David fights Goliath

Before being able to secure venture capital funding, many small businesses first seek to obtain funding by asking those who would have most faith in their business – their customer base. Traditionally, any share offer made to the public must be accompanied by a prospectus. But the cost of preparing such a prospectus usually well exceeds £100,000 and must be approved by an FSA-authorised company or agent. This, for any small business just starting out is often too high a price to pay.

In 2005, a new EU directive came into force. The Public Offers of Securities Regulations 1995 were repealed and new provisions of the Financial Services and Markets Act 2002 (FSMA) were implemented along with the Prospectus Rules made under the powers contained in the Act. In addition, a new Financial Promotion Order came into force.

While it is well-intentioned, this legislation has been poorly implemented by the UK Government to the extent that it renders the legislation useless for the purpose it was intended and enables only the FSA and/or its agents to financially benefit from it.

In brief, the UK implementation of the directive should enable non-public companies to make public share offers without a full prospectus in specific circumstances. One of these is that an exemption could be applied if the amount of investment being sought is under £100,000.

However, it is not that simple. A company must obtain specific legal advice from a suitable FSA-authorised agent to ensure that, even though a prospectus is not being issued, the business would fall within the FSA advertising guidelines. Such approval costs at least £25,000 with another £50,000 to £75,000 required once the investment has been secured.

In effect, with this hidden cost, any small business would be out of pocket after trying to secure funding for any amount under £75,000.

Companions2travel.com, a small social networking business in the UK with 16,000 members is one such enterprise battling with these regulations to secure further funding to grow its business. At present, the business cannot actively court investment from its own members (or outside investors either), without first having to spend £75,000 to start the process.

The business wants to be the first social networking site to enable its members (who want to do so) to invest in it and reap the benefits of helping create the site and grow it in the first place.

Nathan Green, director, Companions2travel.com explains his business dilemma. “We are/were seeking to obtain funding for C2T by offering the members (and other interested investors) shares in the business. This share offer would be relatively small – intended simply to kick-start the business and the precursor to a possible much larger public offer at a later date.”

But he adds the current regulations are strangling their means of expanding the business and also keeping members from investing in a business they use and believe in. “None of the existing social networking sites have given anything to the people who helped make them what they have become. The founders have benefited financially but the people using them and making them haven’t. So we have potential investors. We know this because the members have asked us if they can invest. But we cannot formally organise anything and announce our offer, or even an intention to offer, unless we either go plc and pay for a prospectus or make use of the exemptions available in the Prospectus directive. Neither of which we can do as the costs of both are prohibitive and exceed the proposed investment level significantly.”

In order for Companions2travel to raise investment, EU and UK guidelines insist an FSA agent is hired to review the offer. So it’ll cost upwards of £75,000 to seek a maximum of £60,000 investment, which actually means Companions2travel is £15,000 worse off. “All this because we are not a plc company,” laments Green.

The legislation is supposed to help small companies like Companions2travel circumnavigate strangling regulations, but in fact it is having the opposite effect.

Green says: “These new guidelines are so contradictory to their original intention that it is impossible to actually make use of them, and we would still be required to hire in an FSA-authorised agent to review the offer. Again, this would cost £75,000 for a maximum investment of around £60,000!”

Green adds: “These regulations affect not only us but other small businesses and are strangling small-business growth in this country.”

Indeed, The Department for Business, Enterprise and Regulatory Reform recently reported that while the UK compares well with other European countries, the percentage of growing businesses is significantly lower than in the US. One key reason given was that many UK companies have no ambition to grow. But it is due to such legislation that UK businesses have no chance to grow.

Peter O’Driscoll, a London-based partner of US law firm Orrick, says: “It is generally much easier to set up a business in the US than in Britain. The US attitude to venture funding is more relaxed than in the UK. There are exceptions, but UK VCs are not that entrepreneur-friendly. If I were a technology entrepreneur, I’d definitely go to Silicon Valley to raise funds”.

On the plus side, John Hutton, Secretary of State for Business does recognise that Britain has seen a significant increase in the numbers of small businesses in the last four years and has advised that the Government “must now build on this success and ensure these small enterprises grow and take advantage of the new global markets.”

Green stresses that their case is in no way unique: “We’ve no doubt there are lots of small, independent companies in the UK who are being strangled by these same regulations, and by digging further I bet you’ll run across lots of examples similar to ours.”