incentives: These can be ideal for innovation-driven projects or early-stage exploration, and the larger grants are often aligned to strategic priorities for the UK. However, there is a risk of diverting business focus if these funds aren’t fully aligned with core priorities.
- Debt: Preserves equity and may be a good fit for businesses with established revenue or tangible assets. But higher-risk or younger companies often struggle to secure traditional loans on acceptable terms, and personal guarantees are common moving the ultimate risk back to the entrepreneur.
- Venture Capital (VC): Offers essential growth funding for pre-revenue or IP-rich enterprises. Founders, however, must be prepared to give up a stake in the business and operate under tight growth targets.
- Private Equity (PE): Typically involves a majority stake and can supercharge expansion. For many mid-stage scaling businesses, PE can be a tipping point, providing not only capital but also a boost of expertise and experience. However, it demands stringent due diligence and careful alignment between founder and PE backer. In fact, it’s crucial to work with a partner that shares the same values and goals as you.
- Stock markets: There has been a recent resurgence in interest in public listings, and the access to deeper sources of finance, more distributed ownership leading to less invasive control, and the benefits of profile can be invaluable for super-scalers. The main challenges involve stricter reporting rules and steeper governance overheads, which also requires a deeper skill set at a board level.
Bridging the gap
For SMEs on the cusp of big breakthroughs, the combined finance, knowledge, and trust gap around funding can create significant barriers to overcome. But with numerous promising policy efforts, increased appetite for institutional investment, and ever greater advocacy and support from industry authorities, there is reason for optimism.
The key, as Yoto learnt, is to have a firm understanding of what it is you want to achieve and the resilience and determination to stand strong and hold out for the right solution for your business.
This isn’t something an SME leader has to, or should, do alone. Weighing up the many options and opportunities can be a complex task; expert help will pay dividends in the long run.