The surprise failure of Azlan?s three for 10 rights issue might be interpreted as 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 favourable. Investors do turn companies down, but they do so in other industries.
According to Keith Shipton, chairman of Chase Technology, it is individuals? track records that investors look at. Shipton has raised several million pounds by applying to merchant banks, and says that the credibility of a company and its portfolio depends almost entirely on the credibility of its principals. ?Potential investors carry out their own appraisal and assessment of the company and its board, which is like a due diligence process. On that they base their judgement. If the main figures are convincing and the overplan feels right, there is not going to be much of a problem.?
There is plenty of institutional interest in investors in IT because those investors rarely take a short-term view and are often prepared to wait several years to see a good return on their investment. For those prepared to wait more than five years, an annual return of 50 per cent is common.
The exponential rise we?re seeing in the number of investors around is matched only by the growth in the number of entrepreneurs and new IT companies. Of course, most of those need capital and there is often a direct correlation between the age of the business, its need for capital and the difficulty it has in raising it. The younger the firm, generally speaking, the greater its need and the more difficulties 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 a company needs, there are classic business school techniques which any investor will apply. These are partly guesstimates on the size of the market and the likely level of sales, combined with extrapolations of the fixed and variable costs.
Potential investors can build up a picture of the cash requirements and possible cash flow shortfalls. By working these in with various ?what-if? scenarios, for instance, what would happen if more staff were taken on, or the effect of expansion and acquisition at certain times, a two to five-year picture can be created of how the business could look with the right funding at the right time.
The key to getting funding is to seek it from the right places at the right time. Thus a start-up company in which the risks are highest will be extremely unlikely to get funding from a conservative mainstream organisation. But an established company with proven products, market and management will have no trouble getting funding from the conservative source. It is a matter of matching the source 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. On the other hand, the established company will be paying only a little above the average bank rate. The seed capital investor may expect an annual return of up to 80 per cent, spread over five years, or 60 per cent at startup, then 50 per cent at first running stage. Shipton says: ?Annual returns of 80 per cent may seem outrageous but you have to remember that investors have to use their successes to compensate for their losses.?
Shipton adds: ?Investors start by analysing the risks. Of primary consideration is the management. They look at 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.?
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 various 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 claims less return, and the first investor is paid off.
According to 3i, it takes a start-up 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 startups, one in eight is a ?huge success?, two in eight fail within a short time of the original investment, and five in eight limp along.
Raising venture capital is a perpetual business. No sooner is one lot of finance in place than the principals have to start thinking about 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 mix of private sources and institutions.? He went to people he knew, some of whom act as agents putting together various lenders until the company seeking capital has enough funding. ?Private cash is, without doubt, the most expensive type of capital,? says Shipton, ?and it often has various restrictions and covenants attached.?
Providers can also be ruthless about applying the covenants if things do go wrong, hence the term vulture capitalists.
Shipton says: ?We developed a private placement document which outlined who we are, what we intend to do and the reasons why investors should have confidence in us.? His intention, he says, is to build a company by a combination of acquisition and growth.
?That?s what a lot of investors like, because then they can see the point at which they will get a return on their funding.? He says that an ideal is to expect third market listing within 12 or 18 months.
There are basically two types of investment: those that look for a slice of equity and those that don?t. For companies which lack a track record, and which would prefer not to have 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 investor?s point of view, having someone on the board can be the best way to control the company and look after the investment. There is also often an agreement that the company?s 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 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 many companies need to be flexible to continue to meet the changing demands of the market and, if every decision has to be considered by a larger group of people ? some of whom may not fully understand the niche sector ? it is losing an immediate advantage.
Many of the most successful companies have started out on a shoestring and have deliberately limited their borrowings. Although the main reason behind this strategy is a reluctance to lose control of the enterprise, lack of interest from 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 few ? 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 founders themselves who 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 bizarre and unnerving situation that all your personal wealth is tied up in the company on which you rely to give you an income. If it fails, you lose not only your savings but your source of support. It is a high-risk scenario which is warranted only if the returns are going to be very good.
The important trick is to get the level of funding right. Overfunding can be just as often a reason for failure as underfunding, because debt is expensive and it can be the last straw which breaks the firm.
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 rather be overfunded than underfunded. I can always find uses for the cash which will get more return that 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 is a cost and it can be very expensive.
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