| The art of raising finance for ‘S&T’ |
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Jim Mulqueen discusses the particular problems associated with raising
finance, and common pitfalls that should be avoided by start-up
software and technology companies. |
The Software and Technology (‘S&T’) sector has been Ireland’s greatest success story of the
1990s. Although this has been largely dominated by a number of multinationals, several indigenous Irish companies have come to the forefront, including CBT Systems and Iona Technologies. Following close on their heels are the likes of Flexicom, Baltimore Technologies and River Deep. Many layers beneath these lies a core bedrock of S&T ventures, some of which will become the industry leaders of the next decade. But there are several difficulties facing those start-up companies in raising finance to develop into successful corporations.
The Marketplace
Risk Profile
While the risk associated with raising finance for start-up S&T companies is great, the potential rewards are huge if they succeed. Traditional providers of long-term finance typically shy away from start-up ventures because of their inherent high-risk profile. In the case of S&T start-ups this problem is exacerbated by the fact that any funding raised is likely to be expended on non-recourse items such as product development and marketing, rather than on tangible assets.
Banks
Banks are not leading financiers of start-up S&T companies for a multitude of reasons, including:
l Lack of security - most S&T companies are not asset-backed and few own their own premises.
l Large development losses in the balance sheet
of many S&T companies - lending to a company with
no history of profits is often perceived as
high risk.
l Difficulty in valuing a company whose main asset is in the form of intellectual property.
Venture capital funds
In most cases, finance for start-up S&T companies should take the form of medium to long term equity. There are several venture capital funds that provide such finance, some of which even specialise in S&T companies. However, there is a gap in the market for venture capital money in the ?500k to ?1m range, i.e. the typical finance required in first round funding by many start-up S&T companies. The reasons for this are as follows:
l These investments require high levels of resource to manage, in the context of the overall VC fund size.
l VC funds are typically more interested in longer established companies entering an accelerated growth phase which represent less risk.
l VC funds look for investments with a likely exit mechanism in the medium term, such as a trade sale or flotation, something that is extremely difficult to predict in the case of start-up
S&T ventures.
Admittedly, there are a number of smaller funds in the marketplace that provide finance in the ?500k to ?1m range. Most of these are not interested in investing at this level in start-up situations or firms with unproven technologies. For some of these funds, an investment of ?500k to ?750k represents their individual investment limit, and could represent 10 per cent of the overall fund. Accordingly these smaller funds are usually not prepared to place such amounts in high-risk start-up S&T companies.
BES funds
Historically, the large BES Funds invested in start-up S&T companies as part of a larger portfolio. Recently, this has become a less effective method of funding for S&T companies since the overall limit for BES investment in each company was lowered from ?1m to ?250k in last year’s Finance Act. Most of the BES Funds withdrew from the market following this, as it was not feasible to manage four times as many companies with, effectively, the same level of fund management fees. Many BES Fund Managers also felt that ?1m was a substantial amount with which a company could achieve something over a five year timeframe, but that ?250k was unlikely to be enough to make a significant difference to a growing company.
However, in the case of start-up S&T companies, one should not underestimate the value of BES as a mechanism for raising money from private investors. Many start-up S&T companies are unable to raise their required amount of first round funding because the market perceives them as being too risky. BES funding of ?250k, raised often from family and friends, can provide companies with a capital base sufficient to finance their early stage growth, and allow them to develop to a level where they can position themselves for a further round of funding. Although this can be high-risk finance, investors only effectively lose half their money in the event of a complete failure.
Enterprise Ireland
Enterprise Ireland has been instrumental in financing and assisting in the growth of numerous start-up S&T companies in the past. However, this funding is likely to be significantly reduced in the future as less EU money is available. With the reduction in funds available, competition for them from entrepreneurs will rise. Already some of the schemes under which S&T companies can access finance are competitive, i.e. companies compete among each other for the same funds. The other services offered by Enterprise Ireland are often under appreciated and under utilised - they can provide management support, mentoring programmes and, with the addition of the former Trade Board, a market research and contact service. The agency has established an office in Silicon Valley, for example, which can provide office-space to S&T companies during their first months in the US.
The Pitfalls
Selling the Vision
Every entrepreneur has a vision. Prospective investors in start-up S&T companies need to embrace this vision if they are to commit funds to the venture. Many S&T entrepreneurs attempt to raise finance without being able to communicate a clear vision of where their company is going and how it will get there. Two key areas where S&T companies repeatedly fail in convincing investors of their vision are those of management and marketing.
Frequently, attention needs to be focused on the board of directors and management team. In the absence of proven technology, investors are often investing in the ability of people to deliver. Obvious deficiencies in key areas such as finance, business development and marketing should be addressed. Appointing a reputable player within the industry to the board is the ideal scenario. This can lead to added value in terms of credibility, business development and access to strategic planning advice.
It is important to present a well-defined marketing strategy including specific details of how markets will be entered and developed in the short term. The idea of entering the UK market in year one and the US market in year two will not enhance credibility unless the finer points of each market entry strategy have been clearly demonstrated. Companies often make the mistake of not following their marketing strategy through to its operational level and this can lead to loss of confidence by potential investors.
One dimensional companies
Most small software companies evolve out of, and grow with, one core product. In many cases the technology underlying this product has been initially developed for one main customer. Such companies require finance for the commercial exploitation of this product and its development in new markets. This scenario always presents difficulties for financiers due to the increased level of risk involved with over-dependence on one product and/or one customer. While it is not always possible for companies to diversify fully prior to fund raising, it is important that one can demonstrate to potential investors how these issues will be addressed.
Staged financing
Most start-up S&T companies commence fund raising with expectations of a funding requirement and the level of equity to be released for this. Many find that these expectations seldom match what is available in the marketplace. In start-up situations, many investors will only commit their funds in stages, usually upon the successful achievement of agreed targets or milestones. Promoters of start-up S&T companies should be prepared to release equity to potential investors to access first round funding- there is always scope for building in claw-back provisions should the company exceed its targets. While promoters may have expectations as to the value of their company, they need to recognise that providers of first round finance should be compensated for taking more risk.
Raising finance for start-up companies is never easy. When operating in the Software and Technology sector, further complications are encountered. However, limited finance at start-up level is available in the marketplace. Funds can be accessed easier when companies have prepared properly and can communicate their vision effectively. |
Jim Mulqueen is corporate finance manager at Farrell Grant Sparks.
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| Article appeared in the January 1999 issue.
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