Bet Your Bottom Dollar

The surprise failure of Azlan?s three-for-10 rights issue might be interpreted as a lack of investment confidence in the IT industry. But according to many who have tried to raise capital, the mood towards IT companies is generally good. Companies are turned down, but then so they are in other industries as well.

According to Keith Shipton, chairman of Chase Technology, it is people and individual?s track records that investors look at. He has raised several million pounds by going to merchant banks, and says that the credibility of a company and its portfolio depends almost entirely on the credibility of its principals.

?The potential investors carry out their own appraisal and assessment of the company and its board, which is like a due diligence process,? he says. ?On that they base their judgement, and if the main figures are convincing and the overall plan feels right, then there isn?t going to be much problem.?

There is plenty of institutional interest in investors in IT because they are rarely taking a short-term view and are prepared to wait several years before they see a good return. For those waiting for more than five years, 50 per cent a year is common.

And if there are more investors than ever before, the exponential rise is perhaps only matched by the growth in the number of entrepreneurs and new companies. And most of those need capital. There is often a direct correlation between the age of the business, its need for capital and the difficulty it has in raising it.

Generally speaking, the younger the firm, the greater its need and the more difficulty its principals will encounter. Azlan is an exception to the rule, but it is widely accepted that the issue flop was no real reflection on Azlan or its potential, more a matter of timing and bad marketing.

In determining how much capital will be needed, there are classic business school techniques which any investor will apply, and it is foolish to attempt to go for more. These are partly guestimates on the size of the market and the likely level of sales, combined with extrapolations of the fixed and variable costs. A picture can be built up of the cash requirements and possible cash flow shortfalls. By working these in with various ?what-if? scenarios of what would happen if more staff were taken on, and the effect of expansion and acquisition at certain times, a two-to-five-year picture can be created of how the business could look if it had the right funding.

It is crucial to realise that the key to getting funding is to seek it from the right places at the right time. Thus a startup company in which the risks are highest will be unlikely to get funding from a conservative mainstream organisation. But an established company which has proven products, proven market and proven management will have no trouble, provided the prospects are good, of getting funding from the conservative source. It is a matter of matching the source of the capital with the purpose for which it is needed.

The company which does invest in a greenfield startup will be expecting far greater returns, because the risks are higher. It is not unusual to expect to multiply the original investment figure by a factor of 15, and 10 is standard.

But the established company will be paying only a little above the average bank rate. The seed capital investor may expect up to 80 per cent of a return, spread over five years, moving to 60 per cent at startup stage, then 50 per cent at first running stage.

Shipton says: ?Annual returns of 80 per cent may seem exorbitant, but you have to remember that the investor has to compensate for the bad losses with the successes.

?The provider of the capital starts by analysing the risks and the primary consideration is the management in place. They look at the relevant skills, the combination of those skills and what sort of chemistry the mix produces. They take the view that it is better to have a good team with a so-so product or idea, than a good idea with a poor team behind it,? he says.

A good mix is one which combines different backgrounds as well as experience. Thus a team which is made up of a group of people with similar school and work experiences is not necessarily more likely to succeed than one made up of diversity.

Capital investors hedge their bets by providing the money in stages, with higher interest rates at the beginning. That way the investor can quickly pick up if a company is failing to meet expectations and in the worst case will write off any funds already given out.

There are a variety of ways that investors can expect to see a return on their capital. It may be loan stocks, shares or straightforward cash. The latter is most often derived from capital profit on the sale of the investment, when it passes on to another investor. Once the company has matured it can change the source of its capital to one which demands less return, and the first investor is paid off.

According to venture capitalist 3i, it takes a startup company three such separate rounds of finance and an average of seven years before it becomes cash independent and can be deemed to be a success. Of these, one in eight is a huge success, two in eight fail within a short time, and five in eight limp along.

So raising venture capital is a perpetual business. No sooner is one set of financing in place than the principals have to start thinking of how and when they will pay off that source and move to a cheaper one. In the same way that investors are reluctant to put all their eggs in one basket, it also makes sense for the investee to put together a mixed portfolio of sources.

Shipton says: ?We are a computer services company and all the money we have raised so far has come from a mixture of private sources and institutions.? He went to people he knew, he says, some of whom act as agents putting together various lenders until the company requiring funding has enough. ?Private cash is without a doubt the most ex-pensive type of capital,? says Shipton, ?and it often has various restrictions and covenants attached.? The providers can also be ruthless about applying the covenants if things go wrong with the result that the term ?vulture capitalists? is sometimes heard.

Shipton continues: ?We developed a private placement document which outlined who we are, what we intend to do and the reasons why investors should feel confidence in us.? His intention, he says, is to build a company by a combination of acquisition and growth and take it to market. ?That?s what a lot of investors like, because then they can see a point when they will get a return on their funding.?

He says that an ideal is to expect Third Market listing within 12 or 18 months. ?An early offering means the expected holding period for the investor is shorter, and the principals will need to trade off less equity to get the original funding.?

There are basically two types of investment: those that look for a slice of equity and those that don?t. For companies which are seeking significant funding but are lacking a track record ? and would prefer not to have a millstone of a large debt repayment ? giving away a part of the business as part of the deal can make sense. But few principals like the idea.

From the investors? point of view, having someone on the board can be the best way to control the company and look after their investment. There is often an agreement that the principals cannot offer or sell any more shares without offering them first to the investors or preferred shareholders.

Shipton says: ?Many venture investors want at least a third of the equity and want to put someone on the board, but apart from the idea that we are giving something away for nothing, it can slow down our ability to think on our feet.? He says that many companies need to be flexible to continue to meet the changing demands of the market. If every decision has to be considered by a larger group of people, some of whom may not fully understand the niche sector, the company loses an advantage.

Many of the most successful companies have started out on a shoestring and have deliberately limited their borrowings. Although the main reason is probably a reluctance by the principals to lose control of the enterprise, lack of interest by investors is another.

Shipton adds: ?It also has to be said that many new companies cannot attract any investment because they are too risky. It is impossible to attract a bank when you have little or no assets, and even if you are willing to put up your personal assets the bank expects the principals to have 25 per cent of the equity as well.?

As companies struggle to reach first base, they often rely on the four Fs of funding: the foun-ders themselves often have to dig deep to find the necessary cash from their personal savings, which are often exhausted before they turn to family, friends and the foolhardy. The result can be the unnerving situation that all your personal wealth is tied up in the company you rely upon to give you an income.

If it fails, you lose your savings and your source of support. It is a high risk scenario which can only be warranted if the returns are going to be very good and are gilt edged. Unfortunately, the judgement of those closely involved with the enterprise is not necessarily the most impartial.

The trick is to get the level of funding right. Overfunding can be a reason for failure as often as underfunding, because debt is expensive and it can be the last cost which breaks the camel?s back.

Most entrepreneurs regard debt as a cheap liability in proportion to the returns it delivers, and Shipton is clear that he could not achieve his expectations without funding. ?There is certainly a balance, but I would prefer to be overfunded than underfunded. I can always find uses for the cash which will get more return than the cost of having it,? he says.

The objective of the investee is to reach a point when cash flow covers all eventualities, and the company has no need of funding. Wherever it comes from, finance can be very expensive, so it?s far better to be free of any debt.

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