THE BLOG

Why Banks Can't Provide Finance for Start-Ups

15/08/2014 15:56 BST | Updated 14/10/2014 10:12 BST

As a start-up in the UK, raising money can be difficult, unlike in the US. Investors aren't just looking for a good idea but instead a proven product is needed and the entrepreneur needs to be in a positive position with cash flow.

The most common route to funding in the UK is retail bank loans. Banks lend money with low interest rates to individuals, rather than to companies. This is helpful when starting a business, as it means there is a low level of repayments; however there is often a high level of personal risk.

Banks like to make sure that they get a return on investment and are therefore not in the risk game, nor should they be. Instead they are about security and making a guaranteed return. For example, on a £6,000 loan over five years, based on 5% interest rate, the bank will earn £960 in interest. This is a low reward, compared to the risk of default and means the bank would need to have seven successful loans to cover a single defaulting loan. This is often the reason why there is reluctance in start-up financing through the banking system and usually with no significant benefits to the start-up.

Schemes such as the start-up loans by the Government are another solid resource that is flawed. The scheme encourages the banks to lend and protects them from the potential defaults from borrowers, but this still doesn't help the borrower, the risk is still present, so I'm not sure what the incentive is for individuals to go down this route of funding.

Another issue arises when start-ups don't know how much money they will make or how much they will need to spend in the beginning of the business. It is therefore hard to know the level of risk. Although entrepreneurs will have created a business plan at this stage in order to gain investment, realistically this plan is just a potential scenario and by no means is a guarantee of the success the company will have.

In contrast to the UK, in the US, there are a large number of high net worth individuals (known as business angels) looking to invest in others ideas. In most situations with this type of investment, if a business doesn't work then all parties involved can walk away. There is limited liability for the entrepreneurs and it is likely that investors are savvy enough to have investments spread out amongst enough different ventures that they will make back from one investment what they have lost in another, if not more.

Although there is some risk involved in this kind of investment for business angels, in return they are potentially getting a stake in a company that could go on to make millions, for a very small sum of initial investment. For example, as mentioned in my previous blog on Unicorn Hunting, of the 39 start-ups that belong to the "Unicorn Club", 27 have come from San Francisco's Bay Area. Unicorns refer to software companies started since 2003 and are valued at over $1 billion by public or private market investors.

The high net worth individuals that invested in these 27 companies have done incredibly well on their return on investment and the entrepreneurs, who started them, were able to build up the companies with reduced accountability.

Another benefit of personal investments is that they come with a support network that allows less experienced entrepreneurs mentoring and support, allowing more chance for greater success. Not only will they offer the entrepreneur they are investing in money but experienced advice too. The founder of a start-up may be an expert in what they do but that doesn't meant they will have a full range of business skills and know exactly how each different part of a business works. This is why mentoring alongside a financial investment is so important for a start-up to succeed.

In my opinion, the barriers we have in the UK for start-up funding is that we are trying to plug the gap of start-up financing through the banking system, and that simply doesn't work as it doesn't remove the liability from the entrepreneur. If we want to keep entrepreneurism in the UK and drive this country as a hub for innovation and forward thinking, we have to create an ecosystem that allows entrepreneurs and investors to come together to allow for this growth.