Oliver Woolley, partner at venture capital firm Envestors, gives advice to an early-stage Web 2.0 social networking site, turning over £600,000 per annum seeking £750,000 expansion capital for 10 per cent of the business

The social networking site says:

We run a social networking site which generates revenue from video ads, banner ads and targeted product profiles. To date, the business has been funded by one business angel investor in the US (although he is English!), who has put in around £350,000 in four tranches. We are looking to raise £750,000 and are prepared to give away up to 10 per cent of the business. The money will be used primarily for marketing to get us to break-even (estimated at £2.5m turnover). Of the £750,000 investment, £150,000 will go back to repay loans to the business from the management team and the business angel investor. Who should we be approaching—business angels and/or venture capital providers (VCs)?

Oliver Woolley says:

The short answer is that you should consider both business angels and VCs. The latter will probably comprise early-stage investment funds, such as the Regional Venture Capital Funds, as opposed to traditional VCs, which rarely go below £5m.

Without knowing much about your particular business, the two key issues here are the valuation at which you aim to raise the funds, and the use of funds to repay directors' loans.

If you are looking to raise £750,000 and give away 10 per cent of the company, that implies a post-money valuation (i.e. after the money has gone in) of £7.5m.  This in turn assumes a pre-money valuation (i.e. the value of the business now, prior to investment) of £6.75m (i.e. £7.5m less £750,000). Of course we have not had a chance to see the full business plan, but since your business is still quite a way from profitability, it is unlikely that this will be seen as an attractive proposition at this valuation since it is likely there is still a degree of risk before the business is break-even. 

So what sort of ballpark valuation could you expect? Well, at one end of the spectrum, some institutional investors say 'revenue less than £1m, pre-money valuation less than £1m'. Should an early-stage investment fund be interested, they would probably look at a valuation of £1m to £2m, depending upon the perceived risk of the business getting to break-even. Private investors or business angels generally offer slightly more generous terms than funds.

The other issue is using some of the funds to repay directors' loans. Most investors will not want any of their funds used to repay loans from existing investors or the management team. They will expect these loans to be capitalised in terms of converting them into equity or long-term debt, so that everyone makes money on exit i.e. selling or floating the business.

There is no harm in testing the market with these terms, but you will probably get more interest if the valuation is lower and the directors' loans are not to be repaid.

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