ing vent Venture capital’s status as an important source of finance for technology start-up companies is enhanced during periods of economic downturn, argues Dave Cheesman

IT1: start are many reasons for wanting to your own company. Perhaps you a fantastic idea your employer is

not interested in and you want to show it can be done. Maybe you’d like to be your own boss, or gain the respect of your peers. Last, but not least, you might simply want to get rich. Not surprisingly, there’s no shortage of engineers who dream of starting out on their own. However, knowing how to go about it, or having the necessary tool kit of skills and experience, is another matter.

Whatever the nature of the company, it won’t get far without money. In many instances, ‘family and friends’ will be the source of early capital, although in recent years the role of the ‘business angel’ has become increasingly important. Since the rediscovery of an entrepreneurial culture in the UK in the early 1980s, many. people have launched successful technology start-up companies. Subsequently, they sold or floated these companies, and used

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Enter the venture capitalist Investment situations where there is a definite risk that the investment will be lost are the natural domain of the venture capitalist. The venture capital industry started in the US in the 196Os, and was the source of financing behind some of the world’s most spectacular new companies, including Microsoft, Apple, Intel and 3Com. By 2000, a colossal $100 billion had been raised by the venture capital industry, which, over the years, has created thousands of millionaire entrepreneurs and accelerated the development of numerous technologies ranging from gene therapy to photonics.

Relative to a bank, the venture capitalist will look for a high return on investment. In exchange for venture capital funding, a share of the company is acquired, which eventually gives an investment return at exit, when shareholders

can sell at flotation or the company is acquired. This

... And I’m certain we’d be even more impressed if we could know precisly what

investment it does ...

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mechanism presents the founders of the company with a difficult decision, as they must decide how much of the company they are prepared to. sell to obtain the level of funding required. On the positive side, a good venture capital firm will be able to bring more than money to the deal. More often than not, it will be staffed by experienced ex-industrialists well- versed in the technology involved. If they are doing their job well, these individuals will bring help, contacts and advice. They can also help guide a company through the very difficult early stages of growth, having assisted many other companies who have trod the same path.

What do venture capitalists do? The venture capitalist raises funds from large institutions, such ‘as pension funds, private foundations or trusts, who wish to invest in private equity but lack the skills to do this for themselves. Funds can be anywhere between L.50 million and LSOO million in size, and have a typical investment life of around ten years or so. During this time, the venture capitalist acts as the fund manager, investing the money in a portfolio of companies. In general, a fund will be aimed at a particular field, such as biotechnology, communications, or electronics. Funds can also. be targeted at distinct stages of a company’s development, e.g. start up, early stage, development stage, later stage, management buy out (MBO) or management buy in (MB1)-(see .panel ‘A quick guide to venture capital speak’).

If the company is successful in growing its sales and eventually moving into profits, it may be either bought (an acquisition) or floated on a stock exchange. In the case of an acquisition, usually by another company, the venture capitalist will receive cash for his shares. Management may also receive cash, but often the buyer will want to ‘lock in’ good managers as they represent a great deal of the value of the business. This lock in will frequently take the form of an initial purchase of some of the managers’ shares, with the option of buying the remainder later, typically within a few years, if the sales continue to plan. In return for this restriction, the buyer will sweeten the deal with either a premium on the share price or some further incentive.

In the case of a flotation, the company is offering its shares for sale on a public market- for example the London Stock Exchange or the NASDAQ. There are numerous regulations and complexities in doing this, and, again, all share trading may be restricted for a while to create an orderly market in the shares, so that, for

example, the venture capitalist and the managers may have to wait six months or so to start selling their shares. At the end of the investment period, most of the venture capitalist’s companies should have been sold or floated, producing gains for the fund investors.

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What does the venture capitalist look for? The art and science of picking venture capital winners is complex and involved. The following pointers to what makes a good investment are based on years of involvement with start-up companies- successful and otherwise.

The idea Is the product or technology realistic? Can it be made to work? Can it then be manufactured cost-effectively? Venture capitalists are constantly amazed by the way in which highly competent teams, with a real command of their technology, fall into the trap of assuming that manufacturing or selling is just a simple add-on at the end of the plan. Often the cost of making and selling the product is several orders of magnitude greater than initial product development, and the technological challenges are far more daunting.

Is the product unique? Do patents protect it? It is no use developing a product when there are already various equivalent I versions in the market. I have only ever come across one company that failed because its technology could not be made to work. Companies fail for other reasons, as we shall see.

Marketing Having a product is one thing, but who will buy it and why? How big is the market? Even if it is big, how is the company going to get at the market? Beware reports predicting billion dollar sales-they always do. Instead, drill down to the area that the business can target-the addressable market. How are you going to get to the people who may want the product and then persuade them to buy? Building your own sales force will be expensive, take a long time to become really effective, and, even then, can they pull in sufficient profitable business? How should the product be priced? Could it be better sold by entering into a deal with a bigger company with a world-wide presence? And, if you did this, can you guarantee that they will take your product seriously?

Often, with new and novel products, it’s simply impossible to estimate the potential market with any degree of certainty. Could Baird have given any forecast for the eventual world- wide TV market? It should also be remembered

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that new products will transform existing markets, possibly eliminating current established products-witness the video camera’s impact on 8 mm film. Twelve months after product la,unch the market will be dramatically different. Prices will erode, the behaviours of customers will alter, and the usage of the product will change-usually demanding new performance and functionality. Trying to penetrate a market dominated by big players is very difficult, even if you have a better product.

Finally, don’t fall into the trap of believing that you have no competition. In some form or another, every business, no matter how innovative, will have competitors, and a venture capitalist will insist on a clear articulation of who they are. Management Companies go bust because of management failure. There are very few exceptions to this rule. Entrepreneurs have to grasp some pretty basic, but difficult, lessons about the management style and behaviour needed to deliver business success. Technical skill is not enough. You will need commercial skills, so that having a finance director from day one, even if they’re only part time, is a good strategy. It is very common to see brilliant and capable engineers start companies and grow them to sales of a million pounds, or so, only to stumble because they do not have the commercial or organisational skills to grow beyond this level. Have you got persistence and vision? Is your experience relevant to what you are now trying to do? This may sound like a tough job specification, but, in reality, those who succeed in building their own successful companies are special people.

A good team is more likely to succeed where all the necessary disciplines are covered, i.e. sales, finance, technical and manufacturing. An individual can take responsibility for more .than one function. Flexibility is king- forget about job descriptions, everyone must be ready to do whatever needs doing to their best abilities. Familiarity helps; a team that has worked together before stands a better chance of succeeding than one .‘synthesised’ by the investors or the founder.

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The plan Preparing a good business plan is absolutely the key to successful fund raising. Venture capitalists read thousands of plans a year, but only a handful get backing. The plan is the first indication of the capabilities of the management team-the acid test for whether or not a proposal is worth pursuing. Can the

management team express its business ideas succinctly? Is there evidence of vision and passion? Is the plan realistic? Are the marketing ideas sensible? The plan should provide a positive answer to all such questions.

Make the plan s h o r t 4 0 to 30 double-sided pages is more than enough. Avoid presentational gimmicks, and, most important of all, do not incorporate hundreds of spreadsheets! Contrary to what some authors of business plans seem to believe, the acceptability of the plan is inversely proportional to the amount of spreadsheet analysis. Three spreadsheets will generally suffice: profit and loss, balance sheet and, crucially, cash flow, each for five years. No company ever completely meets its plan, and in five years who knows what will happen. Irrespective of the actual figures, the venture capitalist will be looking for evidence that serious thought has been given to the plan and that it is supported by realistic assumptions.

The introduction or executive summary needs . . . . . .

1 A quick guide to venture capital speak seed stage-the very first funding of a new company, often when it is at the concept stage with little to show. Funding may come from friends and family, specialist Angels or venture (seed or incubator) funds

early stage-often the first funding that involves an institution, like a venture capital company. Usually there is something to show at this stage, an early prototype or concept

development stage-a product exists and there may be some customers. The funding is to finish the product, get production going and initial sales underway c

later stage-the concept and business is proven, but the company maybe

production and sales

MBO (management buy out)-when funding is provided to allow a group of managers within a company to buy part of that company and set it up as a separate business, owned by them and the venture capitalist funding the deal. Can be referred to as a ‘spinout’

MBI (management buy in)-like an MBO but a group of external managers and venture capitalists spot a possibly underperforming company or division and buy it from the owners

flotation-when the shares of a company are offered for sale on a public market for the first time, usually t? raise a significant amount of investment

1 has yet to reach break even and needs further funding to expand I

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trade sale-the sale of a company to another company, usually involving the sale of all the shares

private placement-when the shares of a company are offered for sale to a select group of private investors in order to raise capital

due diligence-the checks and investigations the venture capitalist carries out on a business, its management, markets and products

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.. - - - _ _ _ . -

Successes and messes Why some embryonic companies fail and why some succeed-a quick check list

Signs of problems a high spending culture, big cars, expensive offices uncontrolled egos, many fancy job titles, labelled cal: parklng spaces continual re-planning lots of advisors unhappy workforce, no respect for leaders, high-stress culture 9-to-5 culture, an empty car park at 5.30

poor skill levels-management never hire anyone who may be a threat unrealistic plans and expectations marketing wrong-wrong channels, pricing, customers

’ management often come from diverse backgrounds

‘ 0 people speak in buzz-words l lots of organisation charts

always fire-fighting merchandising (e.g. company T-shirts)

Signs of winners , lean and mean, spend on the things that matter @ood people, essential

equipment, training), and nothing else clear plans that are adapted when needed

workforce respect the leaders open all hours culture managemenufounders have often worked together before highly realistic plans good, targeted marketing plastic organisation, people do lots of different things-do what’s

people work hard but seem to have fun

! high skill levels

needed

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a great deal of thought. This is the part that will engage the interest of the venture capitalist. Keep it short and to the point. Remember, venture capitali‘sts tend to have very ‘short attention spans! The summary must rapidly and simply explain what the business does. Some venture capital companies have website guides designed to help entrepreneurs structure a good document (see www.adventventures.com) .

How do I raise venture capital? The first step is. to choose a source of funding. A good start is the British Venture Capital Association (www.bvca.co.uk), who provide a list of all venture capital firms, detailing their area of specialisation, the level of funding they provide and the stage in a company’s development at which they invest. It is then very wise to find an introducer. The latter is typically an angel or business person, known and respected by the venture capitalist, and their endorsement will be invaluable in ensuring that your proposal is taken seriously. Also, remember that fund raising can take a long time. In the present economic climate it may take up to nine months between presenting your plan and

getting cash into the bank. Early stage companies always have problems, and, no matter how good the team, delays are inevitable. Make sure you raise sufficient funds. The worst thing that can befall a young company is to run out of cash early in its development.The venture capitalist will carry out some thorough referencing on the team, so be prepared and make sure that you have your referees lined up and ready.

One major challenge is the valuation of your business. The basic maths is simple. If you wish to raise E1 million and you think your business is worth E4 million, you will have to sell 25% of the equity, (in the form of shares). Be realistic but firm on valuations. The days of ‘concept’ start up companies valued at E100 million are long over. Inevitably, there will be a gap between your valuation of your company’s worth and the valuation of the venture capitalist. Do not despair. Venture capitalist have evolved various mechanisms to bridge these gaps to the satisfaction of both parties.

Once the initial research on your business has been completed, the venture capitalist will make an offer to invest in the form of a term sheet, specifying the basis of the investment. This is then .normally followed by a period of negotiation and due diligence, after which a final deal is agreed. At this point, the venture capitalist usually has to make a formal approval submission to his investment committee. Finally, a legal agreement is drawn up detailing the terms of the investment and duties of the parties which, when signed, releases the money into the company.

Signs of success and failure Successful companies can be a delight to work with, not just because they are successful, but because of the way management behaves. In a winning company, there will always be cars in the car park before and after the hours you would expect. There is little friction between the staff-they’re all too busy for politics. Management roles are flexible, even though there will be a clear leader and the staff respect the founders and management. One dominant characteristic is predictability. There will be problems, sometimes very difficult ones, but management identify what the problem is and provide a solution. The successful business is also irrepressibly inventive. Its staff are always coming up with new ideas, new ways of fixing things and new ways to sell.

The culture is often one of tightly controlled costs and no frills. Offices wil1,be adequate but basic. I recall one start-up company, which later

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developed into a very successful optoelectronics business, that furnished its new offices and meeting rooms, including copier, fax and phone system, for just G5000. We held board meetings there for several years in a perfectly adequate meeting room sitting on secondhand chairs with threadbare arms. However, they did spend L200 000 on the best, most efficient piece of production equipment that did its job superbly The founders are now all rich men, busily involved in their next start-up companies.

Unsuccessful companies, on the other hand, often exhibit one or more of a series of all too familiar attributes. A ‘spending culture’ is a major danger signal. There are inadequate controls on expenditure, and, more significantly, members of the management team spend too much on themselves, with lavish offices, expensive company cars, inflated salaries and bonuses. This behaviour is sometimes linked to a ‘status culture’, where managers’ actions and motivations are shaped by the need to bolster their egos and status, rather than addressing the real concerns of the business. Failing companies often blindly follow obviously inappropriate marketing strategies, maintaining for example, an expensive direct sales force when they ought to be developing distribution channels.

The current climate There is no doubt that industry world-wide is suffering a downturn. The technology highs of late 2000 are past, sales are under pressure, companies are downsizing and stock markets are depressed. But there is a bright side. Industry’s fortunes tend to rise and fall on an eight to ten year cycle. There were big lows for the UK in the early 1980s and 1990s, and experience has taught us that such events present interesting investment opportunities. In particular, shares tend to fall in value, which can be good news for anyone wanting to buy a company or to invest in equities.

Take the example of a company with a good new product idea that started up in early 2000. It probably raised money at a high valuation, with investors paying a high price for the shares on the expectation that once the product had developed and sales started the company would be floated on the London Stock Exchange, providing a substantial return on the initial investment. Now, however, in a depressed market, floatation is out of the question, and the company has to go back to investors to raise more money-or fail. The product and market for this company are still good, but i t will now take longer to reach profitability. Venture

capitalists can see this, and can also see that the company needs to have enough money to take it through to when markets improve, at which point there can be an exit. But the venture capitalist is now only prepared to pay a reduced price for a share of the company, so, in effect, the new investors ‘get all the value of the accumulated R&D and initial marketing at a discount.

An intelligent investor will also make sure that management, who might otherwise suffer a , ’

dramatic reduction in their stake in the business, are re-motivated with a conditional share- holding in the form of performance stock options. These are shares that are promised to the option holder in the event that the company reaches a predetermined value at some point in the future.

This is an example of counter-cyclical investing, where the investor invests as markets go down, builds value in the companies during the downturn, and then exits them when they have become good profitable businesses as the markets climb again. It often takes up to eight years to achieve this result.

Economic downturns not only provide valuable investment opportunities, they also appear to act as a spur to the creation of new companies. Possible reasons for the association between falling markets and company, creation include staff being forced into starting a business because they were made redundant, or spotting an opportunity to spin out the division they were working in because their company, suffering in the downturn, is no longer interested in it. Irrespective of why a start-up company is formed, management skill remains the indispensable ingredient-that diffuse and difficult-to-define mixture of technical, marketing, sales, financial, organisational and motivational skill, coupled with dogged determination, and sometimes pig-headed obstinacy, that leads on to success.

I wish you well in your endeavours.

0 IEE:2002 Dave Cheesman FIEE is a Director at Advent Venture Partners, specialising in electronic and IT investments. He has been a venture capitalist since 1988. His industrial experience includes Technical Director of Varian Computers, Univac’s Director of Technical Operations for Europe, and Managing Director of Dowty Information Systems. He has helped raise three major funds with Advent, the latest for $450 million, and currently sits on the boards of nine companies. He can be contacted at Advent Venture Partners, 25 Buckingham Gate, London, SWlE 6LD (dave.cheesman@adventventures.com tel: f 4 4 ( 0 ) 2 0 7630 981 1).

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