Funding an internet business

This guide is based on UK law. It was last updated in September 2004.

Overview

E-Commerce is growing in the UK at a rate not far behind that of the US. Setting up and financing an internet business is a great challenge. There are a number of considerations that have to be borne in mind when you start out. This guide will help you identify the type of entity that you need and indicate some of the ways in which you can raise cash for your new venture.

Choice of entity

If you are starting a new business, one of your first considerations will be the entity from which you will run the business. The main choices are:

• to run the business as a sole trader,
• to form a partnership, or
• to form a company.

A company is a legal person in its own right and this means that:

• the liability of a shareholder in the company is usually limited to the total amount of the nominal value of the shares he holds. So if he holds 50 £1.00 shares then his liability is, on the whole, limited to the £50.00 paid for the shares;
• generally, the directors have no liability for any debts they incur on the company's behalf . It should be noted, however, that landlords and banks may require personal guarantees from directors and that the directors may also be liable for wrongful or fraudulent trading.

For these reasons, when setting up an internet business, the limited liability company is a popular choice of entity. The new company will need to appoint its directors and company secretary and issue shares. If there is only one director, that individual cannot also act as company secretary.

If you are an existing business wanting to launch an internet venture, you should consider whether to do so within the existing company or whether to set up a separate legal entity. This will enable you to "ring-fence" any possible liabilities connected with the internet business. If you are hoping to offer shares to the public in the near future (known as an initial public offering, or IPO), it will make matters easier if the business is new and separate from any associated business. In this way, you can ensure that if the new venture fails, your existing business will not be affected. There is a risk that if you use your existing company to develop your e-commerce venture, that the new venture will be stifled as it will be competing with your existing revenue streams. The current trend is for existing businesses to set up separate companies for their e-commerce ventures.

In some cases, it may be appropriate to enter into a joint venture with another company to run your new internet business. For example, if the concept was to set up a web site selling books, you might wish to consider entering into a joint venture with a publisher, with the risk and revenue being suitably apportioned between the parties to the joint venture. There are different types of joint venture. You can form a new company or partnership with another party or you can proceed with just an agreement setting out the rights and obligations of both parties. There will be legal and tax implications depending on the choice of structure.

Business plan

Once you have a business concept you will need to draw up a good business plan and arrange finance. Potential investors in the business will rely heavily on the business plan. They will be keen to see that your business is an early entrant to the market; they will want to know what the barriers of entry to your relevant market may be; and they will need confidence that you have both a strong management team and a good strategy for growth. It is also essential that you identify your revenue streams. Investors are no longer willing to invest simply because the company is a dot.com.

Sources of finance

There are several possible sources of finance which you can use alone or in combination:

• Business angels
• Venture capital
• Corporate venturing
• Debt financing
• Incubators
• Initial public offerings

These are explained below.

Business Angels and Venture Capital

Business angels are typically wealthy individuals who wish to invest in companies in return for equity, i.e. a shareholding. A business angel will normally invest between £20,000 and £400,000 in a single business. Business angels are prepared to invest in start-up companies but, because of the risk involved, they are extremely selective and may impose some tough conditions. Most business angels seek an exit within four years. Often, the injection of cash from a business angel acts as leverage for attracting funds from other sources such as banks.

The National Business Angels Network, which is supported by the DTI, may be able to assist in finding a business angel for a start-up company.

Venture capital companies (VCs) normally operate a number of funds which they are prepared to invest in companies. Most VCs target companies which need an investment of £100,000 or more and thus may not always be appropriate for a start-up company.

The British Venture Capital Association represents many of the UK VCs and can suggest appropriate VCs to approach depending on the type of business and the amount of finance required.

Because both business angels and VCs take equity in the company, any return on the funds invested is dependant on the growth and profitability of the business. For this reason, business angels and VCs may wish to take a role in managing the business, and may also provide strategic advice, marketing and networking facilities.

Business angels are often able to move funds quickly and this could mean that the cash could be received by the company within a relatively short period whereas it is likely to take a minimum of three months to receive the funds from a VC.

Corporate Venturing

Corporate venturing is another possibility. This is simply where an established company provides capital in return for a stake in the internet business.

Banks

Banks may be prepared to provide loans. The amount of money you can borrow from the bank will depend on many factors including the strength of the business plan and the level of security that can be offered. The bank is likely to require security over all of the assets of the company when providing a loan. If things do not work out, the bank can sell the assets to recover as much of its loan as possible.

A start-up company is unlikely to have any assets and therefore the bank is likely to require personal guarantees from the directors before lending any money. A personal guarantee may mean the bank taking a charge (or mortgage) over your home and advice must be taken before agreeing to such a course of action.

If no assets are available for use as security, the Government sponsors a scheme known as the Small Firms Loan Guarantee Scheme which might be helpful. You can find further information here.

Incubators

Incubators are traditionally companies or individuals who are prepared to provide certain "core" facilities to several companies at the same time. They may provide premises from which to operate, the use of computer systems and equipment, certain essential employees (such as a secretary) and payroll facilities. Some companies are now specifically set up as incubators to invest and provide facilities. In return they will take a percentage of the equity in each of the companies they are supporting. The exact terms of the agreement will be negotiated between the parties.

Initial public offerings

Depending on the nature and stage of development of the company, it may be possible to raise funds by offering shares in the company to the public. The funds are raised by offering the shares at a price above the nominal value of the shares. The company would normally appoint a broker to assess the likelihood of take-up of the shares and to help find subscribers. This activity is tightly regulated and specialist advice should be sought prior to embarking on this route.

Other possibilities

The company may also be able to take advantage of various incentives. For example, regional incentives are available to businesses in certain areas of the country and there are also independent organisations which may offer grants or cheap loans to certain types of business.

Almost any type of funding will involve you entering into detailed agreements with the party providing funds. Be sure to seek professional advice in all cases before doing so.

Making money

It is all too easy to get carried away with your exciting e-commerce plans and forget that you need to make money. All funders are now looking for reassurance that start-ups will become profitable in the short to mid-term. You need to identify your sources of income.

See also:

Funding (checklist)

Starting in E-business - General Considerations (checklist)

Web Design (checklist)

Terms and Conditions (checklist)

ISP and Web Host Conditions (checklist)

Any questions? Please contact struan.robertson@out-law.com / 0141 249 5422 or one of our other contacts.