In the U.K., despite record low interest rates and the biggest bout of quantitative easing of any of the main developed economies, many SMEs are finding it hard to raise capital to promote a smart idea. Banks are becoming more risk averse, and with the Basel III requirements, are only prepared to lend to untested ideas at exorbitant rates – if at all. That’s why many successful start-ups are being creative in raising funds.

Theo Vermaelen is Professor of Finance at INSEAD and believes that banks are partly constrained by regulation which obliges them to be risk averse in their lending.”Banks are handicapped by overregulated oversight. It’s bad for them but it’s a great opportunity for others to get creative. Banks are scared of making bad loans and so are becoming more risk averse. But that also represents great opportunities for those prepared to take risks again.”

Hailo is a taxi broking service – linking passengers and black cabs through an app on their smart phones. They are one of those startups who have been creative with funding. The Chairman and co founder is Ron Zeghibe who has brought a U.S. venture capital approach to European start-ups like Hailo who wouldn’t normally get a look-in with these funds.

“I would contest whether it is a good idea to go to a bank. They’re not equipped to understand and fund this kind of risk enterprise. A start-up would be shut down at the beginning. I see no way to  raise serious money without severe restrictions on cashflow.” Hailo is the leading service in London and has now expanded to New York, Dublin, Madrid, Barcelona and four other cities. So far they’ve raised £20 million from private equity funds and have another £30 million in the pipeline.

Private Equity Angels

It all started with three enterprising London cabbies having a good idea to boost dwindling income by providing an online service to avoid empty return journeys from airport drop offs. The initial funding came not from a bank but from angel investors – friends, family and overstretched credit cards – the banks didn’t want to know. They then saw the potential to move the concept to the next stage but lacked the capital to expand. The three cabbies teamed up with three IT investors (including Ron Zeghibe), hit it off over a meeting in a café and set up Hailo.

“Hailo makes an inherently inefficient process efficient. Previously it was a line of sight solution. The driver and the fare had to be able to see each other to link up,” says Ron Zeghibe. “The clever thing about the Hailo app is that it enables both sides to see through walls.” The passenger simply keys in their location on their smart phone and they get an almost immediate response from free cabs in the area.

At Hailo, the drivers use their experience to manage the drivers, while the management guys, like Zeghibe, manage the bigger strategic issues. “A key part of that strategy – and a key difference from competitors, was to sign up more than 20,000 drivers from the beginning rather than trying to build a big customer base. We sold it to them as a vital tool for their business which also had a taxi broking app attached.”

The initial round of financing from private equity enabled them to fund the breech between signing up a critical mass of drivers and seeing consumers sign up. That creative approach has helped make Hailo the market leader in apps based taxi broking. A traditional bank might not have appreciated the creative thinking behind this counterintuitive strategy until it became a fait accompli.

Hedging bets with a credit card

Harris+Hoole is another business that got creative with credit. Using a credit card to get their idea off the ground it has subsequently attracted investment from the U.K.’s biggest retailer, Tesco. Founder Nick Tolley is an INSEAD alumni (MBA'04J) who left Fontainebleau convinced that he wanted to run his own business rather than work for a big corporate.  His original idea was to open an upmarket sandwich shop in London so he worked making sandwiches in a café. “I was earning around £5.00 an hour which did little for INSEAD’s average graduate earnings, but it taught me a lot about running a business. And I quickly realised that it was coffee not sandwiches that made the money.”

Faced with a crowded market for coffee on the High Street and no available finance from risk- averse high street banks, Nick and his co founders (his brother and sister) leased a pop-up site in an existing retail outlet. “I had a credit card in a drawer for emergencies so I used that to buy our first coffee machine in 2006.”

The pop-up shop was a success and with some help from the bank, they grew the business to eight outlets. But progress was slow. “We needed about £300,000 to open a new branch and the bank eventually knocked us down to £160,000 and even then it took 18 months before we saw any money.”

Drinking the business plan

Frustrated with the banks, the Tolleys raised some of the money for expansion through a form of microfinancing from existing customers. “We had a shop in the City which was doing very well, so we put a notice on the coffee machine, asking for small parcels of capital to open more shops. These city traders waiting in long queues saw six people in front and six behind them all paying a premium price for a cup of coffee and did the sums. In a sense they were drinking the business plan.”

Last year they decided to scale up the operation, and take on the challenge of crowded High Streets throughout the U.K. But in order to grow quickly they turned to Tesco for finance. The High Street giant invested in a non-controlling stake in Harris+Hoole which enabled the Tolleys to take over economical leases from a retail chain of card shops that had gone bust.

Fast Finance from Tesco

Despite some negative press about their involvement with Tesco, Nick Tolley is convinced this unorthodox source of funding is right for his business. “They understand the High Street, understand the need to move quickly to gain a competitive advantage and more importantly they want us to succeed.” Tesco has also done similar deals with distinctive independent brands.

Professor Theo Vermaelen says such arrangements are becoming attractive to businesses with cash to invest. “Some corporations with substantial cash reserves are setting up separate divisions to lend to businesses where they can generate a higher rate of return, and also provide finance over a longer term to growing companies,” he says.  That is important to entrepreneurs like Nick Tolley who want investors “to be engaged beyond the usual private equity time horizon of a couple of years. Tesco are in this for the long term and moved quickly.” 

In Hailo’s case, American style venture capitalism is beginning to make inroads into Europe. Hailo attracted investment from U.S.-based private equity firm, Accel Partners, who were early backers of Facebook.  Ron Zeghibe from Hailo believes that Europe is catching up on innovative funding.

“My experience of British venture capitalism over the last 20 years is that private equity was largely driven by people with financial backgrounds. In the past few years, people with industry expertise are helping entrepreneurs with new ideas. Not just providing capital but business expertise and that has really improved the hit rate in Europe.”

Vermaelen provides another example of how the new environment spurs innovation: “Euronext is working together with Dutch banks and pension funds to bundle loans to small and medium enterprises in a bond and sell these bonds to pension funds and others looking for high yield. The bonds will be traded on Alternext, the trading platform for small and medium enterprises.  Banks will still provide expertise in credit risk assessment but will no longer provide all the funds. ”

The Hailo chairman also believes that government needs to do more to encourage investment in new ideas and new businesses. Rather than quantitative easing, he believes that government needs to create a level playing field for private sector industry. “If they make it more attractive for capital to be drawn into these sectors then you could really ignite the fuse that would really let this thing explode.”

Theo Vermaelen is Professor of Finance and The Schroders Chaired Professor of International Finance and Asset Management at INSEAD. He is the Programme Director of Advanced International Corporate Finance, part of INSEAD’s suite of Executive Education Programmes.

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