| Securing private equity in a tougher capital market |
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| Liam Logue discusses some opportunities for Irish companies hoping to get funding as the economic outlook softens |
This year has been a tough year to be in the technology sector. Gone is the exuberance of 1999 and 2000, as companies must become accustomed to operating in a less forgiving environment. Nevertheless, we remain very much bullish on the indigenous Irish IT sector. The global economic downturn was bound to impact on Ireland but we have no grounds to be overly pessimistic. Given the relative youth of indigenous Irish technology companies we can be blinded to the fact that there will be peaks and troughs as in any economic cycle.
Most investors recognise that the long term potential for Irish IT companies remains robust. The investment environment is if anything better now than twelve months ago when investors were feeling the hangover from the crazy days of the late nineties. The truly smart investor picks the future winners in tougher times when valuations are low and stands to reap the benefits as the economy recovers.
Fundraising is the hardest challenge for Irish IT companies today. The freefall in technology stock prices has frightened most private investors from the market leaving the venture capital route as the most realistic option for raising funds. While an air of pessimism seems to permeate the current environment, the uplifting reality is that there is an unprecedented level of venture capital money available to Irish IT companies. In addition to well-funded domestic venture capitalists, the European market is buoyant with new funds established and an influx of US money. A large number of funds were simply sitting on their cash last year given the unsustainable valuations being touted. Given the market correction, and more rational expectations, we are finding more and more investors coming out of hibernation and increasing investment activity. Higher-risk investing is after all their raison d'etre, and the only way they can earn the return promised to their pension fund and institutional investors.
However, the criterion for securing private equity has become much tougher over the last twelve months. Only the very best presented companies can reasonably expect to meet the selection criteria of the venture capital community. In the current market, investors’ focus is on a company’s commercial value proposition as much as the underlying technology. It is vital to be able to articulate clear responses to the fundamental questions: who is your customer, what are you selling, why will they buy from you, how will you achieve scale, and who are your competitors?
A well-balanced and experienced management team is a pre-requisite for a successful fundraising. Ideally the team should possess entrepreneurial flair combined with strong commercial acumen. The team should have vision for the long-term and ambitious expansion plans but tempered with the pragmatism in dealing with the realities of the current economic environment. As ever it is essential for management to deliver on its promises, especially targets set out to be achieved over the course of the fundraising process. The mantra of ‘under-promising and over-delivering’ takes on all the more importance in these tougher times.
While good management may seem an obvious point, it was too often ignored in the heady days of NASDAQ 5000. While the malaise of certain technology companies has been blamed on the economic downturn and reductions in IT spending, the reality is that many companies were simply poorly managed. Cost control disciplines were often absent and sadly expectations were that the funding tap would be running indefinitely.
Investors have learnt lessons from this and only the best management, with a good mix of disciplines (technical, commercial, financial etc) can successfully raise funds anymore. Companies must be focused on a fast-track to profitability. No longer can IT companies ‘party like its 1999’.
Investors are now seeking companies with clearly focused marketing strategies rather than spreading resources thinly in a vain attempt to conquer the world. In particular many Irish companies viewed the US market as the Holy Grail and pursued cash-consuming US expansion strategies. In the current environment, companies need to consider not merely the size of the target market but the cost of penetrating it along with a realistic assessment of level of achievable revenues.
Before commencing the fundraising process, it is essential to set out a clear roadmap of milestones to be met over a two to three year time period with conservative estimates of the funding needed to achieve them. Companies need to work on the assumption that the IPO market is closed for the foreseeable future. Ideally sufficient funds should be raised to reach break-even or certainly without having to dip in the kitty for an 18-24 month time period.
Valuation after the bubble bursting
Valuation is an important consideration for any company in the fundraising process and indeed has often been a source of pain for company promoters over the last year.
The fin-de-si?cle valuation bubble has burst and we are unlikely to see valuation multiples of that level for another generation. We believe valuations have now reached more sustainable levels and it is encouraging to see laws of gravity returning to the private equity market.
Valuation methodologies remain frustratingly unscientific with sales or gross margin multiples used as surrogates for earnings multiple ratios. An important variable therefore in determining valuation is a Company’s near term financial projections. An investor will also typically assess what can reasonably be expected to be realised on exiting the investment and work back to determine an investment valuation based on venture capital return models. In short, if an investor estimates that a company might achieve a valuation of E50m on exit in three to five years time, the pre-money valuation has to be in single digits on making the investment. This is the reality for valuations of high-risk ventures.
While subjective, we do see clear patterns emerging and as the market stabilises we see valuations becoming consistent for different companies at similar points in the life cycle. One can make a reasonably accurate estimate on the likely valuation achievable on assessing a company’s stage of development, revenue patterns and visibility on financial forecasts going forward.
What’s important is that valuation does not become the only consideration on the fundraising. The message is that while the valuation number gets the newspaper headline, it is only part of the bigger picture. One needs to examine what lies beneath.
The balance of power has shifted firmly from company promoter to venture capital investor and valuation expectations have often been dashed. However, while companies may have to accept a higher cost of capital, the smart investor will seek to incentivise management to drive the business forward. Fair deals are there to be had.
Going forward
We firmly believe the negative sentiment towards technology investing has been overdone and the long-term potential remains healthy. While the technology sector is inherently high risk, certain investors are understandably ‘once bitten, twice shy’ after the hype of recent years.
Nevertheless, the money is available in the market, but companies have to perform better to secure investment. Technology ventures present investors with unrivalled potential for high capital gain but with inevitable higher risks. The last twelve months has often been a lesson of the risks involved, perhaps this lesson learned will serve for a more stable fundraising environment going forward. |
Liam Logue is manager at IBI Corporate Finance.
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| Article appeared in the November 2001 issue.
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